Immediate Annuities: Insurance for the Long Run

A lot of people — I've done it, too — look at immediate annuities the wrong way.

An immediate, or income, annuity is an insurance product that can guarantee an income for life. For example, in exchange for a one-time $100,000 premium, a 65-year-old man will receive about $673 a month until he dies, based on rates advertised recently by a well-known insurance company.

The $673 is based on the man's “life only,” meaning payments will stop when he dies. Other options, which lower the monthly amount, allow payments to continue to a “joint survivor,” such as the man's wife, and/or guarantee a minimum number of payments.

Under the life-only option, if the man lives to age 95, he will receive more than $242,000 over 30 years, the equivalent of a 7.2 percent annual compounded return on the $100,000 premium. But if he dies after one year, he will get back just a tad over $8,076, and his heirs can kiss the rest of the money goodbye.

That, in a nutshell, is why immediate annuities have been a very tough sell.

“The overwhelming focus is that if I die tomorrow, I lose everything,” said William Reichenstein, a chartered financial analyst and professor of investment management at Baylor University.

On the other hand, immediate annuities provide more dependable income than any other financial product. And payout rates are higher than what we would get by investing in bonds on our own.

That's because the payouts, which include both interest and return of principal, are based on the assumption that many annuity holders will die before reaching their life expectancy.

“In essence, the insurance company uses funds remaining from those who die sooner to pay those who live longer than expected,” Reichenstein said.

Conclusion? We ought to look at immediate annuities not so much as investments, as most people do, but as insurance against “longevity risk,” or outliving our money.

Ads for immediate annuities, which used to be scarce even in financial magazines, are popping up in daily newspapers. One recent ad asked, “What will you do when you run out of money?”

Unfortunately for consumers, this upsurge in the marketing of immediate annuities comes at a time of very low interest rates. Insurance companies, which typically invest your premiums in high-quality bonds, cannot pay more than what they earn.

Your age and sex also determine how big a check you get. The older you are, the bigger each monthly payment because, on average, you will die sooner. Men get higher payouts than women the same age because men, on average, die younger.

As a rule, immediate annuities make the most sense for healthy people 70 or older who expect long lives and have few or no other sources of guaranteed retirement income, such as pensions or Social Security benefits.

Also, immediate annuities are most appropriate for people who don't care about leaving a large inheritance or who have enough other assets to do so anyway. Even the most ardent proponents of immediate annuities stress that you shouldn't use more than a portion of your nest egg to buy one, leaving enough liquid assets to fund other needs.

So a good rule of thumb is, consider an immediate annuity for what it is, longevity insurance, but don't buy one until you are sure it makes sense for you.