A Plan to Save for When the Income Stops

When you retire, you are faced with a new reality: Your salary stops. While you will probably receive Social Security and, perhaps, a pension, whatever you have saved for retirement will have to last the rest of your life.

Since you don’t know exactly how long you might live, or what your investment returns might be, it is difficult to know exactly how much you can spend out of your retirement savings and be sure that you won’t run out of money before your time comes.

One possible solution to this dilemma is an immediate annuity. An immediate annuity is a contract with an insurance company, in which you give them a sum of money and they promise a check every month for the rest of your life, the rest of your life and your spouse’s life, or some other agreed upon period.

An immediate annuity is irrevocable, so you no longer have access to that money, just the stream of payments. Some recent annuity products may allow some limited access to the principal, but any withdrawal will reduce the future monthly payment. So, while many folks are comforted by the idea of not outliving their money, it is important to be sure that an annuity is what you want. Even so, it is probably not prudent to put all of your retirement savings into an annuity; you’ll want to have some liquid money.

The amount of your annuity payment will depend on your age and the age of any other beneficiaries, the current interest rate environment, the time period of any guaranteed payment and, of course, the amount of the principal. For example, for an age 65 male, a single-life annuity funded with $250,000 could purchase today a payment of $1,638 per month.

The complaint many people have about single-life annuities is that if the annuitant dies soon after purchasing the annuity, all they received is a few payments, and the insurance company really makes out. A way around that is to purchase an annuity with a period certain. That means that if you were to die before the period certain was completed, your heirs would continue to receive the payment for the rest of that period.

Guaranteeing a longer payout period, however, results in a lower monthly payment. A single-life annuity with a 10-year period certain in the example above could produce a monthly payment, if purchased today, of $1,568, $70 less per month than the single-life version.

Another possibility is an annuity on two lives, so that no matter which spouse dies first the survivor continues to receive a stream of payments. Again, with a longer period of likely payout, the monthly payment will go down. For two spouses, both 65, a joint and survivor annuity funded with the same $250,000 that continues 100 percent of the monthly payment after the death of the first spouse until the death of the second, could provide a monthly payment of $1,358, $280 per month less than the single-life version.

Many retirees with pensions are offered the option of a lump-sum payout or an annuity paid through the pension plan. For those with an interest in the annuity option, it may be advantageous to see whether using that lump sum to purchase an annuity through an insurance company might produce a higher monthly payment. Depending on the terms of the pension plan, it might go either way.

Annuities do provide some tax advantages. For an annuity held outside a retirement plan, a portion of each monthly payment represents return of principal, so it would not be taxable until such time as the entire principal has been paid out. In contrast, all of the return from funds held in a taxable account will be taxable as ordinary income or capital gains. Depending on the investor’s tax bracket and investment mix, an annuity might well defer some tax liability.

One of the problems with the annuity described above is that the payment is fixed. First of all, an annuity purchased now will get a payment based on the current low interest rates. Next, inflation will eat away at the purchasing power of that monthly payment. That $1,638 won’t buy as much 15 years from now as it does today.

To address that problem, there is another form of immediate annuity, a variable income annuity. Here, the amount of your payment varies depending on the performance of underlying investments you select from a menu of mutual fund-like accounts. These could include different sorts of stock and bond funds. As a result, your monthly payment could go up or down depending on investment results. However, the premise behind these products is that over time the investment performance will keep pace with or exceed inflation. For those a bit more conservative, hybrid annuities are also available, which are partly fixed and partly variable.

It usually pays to shop around a bit for an annuity. Different insurance companies may offer different payouts depending upon their actuarial and investment experience. Features and benefits can also vary. It is also important to be sure you are dealing with a financially sound company. After all, you are relying on them to make these payments over many years. Finally, if you think an immediate income annuity might be for you, you’ll want to have your financial advisor help you with that decision.