With a lifetime annuity, you receive payments from an insurance company for the rest of your life.
These programs are increasingly popular for retirement planning, and there are even proposals before Congress that would require employers to provide lifetime annuities to retiring workers. Let’s review how they work along with the pros and cons.
The Good, the Bad
To start, it’s important to understand the promise of a lifetime annuities as well as the problems.
Advantages of lifetime annuities include:
- You get a guaranteed payment for as long as you live, helping to mitigate longevity risk
- You don’t have to manage the money or deal with the emotions or complications of investing (stock market crashes, investing mistakes, etc)
- They look and feel like traditional pension plans once they are up and running
The disadvantages of these products are:
- You lose control over your money once you take a lifetime income stream (if you want the largest payment)
- Similarly, you lose access to any large lump sums for major expenses in retirement
- Payments might not keep up with rising costs for inflation
- You might be able to do better and pay yourself more if you manage your money on your own (or if you hired somebody to do it for you)
- The insurance company handling your lifetime annuity could go out of business (although you might get some relief from your state)
- If you die shortly after starting, you can “lose” and the insurance company keeps the money
How do Lifetime Annuities Work?
When you use a lifetime annuity, you give money to an insurance company, and they make payments to you for the rest of your life (you might also have an annuity available through your employer, which is very similar). You can give them one large lump-sum, or you might make payments into an annuity contract over time. Either way, at some point you say “let’s do it” and they start your lifetime income stream.
The payment that you receive is based on several factors.
- How much you put in: obviously, the more you put into an annuity, the larger your payment will be
- Your age: the older you are, the larger your payment will be. If you are young, the insurance company assumes that they’ll have make payments for many years before you die, so they make payments smaller for younger people
- Options: your payment will be affected based on certain options that you select. If you want the largest payment, a simple lifetime annuity is best (without any term-certain, cost-of-living adjustments, or other options)
Given the amount of money you put in, your age, and your options, the insurance company calculates how much they will pay you each year (you can get monthly payments if you want). Their calculation is based on what they can afford to pay while still making a profit, and is based on assumptions about how long you will live.
Lifetime Annuity Options
In most cases, you can design your lifetime income stream based on what you think is most important. Whether you’re signing up for a lifetime annuity with your employer or with an insurance company, there are several standard options available.
Individual or joint life: annuities can pay out over a single lifetime, or they can cover the lives of two people. For example, if you bought an annuity, what would happen to your spouse when you die? If your spouse does not have assets or a sufficient source of income, you might want to have the annuity pay until both you and your spouse have died. As you might imagine, the joint option results in a smaller payment, because the insurance company has to wait for two people to pass away as opposed to just one. Within the joint option, you can also choose whether or not the survivor gets 100% of the annuity payment, or if a reduced payment will suffice.
Term certain: you can also have an annuity pay out for a minimum number of years, whether or not you have died during that time period. This can help with the problem of purchasing a lifetime annuity, and then dying shortly after – in which case the insurance company keeps almost all of your money. If you use a “term certain” option of 10 years, annuity payments will come to you (or your beneficiary) for at least 10 years. If you live longer than that, that’s great, and the insurance company will continue paying until the day you die. Again, using this option will reduce your payment somewhat.
Refund options: to go a step further, you can use a refund option to ensure that you (or your beneficiary) get 100% of your money back from an annuity. When you die, any remaining money that you never got back (if any) is paid to whoever you choose. This option has an even more drastic effect on your payment, because the insurance company knows they can’t benefit from an early death (sometimes they lose money when people live long lives, and sometimes they profit when people die young). However, the insurance company still earns money by holding your money, investing it, and returning it to you slowly.
Cost of living adjustments: if you get paid the same amount every year during retirement, you might start losing purchasing power over time as a result of inflation. Some annuities allow you to add a cost of living adjustment (COLA) to your lifetime income stream so that your payments increase along with inflation. Your payments might not rise as quickly as inflation in general (or as quickly as the expenses that you pay), but they generally increase according to some definition of inflation. As with other options, you’ll start out with lower payments if you use it, but you have the potential for larger payments down the road. If you intend to take income for several decades, a COLA is worth looking at.
How to Start an Annuity
If you’re interested in using a lifetime annuity, there are several ways to get one. Some employers (including government employers) offer them to retiring employees. You can also purchase an annuity from an insurance company, either directly from the company or through a financial planner.
Be sure to compare income streams from several sources. Your employer’s annuity might be very good (in some cases they’re far better than anything else you can find), but they’re not always the best, and you might want a specific option that is not available through your employer. As you do your research, stick to insurance companies that are financially strong – you don’t want them to go out of business and leave you without income in the middle of your retirement.
Should You Use a Lifetime Annuity?
Hopefully this gives you a better idea of whether or not you’d benefit from an annuity. They have some appeal, but as you can see they are not perfect.
If you decide that a life annuity makes sense for you, don’t think of it as an all-or-none decision. You can use an annuity for just some of your retirement savings and invest the rest using different strategies (in fact it might be reckless to invest everything in an annuity). Just like you diversify your portfolio, you can also diversify the approaches you use to create income.
You should also remember that insurance companies offer these products to make a profit. That doesn’t make them bad, but you need to realize that you’re giving something up when you use a lifetime annuity. If you can see these products in terms of a trade-off between what you get and what you give (as opposed to a perfect solution without any drawbacks), then you’re on the right path.
Evaluate all of your sources of retirement income, and decide how much (if any) to annuitize.