One of the worst fears people face in retirement is the threat of running out of money when they get older, perhaps in their 80s or 90s. No matter how big your stock portfolio and flush your 401(k), if the stock or bond markets take a dive at the wrong time, you can lose your savings just when you need it most. In retirement you can no longer replenish your savings, and it's too late to wait around for investments to come back.
One answer to the vicissitudes of investing is to buy an annuity, an insurance product that produces a steady stream of income for a period of time, typically the rest of your life. An annuity provides a steady income, month after month, that will never run out. But before you sign on the dotted line, be aware of these three potential pitfalls.
An annuity sounds simple, but it's actually complicated. You give a lump sum to the insurance company, and in exchange it sends you back regular payments for as long as you live. But there's an encyclopedia of variations on the theme. One example is the deferred annuity. Instead of contributing a lump sum, you make small payments over a number of years, building up savings. When you retire, the process reverses and the insurance company starts making payments to you. You can also get an annuity tied to the vagaries of the stock market. The insurance company invests your savings, and instead of promising a fixed payment, it offers you larger or smaller sums depending on how the investments work out. You can get annuities with death benefits, spousal benefits, and a variety of other features.
There are no guarantees. Typically, annuities are not tied to inflation. So the nice monthly payment that covers your expenses in 2012 could end up barely paying for dinner 20 years from now. Annuities generally do not benefit from government-backed insurance, so there could be a risk if your insurance company goes bankrupt. And many annuities are "chock-full of hidden fees," according to Elle Kaplan, CEO of Lexion Capital Management. You don't see the fees because they're not itemized by the insurance company, but you know they're there because the amount of your monthly payment is lower than what you can get from alternative investments.
Now is a bad time to buy an annuity. The amount you receive from an annuity depends on your gender, age, and current interest rates. Interest rates are now at historic lows, so annuity payouts are low. For example, if you're a 65-year-old woman, an annuity would pay you back about 5.5 percent per year. So if a 65-year-old woman were to give the insurance company $500,000, she would receive a payment of about $2,300 a month. But a few years ago, when interest rates were higher, a 65-year-old woman received 7 percent a year, which is closer to $3,000 a month.
So, is an annuity a bad idea? Not necessarily. If you are healthy, have good genes, and can expect to live into your 90s, then maybe an annuity is a good bet. If you're a big spender who cannot keep your hands off your retirement nest egg, then relying on someone else to hold onto it and give you an "allowance" might be a good idea. If you have a large retirement portfolio, it could be prudent to invest a portion of your savings in an annuity as a way to diversify your future income. But remember, in a sense, we all already have an annuity plan, in the form of Social Security. So do you really need another one?
Last week, when the whole world was salivating over the Mega Millions record $656 million jackpot, the question came up: would the winner be smarter to take the lump sum, or the annual disbursements? Financial experts trotted out their formulas and pointed out that the lump sum is a higher proportion of the advertised total than ever before. They agreed on the right answer: take the lump sum, not the annuity.
Tom Sightings is a former publishing executive who was eased into early retirement in his mid-50s. He lives in the New York area and blogs at Sightings at 60, where he covers health, finance, retirement, and other concerns of baby boomers who realize that somehow they have grown up.