If you are retired, or retiring soon, you may be approached by someone offering you the opportunity to buy an annuity. This might or might not be a good idea for you, but frankly, it’s hard to know for sure. Annuities have some important advantages, and some important disadvantages.
First, what is an annuity? In simplest terms, it’s the guarantee of a regular payment from one party to another, without any (new) obligation on the part of the recipient. Social Security, for example, is an annuity – once you qualify, you receive payments for life, without having to do anything. Old-fashioned pension plans, which some employers still provide, are also a form of annuity – again, in most cases, you get an income for life, after you retire, with no further work or payment by you.
This is obviously a great deal, once you start receiving it. “Free” money – except that in the case of Social Security and pensions, you have paid for it in other ways, through your taxes or your labor. Still, income for life is a wonderful thing, if you’re retired.
One problem with retirement these days is that most employers do not still offer traditional pension plans, and so apart from Social Security, there is no additional income for life. Employers who do offer retirement benefits usually do so in the form of a 401(k) plan (or something similar), where the employee accumulates an account balance, often with employer contributions provided – which is great, except that it’s then up to the employee – you – to figure out what to do with it. And if the money runs out, say, when you’re 85, and you’re still healthy (or worse, you’re not healthy and have medical bills to pay), you’re stuck. Social Security alone is not going to cut it for most of us.
One solution is to buy your own annuity. An insurance company will be happy to take a portion of your 401(k) plan or other retirement savings, and guarantee you an income for life, even if you live past age 85, and even if you live to 120, or older.
The obvious advantage is that you’ll never run out of income. The less obvious advantage is that even if you live just to a normal life expectancy, you’ll probably still come out ahead, because the insurance company can afford to invest the funds more aggressively than you can, not only because they’re so much bigger, but also because if you manage your own income and try to stretch it out for life, you really need to be careful with it, and not take the chance of losing any, so you have to invest more conservatively.
The big obvious disadvantage, of course, is that you give up control of the money to the insurance company. You do get your nice check from them every month, but if something comes up in your life where you need more money, they have it, not you, and you can’t get it. (Actually, you can get annuities that allow access to your money later, but you pay a lot for this privilege, in the form of lower monthly payments made to you, even if you never take advantage of it – and if you do take advantage of it, then it costs you even more. I consider this a bad deal, and recommend against it.)
The other disadvantage is that if you happen to die shortly after you buy the annuity, you lose the bet, because the insurance company keeps your money. Of course, they don’t really keep it – most of it goes to paying other people who bought annuities and lived on into old age. But the point is, your family doesn’t get it. Again, you can get annuities that will guarantee a minimum number of years of payments (usually 5, 10, 15, or 20 years), so that your beneficiary would get them for some period, even after you die, but as before, you pay for that up front and for the rest of your life by receiving lower monthly payments than you would without that provision. So again, I do not recommend this solution.
Instead, my recommendation is that you not put all of your retirement savings into an annuity, and for any portion that you do want to commit to an annuity, don’t do it all at once. For example, if you had $200,000 in an IRA, you could leave half of it there more or less permanently for future needs (e.g., nursing home care some day), and you could plan to put $100,000 into an annuity. But instead of doing that all at once, put in just $25,000 to start with, and wait a few years before putting in the next $25,000, and so on.
This way, you do not seriously impair your ability to meet other needs you might have. And if you do die in the next year or two, your heirs have not lost very much. But you will probably find that you really like getting that check in the mail every month, and after two or three years, you’ll be very ready to put in the next $25,000. And if you do, you’ll get a nice bonus – since you’ll be older then, and your future lifespan will now be a bit shorter than it had been the first time, the insurance company will be able to pay you a higher monthly amount off the second $25,000. And then higher again for the third and the fourth $25,000.
But then again, an annuity might not be the right thing for you at all. It depends on the details of your financial situation, and how concerned you are about the risk of running out of money versus other risks you face. But if you have any significant amount of savings, it is almost always worth considering.
At the least, it will help you stay disciplined about your level of expenses in retirement. Too many people who have big lump sums available spend them too fast. Though not technically a “risk,” since it’s under your control, it actually may be the biggest financial risk you face in retirement. We Baby Boomers have not been famous for our self-control, especially concerning money!
Chuck Yanikoski is a retirement adviser who lives and works in Harvard. For more about him, or to contact him directly, visit www.ChuckYRetirement.com.