How Annuities Protect Against Longevity Risk
Make sure you don't outlive your retirement finances
Immediate annuities offer income for life (or for a set period of time, such as 10 or 20 years).
When selected for lifetime income, annuities function like Social Security retirement payments or corporate pension plans.
In essence, you can create your own “pension plan” by choosing an immediate annuity with a lifetime payout option.
This protects you from longevity risk—the chance that you may live longer than your financial resources can support you.
Be careful to distinguish between an immediate fixed annuity and an immediate variable annuity. An immediate fixed annuity provides you with a set dollar amount of income for each pay period (generally monthly), whereas the income from an immediate variable annuity fluctuates.
Immediate fixed annuities work like this:
- Make a deposit or contribution to an insurance company (technically, a “premium” payment, since an annuity is an insurance product). In return, the insurance company promises to make regular payments to you.
- Choose how often you want to be paid; many people choose monthly payments.
- The amount you are paid depends on current interest rates. A higher interest rate means a higher payment to you, while lower interest rates mean lower payments. Once you make your purchase, the interest rate is fixed for that annuity, resulting in a fixed dollar payment for you for as long as the annuity lasts.
- Specify whether you want payments for life or for a set period of time. Married couples can choose to cover both spouses, so that whoever lives longest will continue to receive payments for life.
Benefits of immediate fixed annuities include:
- Lifetime income—which few other financial options can provide—is a significant benefit of an immediate annuity.
- They typically pay a higher rate of return than comparable financial products, such as CDs, money markets, or bonds.
- Because annuities are an insurance product, they are protected against default by the assets of the issuing insurance company.
- Each state provides a guaranty fund to protect annuity owners in case an insurance company faces financial trouble. Most states provide protection of between $100,000 and $300,000 of annuity benefits per annuity owner.
Immediate fixed annuities also have some disadvantages:
- Once you make your premium payment and start receiving income payments, you lose control of that money. You cannot cancel the annuity or withdraw more than what you are receiving in payments.
- When you die, your payments stop (assuming you chose payments just for your own life). Any leftover money is used by the insurance company to make payments to other immediate annuity owners who are still living.
- You can select payout options that allow a beneficiary to receive some of your payments, but doing so lowers the amount of income you’ll receive now from the annuity.
- Payments from immediate annuities are often made as a fixed dollar amount. Over time, inflation can erode the buying power of these dollars, as the costs of goods and services rise while the annuity payment stays constant. One way to address this problem is by purchasing a cost-of-living adjustment (COLA) option with the immediate annuity. The COLA option increases the dollar amount of future payments to keep up with inflation, with the goal of preserving the buying power of the immediate annuity payments.
When to Buy Annuities
In general, buy an immediate annuity at age 65 or older. The older you are, the higher the payout rate will be. Because Social Security alone typically is not enough to maintain your standard of living in retirement, retirees should carefully consider an immediate annuity that offers lifetime income. Ideally, you want to generate enough income from all your lifetime income sources (Social Security, pension plan and immediate annuities) to cover all of your essential living expenses (housing, health care, food, clothing, utilities, etc.).
As a general rule, it’s a good idea to buy an immediate annuity when interest rates are relatively high. However, determining if rates are high or low is like asking if the stock market is high or low; it’s all relative to current conditions. An interest rate that is higher now than last year may “feel” high today, until interest rates rise again next year. Accurately predicting how interest rates will change in the future is impossible.
Since it’s difficult to know when interest rates are very high or very low, you may want to buy a series of immediate annuities over time, rather than just one major purchase. It’s the same concept with buying a series of CDs, such as three-month, six-month, one-year, three-year and five-year. That mix of CDs ensures you have both short- and long-term interest rates locked in. By purchasing an immediate annuity annually over a period of five to seven years, for example, you lock in a good mix of different interest rates for your immediate annuities as well.
The other advantage to buying a series of annuities is that you can buy them from different insurance companies. That way, if one particular insurance company runs into financial difficulty, you won’t have all your annuity eggs in one basket. As a general rule, only invest an amount up to your state’s minimum insurance guarantee with any one insurer. Remember, to make sure you have a steady, consistent stream of income, choose an immediate fixed annuity rather than an immediate variable annuity. Income from an immediate variable annuity may increase or decrease over time. Retirees looking for a source of stable and secure income will typically be better served by immediate fixed annuities.
This material is provided by MyRetirementPaycheck.org, a site from the National Endowment for Financial Education that helps people explore all of their retirement decisions.