How to buy a pension with a lifetime annuity

Would retirement planning be easier if you had a pension?

It's a silly question, I know. For most people, the answer is, “Yes, of course.”

Here's a less-silly question: Did you know that you can buy a pension?

Most people I talk to don't know that. But it's true. If you want to, you can buy a pension from an insurance company. You can pay an insurance company a lump-sum of money, and the insurance company will promise to pay you a certain amount of money, which will adjust upward with inflation, every month for the rest of your life. (Or, if you prefer, they'll promise to pay a smaller amount of money every month for the longer of your life or your spouse's life.)

The technical name for such a product is a bit of a mouthful: single premium immediate inflation-adjusted lifetime annuity.

Yep, the dreaded A-word: annuity. It's true that many types of annuities are a poor deal for investors. But I hope you'll suspend your suspicion for a moment to see if this one particular type of annuity may be helpful for you.

They Let You Spend More Money

In addition to making retirement planning simpler (because of the predictable level of income they provide) this type of annuity has another major benefit: It can allow you to spend more per year than you can safely spend from a typical portfolio of stocks, bonds, and mutual funds.

If you've read much about retirement planning, you've probably come across the “4% rule.” That is, most retirement planning experts recommend withdrawing no more than 4% per year from your portfolio in the early stages of retirement.

Even in today's low interest rate environment, a 65-year-old male can get a lifetime annuity paying 5.1%. And that payout will increase with inflation every year for the rest of his life. For a female of the same age, the available inflation-adjusted payout would be 4.5%. (The annual payout is lower for women because the insurance company knows that, on average, they'll have to make payments for a longer period of time for female annuitants.)

Note: For anyone curious, these quotes came from Vanguard's site. You can run your own numbers by going to this page and clicking the “Income Solutions” link, though you'll need to have a Vanguard account first.

What's the Catch?

So far, I've made these annuities sound like an investor's dream come true. But that's not exactly the case. Like anything else, they have their drawbacks.

First and most importantly: The money disappears when you die. If you retire, put your entire portfolio into a lifetime annuity, and promptly get hit by a bus, the money is gone. Your heirs do not get a dime of it. Rather, the money goes to fund the payouts on annuities for still-living annuitants. This is the reason that you cannot build your own lifetime annuity using bonds and other fixed-income investments. Lifetime annuities provide a higher payout per year than you can safely take from a typical investment portfolio because part of that income is coming from other annuitants–ones who have passed away.

The second drawback to such annuities is that they involve credit risk. Granted, insurance companies are subject to regulatory funding requirements that make it very uncommon for them to go belly-up, but that doesn't mean it's impossible.

Finally, lifetime annuities aren't “liquid” in the way that stocks, bonds, and mutual funds are. If you find yourself crunched for cash, you cannot sell a piece of your annuity in the way that you could with other investments.

The Bottom Line

Because they allow for a high withdrawal rate, and because they provide predictable income, lifetime annuities can be a helpful tool for people who have under-saved and are now looking to safely draw the maximum amount of income from a portfolio. But this isn't a retirement tip suitable for everyone.

For investors who have saved enough to be able to deal with the unpredictable returns that come with a stock/bond portfolio, lifetime annuities may not be a good fit. In addition, even if a lifetime annuity would be a good fit for you, it's not a good idea to annuitize your entire portfolio.

More about...Retirement

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Krantcents
Krantcents
9 years ago

Annuities have hidden costs that you pay for in the insurance contract.

Mike Piper
Mike Piper
9 years ago
Reply to  Krantcents

You’re quite right that there are costs involved. I think whether or not they’re “hidden” depends on the provider.

