Set Up a Future Retirement Income, with New-Style Annuities

Last Updated Jun 3, 2010 4:53 PM EDT

If you're saving for retirement and want to lock in a future income on favorable terms, consider buying a tax deferred variable annuity with lifetime guarantees. The prices being offered now are probably too good to last.

Note that this deal might not be best choice for people who need income now. It's for people looking ahead.

The right buyer is someone in late middle age who wants to put part of his or her savings toward a guaranteed future income and won't need to touch the money for at least 10 years.

Praise for these contracts is surprising, coming from me. I've never liked traditional tax-deferred annuities, and still don't. They're basically mutual funds in an insurance wrapper. The annual expenses are high, compared with what you'd pay for those same funds outside the annuity. Worse, your earnings are taxed at high, ordinary income rates rather than at the low rates for capital gains.

When annuities with lifetime income guarantees first appeared on the scene in 2002, I didn't like them either. Buyers were often told that their future payouts would exceed the guarantees, thanks to the expected rise in the value of stocks. The bad markets of the "Naughties" decade wrecked those hopes.

But for people without pensions, the guarantees themselves are attractive, despite the fees. In fact, they're more generous than they should be, in the view of Colin Devine, an analyst of insurance stocks for Citigroup Investment Research. "The insurance companies will never earn back their cost," he says. When they accept that, he says, they'll start offering less attractive deals.

There are two types of annuities with future income guarantees, and each insurance company has its own variants. I'll outline how they generally work, based on an initial investment of $100,000 and assuming that you're not withdrawing any money:

An annuity with a guaranteed minimum withdrawal benefit. The company promises to pay you a lifetime income of, say, 5 percent of the value of your account. Every year, your account goes up by a fixed amount -- the "step-up," now also 5 percent -- regardless of what happens to the investments inside your annuity. At the end of 10 years, your account value will have risen to about $163,000. You can then withdraw 5 percent of that amount, per year, for life -- even if your annuity is worth less than the money you put in.

An annuity with a guaranteed minimum income benefit. In this case, the insurance company guarantees that your benefit base will increase by a fixed annual amount -- say, 5 percent. In the future, you can turn that into a fixed annuity that pays you a monthly income for life. (The only two big players in the market are MetLife and Axa.)

In theory, the investments in either annuity could earn even more than the guaranteed 5 percent. But in real life, that's not likely to happen, Devine says. The annuity's expenses can exceed (are you ready?) 3.5 to 4 percent a year, including the cost of buying income for your spouse if you die first. The market has to boom for you to beat the guarantee, after costs.

But a pre-retiree today might be very happy to lock in a 5 percent increase in his or her principal for the next 10 years.

Devine says that he owns nine of these fancy annuities, diversified among the biggest and safest insurance companies. He bought them for safety. "I don't have any risk tolerance anymore," he says. "Citibank has aged me." (Citi stock dropped from $53 three years ago to $4 today.)

Over the past year, insurance companies -- worried about the future profitability of these deferred income annuities -- have started to raise the fees and reduce the benefits. Devine thinks they're still a good buy. The terms offered today, he say, are likely to be reduced again.

If you bought an annuity during the fat years of 2004 to 2006, you can add money to it, on the older, more generous terms.

One warning comes from Kevin Loffredi, co-founder of Annuity Intelligence Report, which helps salespeople understand how all the contracts work. How you title these annuities -- who's the owner, who's the beneficiary, who gets the income after a death -- is complex. If you make a mistake, your spouse might be cut out or extra taxes might be due. Be sure that the salesperson checks his or her work with the company's legal eagles.

Now let me switch gears and talk about people who want monthly income immediately. You can get it from these annuities, but it usually stops the guaranteed annual step-up in value. (The MetLife and Axa products still rise by the 5 percent you took out.)

Financially, you could do better by putting part of your $100,000 toward a plain vanilla immediate-pay annuity that gives you fixed lifetime payments, starting now (for prices, see ImmediateAnnuities.com).

Put the rest of the money in something safe -- say, a high-quality municipal bond. Together, they'll pay you a higher monthly income than you'd get from the higher-cost income annuities, discussed above. You might also choose a stock-and-bond mutual fund instead of a muni bond, to try for more growth.

The difference is control. If you die before using all the money in the immediate annuity, it might go to the insurance company. With the newer, deferred-income annuities, it goes to your heirs. That might seal the deal.

More on MoneyWatch:
Monthly Checks for Life: 5 Rules for Immediate Annuities
Boomer Nest Egg Anxiety: Will It Produce Enough Monthly Income?
Make Your Money Last for Life
  • Jane Quinn

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