Role of the Payout Annuity

Converting a Deferred or Variable Annuity Account Balance

Having increased your deferred or variable annuity account balance for many years you have several choices for removing your money. You could just surrender the annuity for cash or take out money as you need it. But if you choose either of these options, you forfeit the one feature of annuities that no other investment can offer, namely, the right to "annuitize", which is insurance-speak for converting your balance to a guaranteed life income. You could also lose a valuable tax benefit if you pull out your money all at once or take sporadic withdrawals. That's because when you annuitize, a portion of each monthly payment is considered a return of your original capital and goes untaxed, boosting the after-tax value of your monthly payments. (You don't get this tax break if you annuitize money in your 401(k) or IRA, since you already got a tax benefit when you made the contributions to your account.) This lifetime income guarantee comes with a trade-off, however: You must give up access to your money. To remain prepared for emergencies and the like, you want to have plenty of other assets outside the payout annuity.

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The Two Payout Annuity Options: Fixed and Variable

As in the accumulation stage, you have two basic payout annuity choices: a payment that will remain the same for life or one that will fluctuate, retaining the possibility of going up over time.

1) Fixed Payout Annuity

The premise behind a fixed payout annuity is simple. You turn over a sum of money to an insurer, and the insurer gives you a fixed payment, typically each month, for the rest of your life. (You could also choose to get payments as long as you or your spouse are alive or for a specific number of years.) The size of your payment depends on several factors, including your life expectancy and the current level of interest rates. At recent rates, for example, as a 65-year-old man annuitizing $100,000, you would receive a guaranteed payment of $700 to $750 a month for life, depending on the insurer.

Interest Rates and Inflation

While locking in a guaranteed income may seem like the safest option, it exposes you to several risks. If you are annuitizing when rates are at or near historic lows, as they are today, you could be locking in a relatively small payment for the rest of your life. To protect yourself, you should annuitize several chunks of money over a few years at different interest rates. No matter what size payments you lock in, a fixed payout still leaves you vulnerable to inflation. If prices were to increase at just 2% a year, for example, the purchasing power of the $750 a month you'd have as a 65-year-old today would decline roughly 40% over 25 years.

Combined with Social Security and any pensions you may draw, a fixed payout annuity can provide a retirement safety net, a minimum level of guaranteed income that you can count on to cover much of your essential living expenses. But since your living expenses are almost certain to grow over time while your payout remains the same, you'll need to set aside assets in other investments, such as mutual funds, that can provide liquidity for unexpected expenses. Ideally, you may want to combine your fixed payout annuity with a variable payout version, which can generate payments that will outpace inflation.

2) Variable Payout Annuity

A variable payout annuity also guarantees payments for life, except that those payments fluctuate from month to month. For relinquishing the security of knowing what your payment will be each month, you gain something valuable: the potential for your payments to grow over time.

This, in brief, is how variable payout annuities work. You start by choosing an assumed interest rate, or AIR. This acts as a benchmark that, along with other factors such as your life expectancy, helps determine the size of your first monthly payment. Many insurers let you pick your own AIR, usually between 3% and 6%, while others simply assign one. Next, you divide your account balance among various stock and bond sub-accounts. If the sub-accounts you've chosen earn a higher rate of return than your AIR, your monthly payments increase. If your sub-accounts earn less than the AIR, your payments decline.

Choosing a high AIR will give you a bigger payment initially, but that also sets a higher performance bar, making it more difficult to boost payments later on. If you want your payments to grow, you are better off choosing a lower AIR.

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Remember, even though you're now drawing income, insurance charges and management fees on variable payout annuities are still being charged to your account. Since your return after expenses determines your payments, you have a better chance of seeing your income grow with a low-expense (non-variable) annuity. To increase the odds that your payments will grow over a retirement that may last 30 years or more, opt for annuities with low fees. A variable payout annuity is an excellent way to assure yourself a retirement income that you can't outlive and that has a good shot at growing faster than inflation.

Although variable payout annuities help keep your payments ahead of inflation, they still have some drawbacks. Payments can drop precipitously during market downturns. Additionally, once you start drawing income, you give up access to your account balance.

In recent years, options have expanded. One provides an access period, typically ranging from five to 30 years, during which you can tap your annuity for cash. Another choice is a variable annuity with an option providing limited access to your account and guaranteeing that your income will never fall more than 20% below your initial payment.

Clearly, annuities require some attention to detail. However, once you strip away potential fees, tax advantages and disadvantages and those gimmicky options, you'll find one feature that's unique to annuities: an income you can't outlive. When it comes to planning a secure retirement, that may be the most valuable benefit of all.

Source: - 11-01-2002

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