Immediate Annuities: Friend or Foe?
A few weeks ago, a reader named Richard emailed me with this exact query:
“Is having a non-inflation indexed payment stream desirable? Are there other better options?”
It didn’t surprise me at all that Richard wrote in with this question. If you ask Google whether you should buy an immediate annuity or not, you will find an astonishing 500,000+ search results. This is excellent evidence that annuities — and especially immediate annuities — are a hotly debated topic.
The first thing we need to do to answer that question is to get everyone on the same page with the definition of an immediate annuity. Fortunately, I think Richard answered that question within his query; an immediate annuity is a non-inflation indexed payment stream. In other words, an immediate annuity is a long-term contract you purchase to receive immediate regular payments in exchange for a lump sum investment. Underlying investments can be fixed or variable, and income options can last for life or for a specific length of time.
It’s also important to note that immediate annuities are not the same thing as variable annuities. A variable annuity is another type of product that offers returns that can vary depending on the underlying stocks, bonds, or money market funds you choose to invest in. With a variable annuity, you get tax-deferred treatment of earnings, a death benefit, and annuity payout options that can last for life.
For this piece today, we’re talking about an immediate annuity with lifetime payments funded from a portfolio withdrawal. You could choose to have an immediate annuity payout for a specific time period – say ten years – then the payments would stop. However, you could also choose to receive payments for life. In the case of a specific payout period, payments are based on market interest rates, in the case of lifetime payments, payments are based on life expectancy.
When listeners write in asking about immediate annuities, they often have several reasons why they are curious about this particular product. Lifetime income is obviously a concern, but the real question dives deeper into topics like fear of extreme longevity and anxiety of outliving one’s investment portfolio. Upon further conversation, listeners are worried about running out of income in old age and don’t want to subsist on ramen noodles and cat food. Can’t say I blame them!
So, let’s see how much an average retiree with $100,000 could expect to receive if you did buy an immediate annuity at age 60. If you plug those numbers into an annuity calculator, you’ll find that you could invest $100,000 now and expect to receive around $500 per month for as long as you live.
That doesn’t sound bad at all. After all, $500 per month works out to $6,000 per year. If he starts with $100,000, that’s a six percent withdrawal rate. That’s better than the 4 percent most financial advisors suggest you stick to when taking cash out of your portfolio.
Keep in mind that you can also buy an annuity that covers both you and your spouse. In that case, and with the same amount of money upfront, you could expect to receive around $400 per month.
This sounds like a pretty good deal, but should we all rush out and buy an immediate annuity the day after we retire?
The Immediate Annuity You Already Own
It’s possible an immediate annuity could make a ton of sense for your financial situation and life expectancy. But, what if I said you already owned the best annuity in the world?
This annuity offers payments you can’t outlive and a 100 percent survivor benefit for the largest benefit between two spouses. The best part is, the benefit grows by 8 percent per year every year you defer!
In case you haven’t caught on yet, I’m talking about Social Security – the strongest immediate annuity in the world!
If you’ve listened to the show for a while, you know how often we mention the benefits of delaying Social Security. The problem is, almost nobody takes this excellent advice.
According to the Social Security Administration, just 4.6 percent of women and 2.9 percent of men first claimed Social Security benefits at age 70 or older in 2016. In other words, almost everybody took their benefits early at a huge loss.
So, should you focus on delaying Social Security, buying an immediate annuity, or both? In my opinion, immediate annuities could be an important part of not outliving your income, but I would consider it only after you max out your social security. This is because Social Security is a better annuity than slicing a large part of your portfolio off to create an annuity.
There are a few reasons why:
- Spousal option: You might be able to qualify for a spousal option with your immediate annuity, but your monthly benefit may be reduced. On the other hand, spousal benefits are much more streamlined with Social Security.
- Inflation: Immediate annuities are generally a level benefit, but Social Security almost always offers an increase to cover cost of living. In 2018, the cost-of-living adjustment (COLA) is 2 percent.
- 8 percent growth: Social security offers an astounding 8 percent growth for each year you defer your benefit. This is offered in the form of delayed retirement credits (i.e. higher payouts later on).
To decide between buying an immediate annuity or deferring Social Security payments, you also need to consider a third option — taking portfolio withdrawals.
First off, it’s important to understand that an immediate annuity does remove stock market risk from the equation. However, I think the biggest benefit of taking portfolio withdrawals over peeling some of your portfolio off to fund an immediate annuity is your impending death. Simply put, when you die, none of the money from your immediate annuity will be left to be passed onto your heirs. This is unlike your retirement portfolio which can be passed on when you pass away.
This is the bet you are making with the insurance company when you buy any annuity, but especially an immediate (lifetime payments) annuity. Your investment is pooled with other annuity buyers into a risk pool, and the actuaries decide how many pool members will die early and how many will live longer. If you’re one of the people who dies early, your money basically goes to offset losses caused by the people who live too long.
I mentioned during the immediate annuity calculation that the 6 percent rate of payments is higher than what you might be taking from your investment portfolio. There are two reasons for that; first, your payout won’t increase with inflation. The second reason is that, if you lose the bet and die young, you leave money on the table.
This leads us back to the main question that sparked this debate:
Should You Buy an Immediate Annuity?
Here’s my answer: Maybe.
If you are married, you should have the highest earning spouse delay Social Security until age 70 and the lower earning spouse collect at full retirement age (66 or 67 for most). After age 70, reevaluate your retirement budget compared to your new guaranteed retirement income picture. If your guaranteed retirement income sources are close to covering your retirement budget needs, no further action is necessary.
If there is still a large gap between where your guaranteed retirement income is from where you need it to be, you may need to take monthly portfolio withdrawals.
Keep in mind, at age 70.5, you will need to start taking withdrawals from your IRA. These withdrawals (around 4 percent) are not optional, and a missed withdrawal will result in a 50 percent penalty! If your guaranteed income from Social Security plus your projected required minimum distributions (RMDs) still don’t cover your retirement expenses, AND you still have anxiety about outliving your income, THEN and ONLY THEN should you consider peeling off a portion of your retirement portfolio to fund an immediate annuity.
Waiting until later in life to make this decision does come with perks. Because you’ve waited to make this decision, your monthly payout will be much larger at age 70 versus if you were in your late 50’s or early 60’s. This is because, at age 70, you are much closer to death from an actuarial standpoint.
Looking back to our example, $100,000 at age 60 gets us $500/month. At age 70, however, that same $100,000 gets us almost $650/month and over $500/month if we include a similarly aged spouse. That’s a big difference, and this difference can be yours if you wait it out and see if you really need an immediate annuity — or if you can get by without one.