(MoneyWatch) Many people assume I'm against all annuities, which is reasonable, considering the amount of time I've spent criticizing them. But I have no bone to pick with them. I actually think that a simple annuity, one where you pay a flat amount up front to receive monthly cash for the rest of your life, can make sense for part of your portfolio. In fact, I just sold one a couple of months ago, and I don't even have an insurance license. Let me explain by describing the process.
In search of income
A couple recently came to me for advice. Let's call them Paul and Paula. The husband was 66 and about to retire; his wife was a year younger. They had done all the right things, living below their means and accumulating for four decades.
Like nearly all people I've found who were programmed to accumulate, they were deathly afraid of spending down their portfolio. They wanted income. The couple had two questions to ask: Should Paul take Social Security now, and should they buy a single-premium immediate annuity that would give them "income for life"? They believed they had long life expectancies, based on current health and family history. I explained that though the annuity would give them cash for life, most of that cash was merely a return of their principal.
I also explained that taking Social Security now would reduce the amount being withdrawn from the portfolio but they would be giving up a higher Social Security paycheck later. If Social Security were delayed until Paul reached age 70, the four additional years would raise his payment to $3,497, while accessing funds today would mean a monthly check of $2,510, a difference of $987 a month. If left invested, that $987 would grow with inflation, and Paula would receive the additional money in the form of a survivor's benefit when Paul passed away .
If we assume the $2,510 monthly payment Paul could receive now would grow at three percent annually -- the long-run inflation rate -- Paul would give up about $126,000 and thus need to withdraw the funds to live on during retirement. That's a hard pill to swallow.
By waiting four years and then taking the higher Social Security check, Paul is essentially buying what a deferred annuity. It's similar to a single-premium immediate annuity except the monthly cash flow is deferred to a later time.
I turned to Kelli Hueler of Income Solutions to get a comparable quote on the open market. Working with me, he determined the closest equivalent would be to buy an income stream of $987 a month beginning in four years that would increase by 3 percent annually and have a 100 percent survivor benefit.
On the private market, Hueler noted no annuity promised a CPI escalator and the highest out there offered a 3 percent annual increase. Also, we picked a 100 percent survivor benefit because Paula's Social Security payment would increase if Paul passed away first, statistically likely since Paul is a year older and men do not live as long as women on average.
Hueler found the best price for such an annuity was about $235,500, or about $109,500 more than the $126,000 in checks the couple would give up by waiting four years.
In waiting four years to access Social Security funds, Paul and Paula in effect bought a deferred income annuity at a 46 percent discount to the best price in the open market. And their annuity is backed by the U.S. government and would protect them from the possibility of inflation above the historic of 3 percent average.
Though I had no sexy sales brochures to persuade them, I was able to sell the couple on the idea of buying this government annuity by waiting four years.
I ran my logic by my colleague Steve Vernon, author of "Money for Life"; Mike Piper, author of "Social Security Made Simple"; and Kelli Hueler, and they agreed: The best annuity on the market to protect against outliving one's money is to delay taking Social Security payments. They also said that they couldn't think of a scenario where one should take Social Security benefits before age 70 and buy an annuity on the open market.
After decades of contributing to Social Security, it's human nature to want to have the money returned as soon as possible. And it's always possible the U.S. government could start cutting benefits, though I'd hate to be the politician that votes for that. My advice is that you should think of the benefits you are giving up as premium payments to buy a deferred income annuity backed by the government at a fraction of the price you could buy something comparable on the open market. If you are in good health, it's a no brainer.