As the first part of this article discussed, today's retirees can look forward to longer lives than their parents and grandparents enjoyed. With that longer lifespan, however, comes the need to save more to last throughout a longer retirement. Since decreasing the risk of outliving your savings is increasingly important, strategies that can reduce or eliminate some of that risk are valuable. By giving you the ability to spread income across the remainder of your life, using immediate annuities is one strategy that can help reduce longevity risk.
Many options for payments
Immediate annuities offer a variety of options in how you receive your payments. Perhaps the option that is easiest to understand is the fixed-term option. Under this method, you choose the number of years you want to receive payments, and the life insurance company calculates how much you will receive each month. If you outlive the term, then the contract ends at the end of the term, and you will have been paid in full. If you die before the end of the term, you can name one or more other people, such as a spouse or other family member, as beneficiary to receive payments for the remainder of the term.
The problem with the fixed-term option is that you will stop receiving income at a certain future date. As a result, if you are counting on this income to help provide for your retirement expenses, you always run the risk of choosing a term that is too short. While it may be helpful to know in advance exactly how much money you will receive every month, the fixed-term distribution option does not address the need to reduce longevity risk.
Fortunately, other annuity distribution options allow you to tie payments to your actual lifespan, eliminating the risk that you will outlive your monthly payments. The simplest of these options is to take payments over the remainder of your life. The insurance company uses mortality tables and certain personal characteristics such as age and physical condition to determine how much it is willing to pay you every month for as long as you live. Sometimes known as single life, this option provides a relatively large payment compared to the other options discussed below. No matter how long you live, the insurance company will continue to make payments. If it turns out that you live long beyond the insurance company's estimate of your life expectancy, then you end up getting the better end of the bargain. On the other hand, the downside to this option is that if you die after a short time, the insurance company does not have to return any money to your family or other heirs, even if the payments you received were only a small fraction of the premium you paid.
Because this possibility of losing money is disturbing to many seniors, many annuities offer a combination of the single life option with a guaranteed minimum period. With this option, you will still receive payments for the remainder of your life. If you die prematurely, however, the annuity continues to make payments to whomever you select as beneficiary. Some insurance companies allow you to select a minimum period as long as 20 years or more. The tradeoff? The longer the guaranteed period, the lower your monthly payment will be.
For those who want to protect their spouses as well as themselves, the joint and survivor life option provides for payments that will last as long as either you or your spouse is still alive. Because these annuities tend to pay out for longer periods of time, the amount of your payments will be lower than with the single life option. However, this option may meet the needs of both spouses in their respective financial plans.
Traditionally, many annuities have called for payments that stayed the same throughout the payment period. Over the years, however, inflation eats away at the purchasing power of those payments, leaving some seniors without enough income to meet basic needs. In order to solve this problem, most annuities now allow recipients to elect payments that increase over time, either by a rate specified at the time of purchase, or by whatever the actual inflation rate turns out to be. Using this option will usually result in a lower initial monthly payment, but over time, the payment amounts may grow above what the flat-payment option would have paid.
Some financial advisors generally avoid annuities. In relation to other types of investments, annuities often have much higher annual fees and other costs, sometimes as much as 1% to 2% higher per year. In many cases, the person who sells you an annuity receives much of this added cost in the form of commission income.
Among other things, you pay extra when you buy an annuity (relative to other investments) in exchange for the right to start receiving payments at any time, reducing the risk of outliving your savings. For that reason, buying deferred annuities often means paying immediate, ongoing fees for something you won't use for decades, if at all. Many annuity holders never start taking payments, instead leaving them untouched for their heirs. However, immediate annuities let you benefit from this option right away, so that you get what you're paying for immediately.
By reducing longevity risk, immediate annuities meet a need in a way that is difficult to replicate otherwise. Because it's unnecessary for most people to eliminate longevity risk entirely, a prudent compromise may involve exchanging a portion of your retirement assets for immediate annuity payments, while retaining the remainder of your assets in more traditional investments. This leaves you with the flexibility to adjust your spending as circumstances warrant, but ensures that even if you have to use all of your other assets, you'll still have a steady stream of income from your annuity. As with most financial tools, annuities can bring you valuable benefits -- if you use them correctly.
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Fool contributor Dan Caplinger hasn't decided whether gambling on his life expectancy is such a good idea, but he is certain that he doesn't own shares of any of the companies mentioned in this article. You can count on the Fool's disclosure policy for as long as you live.