Annuities: Can They Help You Retire?

(MoneyWatch)  There's lots of talk these days about how annuities can help you live a more secure retirement. So is it true? Well, that depends on what you mean by secure and what you mean by an annuity.

The annuity analysis is complicated and can be approached from many different perspectives. For this post, I'm only going to focus on one particular aspect of the annuity, and that's the income it can produce compared to the income you could produce from a portfolio of bonds.

First, let's look at what's called a true annuity. A true annuity is a lifetime payment that you receive from an insurance company. It's like a private pension. The way it works is you give an insurance company a chunk of money, and based on your age, they guarantee you a certain income for the rest of your life.

• These types of annuities are also referred to as "single premium immediate annuities" or an SPIA.
• Using an SPIA will generally provide you with the highest lifetime income payment for any given amount of money. So it's the type of annuity you want to look at if your concern is maximum income.

With an SPIA, you no longer have access to your retirement money. You have literally given it to the insurance company, and it's theirs to keep forever. What you get back is a contractual right to the income stream for life.

The income for life deal sounds good, but to me it comes at a high cost. And the cost is the fact that you have to give up ownership of your retirement assets.

So let's assume you decide to keep your money and invest it in a diversified portfolio of investment-grade, corporate bonds. When you invest in individual bonds, you have a legally enforceable right to the interest payments for the life of the bond, and then you have the right to get your money back when the bond matures. Thus, both the annuity and the bonds provide an annual income stream; but with the immediate annuity, you don't have the right to get your money back, and with the bonds you do.

• Of course, with both the annuity and the bonds, the ability to receive your income payments and get your principal back is dependent on the financial strength and survivability of the company that owes you the money. So there's always a risk you might not receive what was promised.

I recently ran an immediate annuity quote (from one of the strongest insurance companies in the market) for a 65 year-old couple with $1,000,000 to invest in an annuity. The insurance company agreed to pay this couple about $62,600 a year for as long as they lived. That's about a 6.26% payout on the $1,000,000.

If you're willing to take a fixed income payment from the annuity company for as long as you live (probably another 25 to 30 years), the question is, how much interest could you generate on high-quality corporate bonds if you were also willing to take a fixed interest payment for 25 or 30 years? You might be surprised to learn that many companies issue bonds that mature 25 and 30 years from now. In fact, many of the insurance companies that would like to sell you an annuity will also sell you their 25 and 30 year bonds.

On a diversified, long-term, investment grade bond portfolio, you could generate somewhere between $55,000 and $58,000 of interest each year. So slightly less than the annuity, but you get to keep ownership of your $1,000,000. The $1,000,000 is represented by the value of the bonds you own. When they mature, you have the right to get your money back, and you always have the option to sell a bond prior to maturity. So you have flexibility. And if you pass away prior to the bonds maturing, the bonds can be inherited by your heirs, so the value remains in the family.

I'm not making a judgement about whether long-term bonds are better than an annuity. In both cases, I would be apprehensive about locking up any portion of my money in a fixed-income payment for 30 years. Moreover, in both cases, you bear the risk that the insurance company or the companies issuing the bonds may not be around for 30 years to pay you what you're owed. After what just happened over the last two years, that's got to be a concern.

The annuity decision is quite complicated. There are different types of annuities and tax issues to consider, and there's no way to cover all of that in one post. As an investor, you need to take in different perspectives about annuities. The insurance industry of course feels much differently than I do. And annuities can provide people with a convenient way to structure a base retirement income.

But to me, the fundamental issue is who owns and controls your capital. I like to own and control my money, so I favor strategies that allow me to create income and keep all my money.

Bottom line. Before you enter into any transaction that you can't change for the rest of your life, make sure you understand how it works and consider other alternatives so you can make an informed decision.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.