That people are living longer, healthier, and more active lives is a sign of a society's economic success. But with that success comes the risk that you could outlive your money or see its purchasing power seriously eroded by inflation.
In either case, buying an immediate -- or income -- annuity is a way to limit these risks. An insurance contract that gives you immediate income as soon as you buy it and keeps paying for as long as you live, it takes many forms and offers varying levels of income (table, page 94). The amount you get depends on your age and gender (on average, women live longer and will receive payouts for more years) and on the insurer's decision about how much to pay you, given its current and future investment returns, its overhead, and its profit.
An immediate annuity shouldn't be confused with a variable annuity, which is an investment product used to save for retirement. Variable annuities have been criticized for high fees and surrender charges, which you must pay if you want to take out your money before a specified period.
Before you start shopping for an immediate annuity, determine whether you need one. That means drawing up a spending plan and comparing that to your income sources such as Social Security and pensions. Most likely, there'll be an income gap to fill. But if you have a hefty nest egg -- say, $3 million -- chances are that regular withdrawals from your portfolio of 4% or 5% a year would do the trick, and you would not need an annuity.
If your income falls short of your spending plans, an immediate annuity could help. You can buy one with your IRA or 401(k) money. The payouts you receive from the annuity will be subject to ordinary income tax, and even if you're not 591/2 yet, you won't have to pay the 10% early withdrawal penalty. You will have to annuitize the entire amount of money in all your IRAs or in your 401(k) to do this.
WISER TO WAIT
If you purchase an annuity with money from outside a retirement account, you're getting a "non-qualified" annuity, which is taxed differently. Suppose you're a 70-year-old man who puts in $500,000. Based on estimates of your longevity, you're expected to receive $750,000 over your lifetime. The Internal Revenue Service considers $250,000 -- or one-third of the total -- as not having been taxed and will require you to pay income tax on one-third of each check you receive.
Even if you think you'll need an income annuity, you should consider postponing the purchase for a few years after you retire. One reason to hesitate is that the older you are, the more you'll get for your money, because the insurance company will be covering you for fewer years. Another is that "once you're in the product, most immediate annuities don't allow you to get out," says Timothy Pfeifer, principal and actuarial expert at consulting firm Milliman in Chicago. Pfeifer points out that some annuities do offer a "limited liquidity window," allowing you to get out if you go into a nursing home or become disabled.
If you're ready to buy an income annuity, you need to zoom in on the features you want. What's key is how changing the terms of the contracts affects the payout. With the Lifetime Income Annuity, an "annuity with cash refund" sold by New York Life Insurance, a 65-year-old man putting down $500,000 could receive $2,981 a month and be assured that the unused cash in the policy will go to his survivor. If he wants a guaranteed 3% a year increase in addition to the cash refund, he'll start off with only $2,243 per month. Another feature in the same policy is that if he has an emergency, he can withdraw up to six months' worth of payments in advance as a lump sum, in return for forgoing payments for the next several months.
Comparison shopping for annuities is tough because the vendors tweak the features so that no two are exactly alike. For instance, the Vanguard Lifetime Income Program, an annuity underwritten by American International Group Life Insurance (AIG) and American International Life Assurance of New York, allows you to choose either fixed or variable income payments. Options include a fixed payment that goes up each year from 1% to 5% or one that tracks the consumer price index (CPI).
The following figures could change at any time, but here's an example. For a 65-year-old man who wants to include survivor benefits for his 60-year-old spouse, the fixed payment from a $500,000 annuity would be $2,521 a month; if the annuity is tied to the CPI, the payment would be $1,635 and would vary annually based on the rate of inflation. With the variable income product, you still get a minimum fixed payout; the rest is determined by the investment funds you choose.
Once you know what kind of features you want, Pfeifer advises that you base your annuity purchase on two main factors -- how much income you'll get for the amount of money you put down and the financial strength of the insurance company. (You can find company ratings at ambest.com, weissratings.com, and moodys.com.) After all, you don't want to outlive the insurance company any more than you do your money.
By Ellen Hoffman