Know the Pros and Cons of Income Annuities Before You Purchase

Let's get the story straight about income annuities, the good and bad.

The bad gets plenty of ink, much undeserved. A survey commissioned by the MetLife Mature Market Institute found numerous errors and omissions in newspaper, magazine and wire service stories about these annuities, which are insurance products that offer an income guarantee.

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At the same time, some overzealous annuity sellers -- I've come across some at sales presentations billed as "educational seminars" -- are prone to overlook potential drawbacks. To the extent it's possible in this short space, I'll try to present a more balanced picture.

The basic concept of income annuities is fairly simple: In return for a one-time lump-sum payment, an insurance company guarantees it will send you a check for the rest of your life.

The primary appeal of income annuities -- the reason many advisers recommend retirees consider them for a portion of their savings -- is that you cannot outlive your income.

The primary disadvantage -- the reason these same advisers warn retirees shouldn't put all their money in them -- is that when you die, the payments can stop and your heirs get nothing.

But I over-generalize, one of the errors cited in the media survey.

Income annuities typically let you choose from a number of payout options, including payments to both you and a spouse or another beneficiary, or payments guaranteed to your heirs for a "term certain" if you and your beneficiary die before. Some offer limited access to principal.

The more features you want in your annuity, the lower the payments you will receive. The basic premise holds true: In exchange for receiving an income for life, you no longer have an "account balance" you can access or spend as you wish.

Before deciding whether that's an appropriate trade-off, you need to know the assumptions behind the numbers the insurance company quotes you.

Those assumptions involve estimating how long you -- or you and a beneficiary -- will live, and what interest rate the insurance company can earn on your money.

For example, for a lump sum payment of $250,000, a man and wife, both 65, can buy an income annuity today that will pay about $1,237 per month until they both die.

One key question -- aside from how much if anything they want to leave to heirs or charity -- is whether this couple can generate the same or higher income by keeping the $250,000 and investing it.

Assuming at least one of them will live to age 89 -- a fair assumption, based on life expectancy tables -- they will need a steady return of 3.14 percent a year to receive $1,237 a month for 24 years before running out of money. (For these types of computations, you'll need a financial calculator).

With an annuity, this couple would avoid the risk of not achieving that return and, more important, of living "too long."

The insurance company, because it sells many annuities, can more safely rely on average life expectancies. For each individual, the odds of living much longer than average are greater.

More annuity advantages: Because payments are considered part return of principal, taxes are lower than if you use your nest egg to generate taxable income. Studies have shown that income annuities tend to generate more spendable income than gradually depleting savings.

Now for disadvantages: With traditional fixed-income annuities, the payments you get remain the same. If you buy such an annuity today, you'll be "locking in" near record-low interest rates for life.

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Some fixed income annuities offer inflation-adjusted payments but the initial payments are lower.

Another option to avoid getting stuck with relatively low fixed payments for life is a "variable" income annuity -- the size of the payments varies each year based on the performance of underlying investments. But that means your income will go down if the investments don't do well.

There are also "hybrid" income annuities, part fixed and part variable. A lot to think about? I suggest you don't rush into any decision -- once you buy an income annuity, the choice is typically irrevocable.

If you need advice, get it from a qualified professional who does not stand to gain or lose by whatever you decide.

But first, consider the financial strength of the insurance company. An income guaranteed for life is worth nothing if the insurance company can't back up that guarantee.

Source: - 07-27-03

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