You'll Need Even More Than You Think

I admit it: For years, I hated annuities.

This wasn't entirely rational -- there are very good reasons to own some types of annuities, as I'll explain shortly -- but it comes from seeing brokers revel in the commissions from variable and equity-indexed annuities during my years in the investment business.

"The fees are crazy," I'd tell people. "The returns don't justify what you have to pay to get them. Buy something stable with fat dividends instead, maybe a utility stock like Southern Company (NYSE:SO) or Consolidated Edison (NYSE:ED). Don't give the broker that much of your money for nothing."

See, like a lot of broker-sold products, these kinds of annuities are designed to encourage brokers to make the effort to sell them (instead of selling something else). That means big commissions, and that in turn means you pay big fees.

Now, there are lots of brokers who do a great job for their clients, and they deserve to get paid. But when we're talking about putting a pool of savings to work to fund a retirement -- and that's usually when annuities enter the conversation -- I think every possible dollar needs to go toward funding that retirement. Not to expand some broker's fleet of BMWs.

The funny thing is, it turns out that -- some -- annuities are a very good way to make that happen.

The power of the right annuity
Making the most of a retirement nest egg is one of the great challenges in investing. On the one hand, we want the most money possible every year -- we don't just want to cover basic needs, we want to enjoy retired life, right? On the other hand, we don't want to outlive our money, because Social Security alone doesn't go very far. And many folks want to leave something behind for kids or grandkids.

Annuities are a simple answer to that challenge: Just hand over a lump sum of money and get a guaranteed return for life. How big a return? Retirement planning expert Jim Otar uses a simple rule of thumb -- for every $20 you put into a good low-fee inflation-indexed annuity at age 65, you'll get about a dollar of annual income. Need $100,000 a year on top of Social Security to retire in reasonable style? Got a $2 million nest egg? You're all set.

Of course, if you want to leave something for the kids, the picture gets more complicated.

When an annuity is not the answer
The Fool's retirement guru Robert Brokamp interviewed Otar recently (the interview is included in the new issue of Rule Your Retirement, available online at 4 p.m. EST today), and in that interview, Otar says that if you're hoping to leave money to your descendants, "you need to have at least 30 times your [desired income in the first year of retirement] at age 65."

Now, I admit that my first thought when I read that was something like wait a minute, that's baloney. That's a mere 3.3% return. I can buy a bucket of dividend stocks and clobber that. I'll live off the dividends, and my kids can inherit the stocks -- and the income stream.

I mean, just off the top of my head, I could buy a bunch of big cash-cow stocks like these.

Source: Motley Fool CAPS.

What's not to like, right? I mean, none of those companies are going anywhere anytime soon.

Of course -- and here's the thing -- that's what we all said about Citigroup and Bank of America (NYSE:BAC) five years ago. They're not dead, but Bank of America's paying a penny every quarter in dividends and Citi isn't paying anything. Anyone counting on that income stream is pretty unhappy right now.

Still, on average, you'd think we'd be fine. But here's the point Otar goes on to make: Using averages is a fool's (not Fool's) game. Markets (and dividends) go up and down over time, and if they go down too far at the beginning of our retirement -- causing us to dip deeper into our savings -- we'll have less money invested once the recovery starts. We'll have fallen permanently behind.

It's an enlightening and sobering interview -- while we'll need to save even more for retirement to be sure it all works out, Otar has some useful ways to make sure it does work out. If you've read this far, I strongly encourage you to go take a look -- if you're not a Rule Your Retirement member, just grab a free trial for 30 days of full access. There's no hidden cost and no obligation to subscribe.