Annuities May Provide Higher Income For Long Retirements

April 10, 2002
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NEW YORK — It’s a product that’s been around for hundreds of years that some people are beginning to give a second look.

It’s the immediate fixed annuity, one of several tools that can be used to construct a steady stream of retirement income.

In a recent study that evaluates retirement portfolio liquidation options, John Ameriks, Ph.D., a research economist at the TIAA-CREFF Institute, the research and education arm of TIAA-CREF Life Insurance Co., found that using an immediate fixed annuity can both enhance and prolong retirement income.

The study, published recently in the Journal of Financial Planning, uses hypothetical future scenarios to explore the sustainability of investment portfolio withdrawals during the retirement years and looks at ways to make the liquidation process more stable over longer retirements.

Since there’s no way to predict what the future holds in terms of investment returns, or in terms of inflation or how long one may live, investors and their advisers must make educated guesses about how much income a retirement portfolio will ultimately provide.

“What we were trying to do was show, basically, the amount of uncertainty that’s involved that people usually don’t realize,” Ameriks explained.

“When a retiree gets to retirement age they don’t know whether they’re retiring in a period where the future is going to look like it did in the 1950s or whether what is to come is going to look very close to the 1970s.”

The other thrust of the study was to point out potential options, particularly the immediate fixed annuity, which Ameriks said is one of the ways people can hedge against longevity risks. It’s like a fixed income product that produces a fixed stream of payments. Payments from the fixed account are guaranteed and do not fluctuate. Like other annuities, it’s only offered by insurance companies. 

The immediate fixed annuity is “immediate” because a person can take it out right here and now with a lump sum of money, rather than pay into it for years. When a person buys a fixed annuity from an insurance company for a lump sum of money, the insurance company, in exchange, promises a stream of income.

It used to be that retirees typically received what was called defined benefit pensions — X amount of pension money from their former employer every month during retirement.

Nowadays most people approaching retirement don’t have that kind of pension. More and more, it’s a defined contribution where the company puts in a certain amount of money and the employee contributes, so the employee is at the mercy of what he invested. 

Furthermore, people are living longer, and retirement income may need to be stretched out over a longer than planned for period.

A fixed annuity can be a way to get around that uncertainty because it can add some stability and some certainty to retirement income flows, according to Ameriks.

Up until very recently, to many people the word “annuity” meant a product used for accumulation — a deferred annuity — or what was essentially a mutual fund in an insurance wrapper, he said. 

“It’s only recently that people have started to look at the income side of the annuity, which is kind of what the annuity is all about,” he said.

“The accumulation phase was just there to help people build up the lump sum they would need to buy the annuity income. That’s why the deferred products exist, but the annuity gets its name from being a payout vehicle for people.”

The reason why it works, he explained, is that it puts the retirement assets of a large group of people together and pools their mortality risks, so that those people’s lives that are shorter than expected leave assets in the pool to make payments for people who live longer than expected.

The pooling is what allows an individual to maximize retirement income. It’s one of the most basic kind of insurance arrangements that anyone can enter into, Ameriks added.

Other than for people in very poor health, the annuity is generally a good idea for those interested in receiving income in retirement, he said.

But the trade-off with an annuity is that the thing that makes it work — the pooling of assets — means the retiree has to give up, at least to some extent, the possibility of leaving those annuitized assets to heirs or beneficiaries.

“For the annuity to work, something has to be exchanged.  In other words, you give up the ability to leave something in exchange for a promise of income no matter how long you live. That’s the fundamental trade-off.”

But if a person doesn’t want to leave an estate and is saving only for his own retirement income, then the annuity becomes an even more important part of what he should have in his retirement portfolio, in Ameriks’ estimation.  

He thinks people more or less assumed that all the problems they experienced and the challenges they faced while accumulating assets would somehow disappear once they got to retirement.

“There are a tremendous amount of issues and priorities people have and there are a lot of products available to help them meet those needs that they need to be aware of. The fixed annuity is just one of them.”

In comparison, a variable annuity is usually invested in equities in something just like a mutual fund. It’s “variable” because it moves up and down in value as any mutual fund would do.

Almost all the annuities provided by insurance companies are fixed nominal annuities — they don’t come with an inflation guarantee. So Ameriks observed that a retiree must be aware of the fact that, over time, inflation is going to eat away at the value of their payments.

Since the variable annuity can rise in value, unlike the immediate fixed annuity, it has the potential to outpace inflation. On the other hand, the fixed annuity completely eliminates the investment risk that an individual may face.

When thinking about retirement income, Ameriks said people need to think about the pattern in which they want to receive that income. Do they want the bulk of their income to come early in retirement, typically the more active phase, or later on in retirement when they’re less active?

What percentage should annuities comprise in a retirement portfolio?

Ameriks said it depends on the individual’s own preferences about their retirement income, their health situation, and how much money they have in what are, essentially, other annuitized forms like social security and defined benefit pension from an employer. 

“The other thing it really depends on in a huge way is the preferences people have for leaving assets to their heirs or to charity,” Ameriks said. “People who are really concerned about estate building might want to reduce the amount of the annuity they buy.”

But if people have been saving and building retirement money just for the purpose of spending it in retirement, than a large chunk of it ought to be annuaitized, he said.

Perhaps some people don’t consider annuities because they simply don’t like insurance companies, Ameriks noted.

“People are distrustful of someone who says they can give them the best deal in the world for guaranteed income. People hear that and they don’t trust it; they’re not receptive.

“You want to know how it works and what the dollars and cents of the calculations are. Let’s talk about the numbers first.

“If people get peace of mind from an annuity that’s fine. I’d rather talk about annuities as a financial product like a stock or a bond or anything else.”

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