Morningstar Advisor on Immediate Annuities

Immediate Annuities: The Key to Retirement


by Judith A. Hasenauer | 04-02-09


We love the cartoon of the family gathered around the lawyer's office for the reading of the will with the lawyer stating the will's contents: "Being of sound mind, I spent it all." Unfortunately, this joke begs the question of how can we guarantee that we and our money expire at the same time? Or, at the very least to make sure that the money does not end before we do. Although we all would like to be able to leave some of our hard-earned nest egg to our children, our first obligation is to ensure that what we have gathered lasts us for the remainder of our lives once we retire--particularly with ever increasing longevity and the financial instability rampant in the world economy. After all, it is better to have "spent it all" rather than having to move in with our children because we outlived our assets.

For the very wealthy, longevity is usually not a problem. However, for the vast majority of people, even those we like to refer to as the "working affluent," outliving funds for retirement is a matter of great concern (some politicians and the news media like to refer to the "working affluent" as "rich," but the term "rich" is, in our opinion, very relative). At the time the Social Security system was initiated in 1937 the life expectancy of the average recipient was only a few short years. Today, increased longevity has everyone expecting many times the expected longevity of 1937. It is not unusual for a working person today to expect to spend longer in retirement than she did working! Thus, fewer years are available to garner assets than there will be to spend the same assets in retirement. The actuaries tell us that it is likely that a married couple, with a 10-year disparity in age, where one reaches age 65, have a probability that one of the two will still be alive in 30 years! Thus, the need for longevity planning.

We have all read about the problems faced by the under-funding of the Social Security system and the problems we will all face when the 77 million "baby boomers" retire. It should be obvious to any serious observer that everyone needs to plan for funding their own retirement rather than to expect that employers or the government will handle it for them--particularly not in view of ever-increasing longevity.

So, how do we handle the problem of increasing longevity? How do we ensure that we and our money end at the same time? The only sure answer is with a payout annuity.

Annuities take many forms. Variable annuities are designed to provide a hedge against inflation because of the vast choice of investment options that underlie them. Fixed annuities provide a certainty because of the guaranteed amount of regular annuity payments. Unfortunately, few provide inflation protection. Index annuities provide both the certainty of guarantees plus a potential hedge against inflation because of the availability of an index that can provide for investment growth. Annuities also take different forms relating to premium payment modes and relating to when payouts begin. We are all familiar with the deferred annuities that have become such an important element in the financial market in recent years. Payout annuities--often referred to as "immediate" annuities are less well known, but of great importance in longevity planning.

Virtually all commercial annuities offered by life insurance companies in the United States have annuity payout options that are guaranteed for so long as the annuitant lives. This is true whether the annuity is deferred or immediate. The basic payout option is simple. The insurer guarantees payments for the life of the annuitant and they stop with the payment immediately prior to death. This "straight life annuity" is rarely selected because it does not provide for hedged alternatives that are appealing to retirees. Thus, payout options often include payments for joint lives, or for life and a period certain with payments guaranteed to a beneficiary if the annuitant dies prior to a specified term of five, 10 or 20 years.

Generally speaking, payout annuities used in connection with qualified pension plans provide for payments for the joint lives of the retiree and his spouse. This is to ensure the spouse is not left destitute on the death of the retiree. Annuities used with qualified pension plans can take two forms: They can be "individual retirement annuities" that are treated similar to IRA Rollovers, or, if the pension plan permits, they can be regular annuities purchased by the retirement plan's trustees for the benefit of the retiree. Annuities should be an important component of any qualified retirement plan because most qualified retirement plans do not provide payments that are guaranteed for the life of the retiree. Instead, they merely distribute the proceeds from the retirement plan to the retiree and leave it to her to determine how to invest it and to plan for longevity. Without a payout annuity, there is a significant risk that retirees will outlive the funds they have accumulated for their retirement.

The federal government, in the legislation covering retirement plans, has dictated that distributions from such plans must be for life or for "life expectancy," as determined by the mortality tables published by the Internal Revenue Service. Unfortunately, "life expectancy" is not "life." There is no requirement that retirement plans guarantee that a retiree will not outlive her retirement funds. Moreover, even if a retiree establishes a payout scheme that makes payments for her IRS determined "life expectancy," there is still a better than 50/50 chance she will live longer than the life expectancy established by the IRS mortality tables. The IRS mortality tables state that, at the end of any life expectancy for any age group, half of the group will still be alive. This half will have outlived their retirement funds if they chose to take them for their life expectancies.

The IRS mortality tables also can mislead a retiree because they are based on the total American population--not just those of us fortunate enough to retire with a qualified pension plan. Thus, it is more likely that employed persons participating in a qualified retirement plan will, as a group, live longer than will the general American population that includes drug addicts, homeless persons and those with no employer-sponsored medical plans. This means that the likelihood if people retiring with qualified retirement plans have an even greater risk of outliving their retirement funds--unless they take distribution of some part of their retirement funds in the form of a payout annuity guaranteed for life.

The retirement crisis facing our country for the next 15 years is profound. The Social Security system is under great pressure, lifetime pensions guaranteed by employers have virtually disappeared from the landscape and it is up to everyone to ensure that their funds last for their lives. Immediate payout annuities are the easiest way to ensure that you and your retirement funds expire at the same time. The alternative is not a comfortable one to contemplate.

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from morningstar.com