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The No. 1 financial fear that nearly every retiree or near-retiree has is running out of money. Regardless of how big a retirement nest egg you have, there's always a nagging concern that it may not prove to be enough -- and if you hit the wall after you've left your last job far behind, it's often way too late to do anything about it.
You won't find many investments that directly address the threat of outliving your money. But one specialized set of investments -- annuities -- gets at the root of the problem by structuring payouts that are designed to last as long as you live, no matter how long that may prove to be. But is the unique advantage that annuities have over other investments worth the price you'll pay for them? To find out, let's look at the recent history of the annuity industry to see how things are changing.
Annuities under fire
Skeptics have argued for years that annuities weren't worth the additional cost that you'll pay for their protection. On top of ordinary fees for money management, annuities typically add on substantial costs related to the insurance element involved, essentially boiling down to your paying extra for the possibility that you'll live beyond your life expectancy. Additional optional fees apply to various guaranteed benefits that many annuities offer, including guaranteed lifetime payouts.
But with perfect hindsight, it turns out that many insurance companies were too generous with their annuities. As a recent Barron's list of 50 top annuities discussed, a combination of rock-bottom interest rates on bonds as well as extreme stock-market volatility forced several insurers to take extreme action in response. Genworth Financial (NYSE: GNW ) and Sun Life Financial (NYSE: SLF ) have exited the variable annuity business, while Manulife Financial's (NYSE: MFC ) John Hancock unit has dramatically restructured its annuity business so that only a narrow group of key partners offer annuities. Hedge-fund manager John Paulson persuaded Hartford Financial (NYSE: HIG ) to go one step further by getting out of the annuity business entirely
Now, after the dust has started to settle, MetLife (NYSE: MET ) and many of the other remaining players in the industry are being more conservative about their promises. That arguably makes annuities less attractive as a long-term investment, but with alternatives looking equally unattractive in many cases, annuities still meet the need of providing more transparency about future payments than you'll get from just about any other type of investment.
What you need
The most irritating thing about annuities from a planning standpoint is that they're extremely difficult to decipher. What investors want annuities to do, in contrast, is very simple: in exchange for an upfront payment, you want to get as big a monthly payment as you can get that's guaranteed for the rest of your life.
But the beneficial tax treatment that life insurance policies get under the current tax code lead insurers to offer more than basic annuities. Instead, you'll find complicated riders and additional terms that offer guarantees above and beyond the basic lifetime payment promise. For example, returns tied to -- but not directly matching -- those of the stock market appear to promise the chance at future bull-market riches.
Look more closely, though, and you'll discover catches like caps on returns that compensate for those guarantees. All too often, it's very difficult even for experts to decipher what will happen with a particular annuity until it actually happens.
Get what you pay for
If you can get the features you want at a reasonable price, then annuities can make a lot of sense. In particular:
- Immediate annuities are a smart way to create what resembles a do-it-yourself pension, with you receiving monthly payments right away.
- Deferred income annuities, also known as longevity insurance, let you put aside money now in exchange for payments starting at a later age, often 80 or 85. That ensures a stream of income kicking in around the time you'll start to outlive your life expectancy, but it's less expensive than a traditional immediate annuity.
Most importantly, take a good look at the costs involved. With rates as low as they are, you probably can't afford to lose 2% or even 3% of your money to fees each and every year if you expect to do well in the long run.
Annuities aren't inherently bad -- but between a few disreputable salespeople and insurers that reward sales with high commissions, they've gotten a bad reputation. Nevertheless, if you're careful to find low-cost annuities with good terms, you may well find that an annuity addresses your worst fears of running out of money -- and that peace of mind may well be worth the price you pay.
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Editor's note: A previous version of this article incorrectly stated that John Hancock no longer offered variable annuities. The Fool regrets the error.