For example, I think Vanguard is up-front about the costs involved in the annuities available through their “Income Solutions” program.

jim
jim
9 years ago
Reply to  Krantcents

There isn’t really anywhere to hide costs in a fixed annuity. Its a contract where you pay them a fixed amount today for the promise of monthly (or annual) payments for the rest of your life. Theres no hidden cost gotchas in there. Its as straight forward as a CD.

jim
jim
9 years ago
Reply to  Krantcents

[edit: didn’t really mean to reply to myself on this one… guess I hit the wrong ‘reply’ link… by the way, I really like the edit feature in the comments here. 😉 ] A few points: There are several different versions of annuities. “single premium immediate inflation-adjusted lifetime annuity” is one version. Other annuities act differently and have different purposes. So its important to differentiate between the different types. Immediate lifetime annuities can be single or joint versions. Single life pays for the life of one person. Joint life pays for the live of a married couple. Insurance companies go… Read more »

Mike Piper
Mike Piper
9 years ago
Reply to  jim

Excellent points, Jim. I hope you don’t mind if I elaborate a bit about the state guarantee associations. (I would have loved to discuss them in the article, but was doing my best to keep it brief.) First point of note: As you said, the amount covered varies from state to state. In addition, the rules regarding the coverage vary from state to state as well. (For instance, some states provide coverage only if you live there when your insurance company goes belly-up. Others provide coverage if you live there at the time of default or at the time of… Read more »

Matt
Matt
9 years ago

I actually looked into something like this awhile back. However, for those of us who are still relatively young, i.e. under 60, there didn’t seem to be an equivalent investment. A pension allows me to defer income now for income later. This annuity basically requires me to show up when I’m 60 with a lump of cash that I give to an insurance company. Based on how much I have, they calculate how long it will last. But what do I do with the cash between now and age 60? In my case, that’s 30+ years! Say I’m 30 and… Read more »

Matt
Matt
9 years ago
Reply to  Matt

Oh, and that annuity must be deferred. Meaning I pay into it at age 30, but it doesn’t start paying out until age 60+

Elliot
Elliot
9 years ago
Reply to  Matt

Most annuities cant be withdrawn until 45-60, so pretty much retirement only. If you want a vehicle to invest in now, and take out from later, you probably want a variable annuity (VA). They aren’t as risky as they had been in the past, and they provide guarantees, something few other investments besides insurance can provide. The idea for the VA is growth now, and then annuitize later. I’d say talk to an insurance advisors, but they’d probably sell you on their brand of product. It might be worth it for you to hire a financial advisor on an hourly… Read more »

Mike Piper
Mike Piper
9 years ago
Reply to  Matt

Yes, it’s possible to buy a deferred fixed annuity. But in most cases, it’s not beneficial. As Krantcents said above, there are costs involved. And there’s usually not much value in paying the additional costs until you’ve reached the point where it makes sense to “annuitize” (that is, the point when you need to start taking income).

Rather, it’s usually best to just stick with a diversified portfolio of low-cost index funds or ETFs for the accumulation stage.

bbains
bbains
9 years ago

Great article on the basics of lifetime annuities. I’d like to point out that the costs and commissions associated with this investment is also a big “gotcha.” Anyone thinking about funding this type of investment should be aware of these. I’m sure that Vanguard keeps its administrative costs very low, but other companies offering these vehicles, especially those that sell through brokers or agents, may not. A lot of the information I’ve seen on this subject has come from financial and investing columnist Scott Burns.

Elliot
Elliot
9 years ago

Good article, but it seems incomplete. A SPIA should not be the entire retirement strategy for anyone these days. If some one retires at 65 and lives to 85, that is 20 years of inflationing they will have to deal with. Some SPIAs have inflation adjustment, but they usually take 15 years before they become worthwhile. A SPIA can be a great vehicle in a carefully planned retirement portfolio. In addition to a SPIA I would recommend considering a Variable Annuity which has a lower pay out, but also room for upside growth to help with inflation. I think a… Read more »

Danielle L. Schultz, CFP®
Danielle L. Schultz, CFP®
9 years ago
Reply to  Elliot

There’s an argument for not getting an annuity that’s inflation adjusted–you get more at the beginning to spend, and if it allows you to draw down less of the rest of your portfolio, hopefully that portfolio can be invested a little more aggressively and grow for the future. It really depends on the individual situation. Best case scenario–an annuity+Social Security should cover all fixed expenses and the portfolio should cover discretionary expenses. As Mike says, an annuity can goose up possible spending if savings are not quite enough.

