By Peter Mastrantuono
Complementing an investment portfolio with an immediate annuity can help retirees enjoy a stable, lifetime income and potentially enhance the sustainability of their investment assets in retirement.
Low interest rates have curbed enthusiasm for immediate annuities, but with rising yields retirees may want to explore how an immediate annuity can bolster their retirement income security.
What is an Immediate Annuity?
An immediate annuity involves the exchange of a lump sum payment to an insurance company for its guarantee to pay lifetime income. Immediate annuities come in three basic forms:
- Single premium immediate annuity, which begins lifetime payments immediately (typically after 30 days from lump sum payment to within a year);
- Deferred income annuity, which defers income for one year or longer, lowering the initial investment needed for a desired income payment; and
- Longevity annuity, which postpones payments (typically until age 80 or older)—substantially reducing the initial investment and commencing at a time when an investment portfolio may be depleted.
The income an individual receives depends upon several factors, including the size of the lump sum investment, whether payments are based on a single or joint life, the individual’s sex and whether payments are fixed or inflation-adjusted.
While immediate annuities commonly pay a lifetime income, individuals may opt for payments over a fixed period of time (e.g., ten years).
Readers interested in a broader discussion of annuities may find How to Evaluate Annuities a good start.
The Benefits and Drawbacks of Immediate Annuities
The chief benefit of an immediate annuity is the payment of guaranteed income for life. No other retirement investment can promise that. The security of having retirement income not tied to the vagaries of the stock or bond markets can be source of great comfort to retirees.
Another benefit is their simplicity. In exchange for a lump sum payment, a retiree receives a regular payment (e.g., monthly) into his or her bank account. There is nothing to manage and no fees to pay.
There are, however, several drawbacks to consider. One is the loss of control over the funds, especially in the event of an emergency—a reason why immediate annuities are more appropriate for individuals with sufficient liquid assets.
Another disadvantage is that fixed payments lose their purchasing power over time. This can be addressed by buying a cost-of-living-adjustment rider, but that requires a larger lump sum payment.
Finally, the lump sum invested elsewhere, e.g., the stock market, may earn a higher rate of return over a longer time frame, though it bears reminding that immediate annuities are not purchased because they are great investments, but because they insure against running out of money.
An Alternative to Bonds
Purchasing an immediate annuity can significantly reduce the probability of financial depletion. In one study, the failure rate of a 50/50 portfolio over 30 years was reduced by over 70% by replacing the 50% bond allocation with a single premium immediate annuity.
In a previous article, we discussed the ways annuities may be used to keep retirees from outliving their assets. To determine the best strategy for integrating lifetime and period-certain income annuities into your retirement plan, consider working with a financial advisor who can walk you through the various alternatives and determine which best fits your personal objectives and circumstances.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.
