As you approach, or perhaps just think about, your retirement, it's natural to focus on the income you're going to need. For most of us, our retirement income will be a mix of Social Security benefits and personal savings, perhaps largely in retirement accounts. Some lucky ones will have pension income, too. If you don't have any pension income coming to you, you might consider buying an immediate annuity. It's kind of like buying a pension.
Let's review what annuities are first. Annuities are essentially contracts with insurance companies, whereby you typically hand over a significant sum and receive regular payments immediately or in the future -- very often for the rest of your life (and, if you want, for the rest of your spouse's life, too).
There are lots of different kinds of annuities: immediate vs. deferred (paying you immediately vs. starting at some point when you're older), fixed vs. variable (certain payouts vs. payouts tied to the performance of the market or part of the market), lifetime vs. fixed period (paying until death or paying for a certain span of time), and so on. Some annuities, such as indexed annuities and many variable annuities, are problematic and unsuitable for many people, charging steep fees and/or carrying restrictive terms. But immediate or deferred fixed annuities are smart options for many retirees or those approaching retirement.
What to expect from an immediate annuity
The average Social Security benefit, as of March, 2016, was $1,345 per month, or about $16,000 per year. (The maximum was recently $2,639 -- or about $32,000 for the whole year.) If that doesn't seem like enough to live off of to you, you'll need to be building and planning on other income streams.
A good stream to consider is that from an immediate annuity. Prevailing interest rates will influence how much insurers will be willing to pay you, and these days rates are very low. Still, if you're a 70-year-old man, $100,000 may get you an immediate annuity paying about $635 per month, or $7,600 per year. A $300,000 purchase would generate about $23,000 annually. (Women can generally expect lower payouts -- because they tend to live longer than men.) For $200,000, a 70-year-old couple might get $1,000 per month for as long as either is alive. If you have that kind of money, an annuity can be a major compliment to Social Security income.
Reasons to buy an immediate annuity
So why might an annuity make more sense than other options, such as simply living off dividend income? Well, let's review a few reasons.
Investment accounts and retirement accounts (especially those that generate significant dividend income) can serve you well, but they can fall in value if the economy goes through some tough times. Any given dividend-paying company might run into trouble, too, decreasing or eliminating its payout or perhaps just plunging in value. That risk might keep you up some nights, and could possibly lead to your running out of money one day. Annuity income is guaranteed, as long as the insurance company behind it is solvent. (You should always favor top-rated insurers and perhaps even divide your annuity-buying money between several of them.)
Annuities can also serve you well if you're worried about running out of money late in life, as your nest egg gets depleted. Remember that fixed annuities can start immediately or can be deferred. If you think you have sufficient income for about 20 years, you might buy a deferred annuity today that will start paying you in 15 or so years. That way, you'll be assured of income later in life, too. Better still, you'll get bigger payouts if they're deferred, because the insurance company gets your money early and can invest it for itself until it has to pay you.
Worried about inflation eating away at your money? With immediate annuities, you can spend a little extra (or accept a little less) in order to have your checks adjusted over time to keep up with inflation.
Finally, remember that as you get older, you may find that you have less interest in keeping up with your investments, or even less ability to do so. Cognitive abilities decline over time, whether we're aware of that or not. Some studies have even suggested that mathematical and financial skills are among the first to go. One 2010 study from the Center for Retirement Research at Boston College found that, "Individuals make the most effective financial decisions in middle age, resulting in lower fees and interest rates on credit and loan transactions." Annuity income, like Social Security income, can keep paying you for the rest of your life -- with little input required from you.
Immediate annuities are not for everyone, but they do make a lot of sense for many of us. Take some time to read up on them and see whether they might make your retirement better.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.