Elliot
Elliot
9 years ago

I agree. I just planned a case for a client who is doing part SPIA part VA. The increased cost of the inflation protection for the SPIA made no sense. Additionally she has an IRA which she will have RMDs and that along with the VA will take care of her inflation protection.

Sun
Sun
9 years ago

Aside from the downsides others have mentioned, this type of policy really seems self-centered. I don’t have children, but I want them to have a better future than I did. If I can leave them a legacy, I rather do that than give it to some insurance company I could care less about.

Mike Piper
Mike Piper
9 years ago
Reply to  Sun

You’re right that lifetime annuities are only a good fit if you do not plan to leave the money to anybody else.

For some people, that’s not particularly a concern. For others, it is. Annuities are definitely not a one-size-fits-all sort of thing.

Sun
Sun
9 years ago
Reply to  Mike Piper

It is the company’s hope that whoever signs up dies early. My children don’t get paid, but the insurance company does. Perhaps there is a shared incentive bonus structure in place to make you that much more motivated to sell this type of policy.

TC
TC
9 years ago
Reply to  Sun

I think you could also make the argument that having the means to provide a basic standard of living for yourself is relieving your children of worries that they will need to care for you financially if you outlive your retirement investments.

imelda
imelda
9 years ago
Reply to  TC

Yup. As a 26-year old already saving for my own retirement, I’m more concerned about my mom surviving hers. I’ve been thinking that an annuity might be good for her, as she has vastly under-saved for retirement.

I guess it depends on the kids’ expectations. Kids who come from a rich family and expect inheritances would probably be pissed off by this. But I don’t think they’d have any right to be; they didn’t earn the money.

TC
TC
9 years ago
Reply to  imelda

Agreed. My parents have no retirement savings whatsoever and I would find tremendous peace of mind in them having *something*, even if it meant I got nothing. Right now my parents are using concerns about my grandparents outliving their savings as a reason not to pursue assisted living options for my grandparents. There are other issues at play, but I wish the concern about them outliving their money were off the table.

Mike Holman
Mike Holman
9 years ago
Reply to  Sun

@Sun – Buying an annuity is not an “all or nothing” proposition. You can convert any portion of your retirement savings to annuities – it doesn’t have to be 100%.

For example if you have a million dollars – you might use $750k to buy an annuity to live off and keep the other $250k for your heirs.

Madeline
Madeline
9 years ago
Reply to  Sun

Our son has a great job within a school system and will qualify for a state retirement pension when he is 50 years old! His Dad and I have run our own business for over 30 years, no group health insurance, no pension, and our savings are not making much money at this time in history. We wanted to retire at age 55 but are now past that with no possiblity of retiring in sight for a while– In a few years we may want to look at the annuity option. I’m not forgetting our son.. but we do need… Read more »

Moneyperk
Moneyperk
9 years ago

This is why I prefer to retire from liquid assets. And Certain IRA’s are beneficial with the right policies.

Karen
Karen
9 years ago

I started a flexible annuity with USAA in August. I’m 22 years from retirement, but I’m planning to use it as a do-it-myself pension fund. I *can* withdraw it all after 7 years if I want to, since it isn’t structured as a retirement vehicle. I also had to name a beneficiary. Maybe the beneficiary is only for the accumulation stage… I’m not sure about that. Also, if I were unable to contribute towards it for a time (i.e. because of job loss or whatever), because I live in Washington, the $30 annual fee that would kick in still wouldn’t… Read more »

Sun
Sun
9 years ago

Funny that Suze Orman just covered this on her radio show recently:

http://www.suzeorman.com/igsbase/igstemplate.cfm?SRC=MD012&SRCN=aoedetails&GnavID=84&SnavID=29&TnavID=&AreasofExpertiseID=107

She’s against annuities and she explains why.

the other Tammy
the other Tammy
9 years ago
Reply to  Sun

Suze Orman is not a financial planner. She is a TV personality.

