En español | Here's the single most important question for people who are planning for — or already into — their retirement years: How are you going to make your money last for life? With good health and good cheer, you're likely to be among the half of your age group that dances past your official life-expectancy age.
Social Security lasts for life, and so does an employer pension. If you don't have a pension, annuities can serve as a pension substitute. Increasingly, financial planners are paying attention to this option as a way of ensuring that their clients don't run out of money.
Annuities are sold by insurance companies. Some come with bells and whistles that aren't worth their price. The safest policies are "immediate pay" annuities, in which you put up a sum of money and your insurer starts paying you a certain percentage of that for life. The payments can also cover the lifetimes of you and a beneficiary, such as your partner or spouse.
Choosing the right type of annuity
These pension substitutes come in three main varieties. An "immediate fixed" annuity provides a fixed number of dollars per month. An "immediate variable" annuity, invested in a mix of stock and bond mutual funds, pays you a fixed percentage of the portfolio's value, which will rise and fall. An "inflation-linked" annuity adjusts your payments for inflation every year (you can also pick a fixed annual adjustment, such as 2 or 3 percent).
You generally get the largest initial payout from the immediate fixed annuity. The others might start smaller but can increase your payouts over time.
What has always bothered people about annuities is what I call the sucker factor. If you put $100,000 into the plan today and die next year, you'll think (from the grave) that you were a sucker because the insurance company retained the money you didn't receive.
Escaping the sucker factor
But it's this very sucker factor that makes annuities so attractive. Because some people will die early, the insurer can afford to pay you more per month than you could prudently draw out of personal investments.
For example, take a 65-year-old woman who has $100,000 in savings. If she puts half of it into stock mutual funds and half into bond funds, and withdraws the traditional 4 percent in the first year, she'll get $333 a month. If she raises that amount by inflation each year, the money could last for 30 years (but with no guarantee).
If she puts $100,000 into a Principal Life Insurance Co. inflation-adjusted annuity, she'll start higher — with $379 a month (at this writing), plus guaranteed lifetime inflation protection. The fixed-payment annuity gives her $531. If she dies after just a few years, "So what?" says Miami financial planner Harold Evensky. "The annuity served its purpose. It paid her more than she could take from systematic withdrawals from savings and insured her in case she lived too long."
Weighing benefits and risks
If you can manage payments that change, consider an immediate variable annuity, says annuities expert Moshe Milevsky of York University in Toronto. You choose the percentage of the total portfolio that you'll want paid out, in monthly amounts. Starting with a lower percentage sets you up for higher payments in the future, as long-term stock values grow. "The potential upside seems to compensate for the downside risk," he says.
Milwaukee financial planner Paula Hogan encourages clients to consider inflation-protected annuities, to preserve their lifetime purchasing power. But don't annuitize all your money, she warns. You need ready cash for unexpected expenses, such as health costs. If you're living on Social Security plus modest savings, annuities may not be for you. They're best suited to people who use them as the safe part of their investment mix, with the rest of their money invested for long-term growth.
Financial planner Michael Kitces of Columbia, Md., has a smart idea for people who'd rather keep their cash and take systematic 4 percent withdrawals adjusted for inflation. Split your savings evenly between stock funds and bond funds, and take the withdrawals mostly from bonds for the first 10 years. The value of your equities should more than beat your gains from inflation-adjusted annuities, his research shows. Of course, there's no guarantee. If you live well into your 90s, Kitces says, the annuities will win.
Jane Bryant Quinn is a personal finance expert and the author of Making the Most of Your Money NOW.