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IRAs and 401ks: Maximize Retirement Income with Immediate Annuities

This post continues my series that advocates using IRAs, 401k plans, and other retirement savings to generate a lifetime monthly paycheck. The kickoff post summarized three ways to generate retirement income:

  1. Invest your savings, and spend just the interest and dividends.
  2. Invest your savings, but draw down principal cautiously so you don't outlive your assets.
  3. Buy an immediate annuity from an insurance company.
I covered option No. 1 in my second post and option No. 2 in my third post. In this fourth post of the series, I'll explore the third method -- buy an immediate annuity from an insurance company -- in greater detail.

For those people who don't have substantial lifetime pensions from their employer, I like the idea of using an immediate fixed annuity for a portion of their retirement savings. This option provides a monthly paycheck for the rest of your life, no matter how long you live and no matter what happens in the economy or the stock market.

An immediate fixed annuity protects against two significant retirement risks: investment risk, which is the risk of your investments declining in value, and longevity risk, or the risk you'll live longer than expected. It won't protect you against another serious retirement risk -- inflation -- and that's why you shouldn't invest all your retirement savings in an immediate fixed annuity.

Before we go much farther, let's define some terms:

  • The word annuity usually refers to a stream of monthly income payments that are paid to you for the rest of your life, no matter how long you live.
  • An immediate annuity refers to a monthly stream of lifetime income that starts right away.
  • A deferred annuity is an investment account with an insurance company that's used in the accumulation phase of your life. Deferred annuities often have high sales charges and poor investment performance, and they've given annuities in general a bad rap. Please note that I'm not talking about deferred annuities in this column.
  • An immediate fixed annuity means that the amount of monthly income doesn't change.
  • An immediate variable annuity means that the amount of monthly income is adjusted to reflect the rate of return on an underlying portfolio of stocks, bonds, or cash investments.
  • A life annuity is an immediate annuity that is paid only for your lifetime. When you die, the payments stop.
  • A joint and survivor annuity is an immediate annuity that continues the monthly income to a named beneficiary -- typically your spouse or partner -- after your death. Payments stop when both you and your beneficiary are no longer alive. I generally recommend joint and survivor annuities for any married or committed couple. For husbands, it's a good way to prevent leaving a desperate housewife after you die.
There are two drawbacks to buying any type of immediate annuity:
  1. Once you buy the annuity, you can't change your mind and get your money back (there are a few exceptions, which I'll address in a future post).
  2. When you and your beneficiary die, no money goes to your heirs.
These two drawbacks are the price you pay for a significant advantage of an annuity: An immediate annuity usually generates the highest amount of retirement income, compared to the other two methods, which are living on interest and dividends, and managed payouts. These two methods don't have the above drawbacks, but they generate lower retirement income compared to the annuity. So you have trade-offs between these methods of generating retirement income, which is why I recommend that you split your retirement savings between an annuity and one of the other two methods.

Why can you get more lifetime income from an annuity? An insurance company looks at average life expectancies when they price immediate annuities for large groups of people -- they can use the law of large numbers for this.
When you withdraw from retirement savings on your own, you have to manage to the worst case, which is you living well beyond your life expectancy. You need to manage to the law of one number -- you! In this case, if you fully understand longevity risk, you become paranoid about outliving your money, so you're appropriately cautious and withdraw from your savings at a low rate. Being successful at managing your money so that you don't outlive it usually means you die with money in the bank -- money that you could have spent had you known exactly when you will die.

An annuity allows you (and the insurance company) to apply all of your principal to generating retirement income without any money left over after you die. In essence, you "die broke" if you invested all your retirement savings in an annuity. Now some people don't want to "die broke"; they may want to leave money to their heirs. If they can manage to live on just interest and dividends or very low withdrawals from principal, then they might not need an immediate annuity.

For those of us who would like to generate as much income as possible during our retirement years, here's how immediate annuities meet the criteria for evaluating retirement income generators that I introduced in my previous posts on this topic.

  • Amount of initial income: High
  • Potential for growth in income: No potential with fixed annuity. Variable annuity provides potential for growth, depending on underlying portfolio.
  • Access to/preservation of principal: No
  • Protection against investment risk: Yes with fixed annuity. No with variable annuity.
  • Protection against longevity risk: Yes
  • Effort to set up: Moderate -- you need to select the type of annuity and a specific insurance company.
  • Ongoing maintenance: None or very low. You'll appreciate this when you're older and are less able to manage your financial resources.
  • Ability to change to other methods: No
There are many considerations for buying an immediate annuity, such as:
  • How do you shop for the best deal?
  • How should you consider the safety of the insurance company?
  • Should you consider certain variations or innovations, such as guaranteed minimum withdrawal benefits (GMWB) or variable annuities, that attempt to address the drawbacks mentioned above?
  • What if you're in poor health?
  • How much of your retirement savings should you apply to an annuity?
I'll address these issues in upcoming posts, and will provide an example that demonstrates how annuities generate higher retirement income compared to the other two methods. Given the meager 401k and IRA balances of most boomers, they'll need to squeeze as much retirement income as possible from their retirement savings.

One thing's for certain: You'll need to spend some time learning and analyzing whether an immediate annuity makes sense for you. Consider it part of your training for retirement. And since you're planning for a 20- to 30-year period, I'd say it's time well spent.

More on CBS MoneyWatch
IRAs and 401k: 3 Ways to Generate Lifetime Retirement Income
IRAs and 401k: Generate Retirement Income with Just Interest and Dividends
IRAs and 401k: How to Generate Retirement Income with Managed Payouts
Husbands: Poor Retirement Planning Could Lead to Desperate Housewives

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