Get some sound advice from a REAL financial planner who will look into your individual situation. There are about a million different variations of annuities–it is not a one size fits all type of product.

MC
MC
9 years ago

How does this compare to Whole Life policies in all. I’m 33 and recently met with an insurance sales person, dressed as a FP and they were trying to sell me on this. I just didn’t see the benefits.

Mike Piper
Mike Piper
9 years ago
Reply to  MC

I don’t know how to put it more succinctly than, “they’re completely different.”

I agree that whole life policies rarely make sense. Plain old term life insurance is usually a much better deal.

Life insurance pays benefits when you die (though there are various types of policies that provide various benefits while alive). Annuities pay benefits while you’re alive.

bob
bob
9 years ago
Reply to  Mike Piper

Not to get too far off topic, but when are the times when a whole life policy makes sense? I’ve always read that whole life policies “can make sense for certain people/situations” but I’ve never really understood what exactly they are.

Mike Piper
Mike Piper
9 years ago
Reply to  bob

It generally only makes sense if you actually have a permanent need for life insurance. Most people don’t. For most people, after a certain point, their kids are independent, they have a pile of savings that the spouse could live off of, and they’re not earning any income anyway. So there’s just no need for life insurance at all. In those cases (which is nearly all), it makes sense to just get a term policy that covers the period for which coverage is necessary. Permanent coverage is sometimes desirable (possible examples: estate planning purposes or business succession arrangements for a… Read more »

Ross Williams
Ross Williams
9 years ago
Reply to  bob

I think this is standard media talk designed to not offend the insurance agents who sell whole life insurance. Which is why you can’t find many descriptions of people it actually applies to. The one thing whole life insurance does is to create enforced savings. My father bought whole life policies for my brothers and I that were then used to pay our college tuition when we turned 18. They also served the function of setting expectations for his kids. There are probably other, and better, ways to do both of those. The other thing is that everyone will have… Read more »

Ron
Ron
6 years ago
Reply to  Mike Piper

Are you licensed for selling Insurance products? I am. There are many different life products available that are applicable to the many different needs and goals of an individual based upon their circumstances and phase of life.Term has its applications as does whole life. Neither is better than the other as they each have different applications. I do not think it is very responsible for a CPA to advise on Life Insurance unless they are licensed to do so and have experience in the industry. I know my clients certainly would not want me to do their taxes! Nor would… Read more »

Ross Williams
Ross Williams
9 years ago

“a 65-year-old male can get a lifetime annuity paying 5.1%. And that payout will increase with inflation every year for the rest of his life. For a female of the same age, the available inflation-adjusted payout would be 4.5%”

For a couple the question is what they can get for an annuity that covers both partners. I believe that is less than the 4% you would get from the standard withdrawal from investments process. So this is actually only a good deal if you are single.

Mike Piper
Mike Piper
9 years ago
Reply to  Ross Williams

Well, at least in theory, the 4% withdrawal rate should be adjusted based on whether we’re talking about a single investor or a married couple — for exactly the same reason that the payout on a lifetime annuity changes depending on whether we’re talking about one annuitant or two. In practice, because the 4% guideline is just a very broad rule of thumb anyway, that fact tends to get glossed over (i.e., ignored completely). Lifetime annuities are neither a better nor worse deal as a result of being married. But, as I’ve said above, they’re not a magic bullet by… Read more »

Ross Williams
Ross Williams
9 years ago
Reply to  Mike Piper

Mike – As I understand the 4% it is not based on any actuarial data for life expectancy. Instead it is based on the likelihood that your savings will survive at least until age 95. So, if there is any adjustment needed even in theory, it would be minuscule. It would be based on the possibility that the increased chances of one of you living beyond age 95 would increase the chances of exhausting the savings. Its helpful to note however, that the 4% rule of thumb does not give you the same security that an annuity will. Its likely,… Read more »

Mike Piper
Mike Piper
9 years ago
Reply to  Ross Williams

You’re right that the origin of the 4% guideline was a series of studies checking to see how various allocation and withdrawal rate combinations would have held up over historical periods of various lengths (usually 30 years). But the likelihood of making it 30 years (or any other particular length of time) increases meaningfully with two people rather than one — though how the investors choose to deal with this increased likelihood of “portfolio failure” is something that will vary from person to person. In any event, I agree with your overall conclusion: The investor’s comfort level with the idea… Read more »

imelda
imelda
9 years ago

I thought there were annuities that returned the money to the estate after the client died? Do those just pay out too low to be worth it?

Mike Piper
Mike Piper
9 years ago
Reply to  imelda

Yes, you can get all sorts of additional riders on annuities. For instance, you could get one that pays out for your lifetime, or for at least 20 years, should you not live that long.

But you guessed exactly right: The additional cost of these riders tends to lower the payout on the annuity to the point where it’s no longer particularly beneficial.

Andy
Andy
8 years ago
Reply to  imelda

Good question.The obvious variable here is the term as none of us know how long we will live this has an effect on our return. The longer we live the better our rate of return, the shorter our life — the worse our return.

BB
BB
9 years ago

Intriguing idea. I never thought about adding an annuity to my bag of retirement tools.
I’d love to see a GRS post on planned giving annuities. JD, is that possible? My alma mater advertises age-adjusted returns that start at something like 7% and go up to 10 or 11%. Sounds too good to be true.

Elliot
Elliot
9 years ago
Reply to  BB

Yes its possible to gift annuities. Non profits like them because it gives them a nice stream of income. Donors like them because they get the immediate tax deduction.

Ross Williams
Ross Williams
9 years ago

Just to be clear: The 4% rule of thumb is based on the likelihood your savings will last 30 years if you start by taking out 4% the first year and then adjust annual withdrawals for inflation. Your life expectancy and your spouses life expectancy have no effect on that number, although 30 years may not be long enough if one or both of you are long-lived. By contrast, the annuity is based on life expectancy. An annuity that pays until both spouses die is going to pay considerably less than the percentages mentioned above for just one spouse. One… Read more »

Matt
Matt
9 years ago

Some good points in this article, some things that are a little inaccurate. Check out these YouTube videos on annuity basics and myths and truths–they can set the record straight on a few things.

Annuity basics: http://www.youtube.com/AllianzUS#p/u/0/EW7go2Couxk

Myths and truths: http://www.youtube.com/AllianzUS#p/u/1/ukXP-J0QbFQ

Annuity basics:

Mike Piper
Mike Piper
9 years ago
Reply to  Matt

Matt, could you elaborate on what was inaccurate?

Steve
Steve
9 years ago
Reply to  Matt

Is there a non-video version of this information?

Richard Hoops
Richard Hoops
6 years ago

Not sure you’ve discussed all annuity options. I have purchased two annuities. One has no fees, the other charges 1%. In both cases, my heirs receive any remaining cash balance upon my death. By contract, I can not lose principal, regardless of what the market does, but can gain when the market goes up.

bfeldstein
bfeldstein
6 years ago
Reply to  Richard Hoops

what companies are these with and what state
do you live in and what are the names of the annunities?
is there a minimum amount to purchase?

Melvin Gishal
Melvin Gishal
6 years ago

Annuity settlement normally comes about because of legal undertaking. It takes the manifestation of an organized settlement installment program in concurrence with an outsider. Customarily these resolutions are legitimate, however they can likewise be connected with an extra security or other protection approach payout too. An organized settlement normally comprises of occasional installments hit over a sensibly long time period. These installments are made on a general timetable to the person who has gotten the settlement through real process. The installments could likewise be diverted to a beneficiary in cases like the life coverage payout.

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