A lifetime income annuity and how it works
When the conversation regarding retirement planning arises, often talk turns to an annuity, what it is exactly and whether it is worthy of consideration in a retirement focused investment strategy.
Typically, just the word "annuity" tends to evoke several types of reactions.
One is the look of disgust and the "I would never put my money in an annuity" reaction.
A second is the "eyes glazing over, heads nodding and falling into a deep sleep" reaction. After all, annuities are not thought of as very "sexy" investments.
And finally, there is the "bewilderment" reaction from those who have no clue what an annuity even is.
While it is true that an annuity may not be appropriate for everyone, there are many cases where it can be an important part of a retirement investment strategy, so it should not be overlooked.
My thought in this column is that a simple explanation of how one particular type of an annuity works, referred to as a lifetime income annuity (or immediate annuity), and how it provides lifetime income, may help avoid some of the reactions above, and show why pretty much anyone nearing retirement probably should at least consider investing in one to some degree.
You can think of the concept of an lifetime income annuity as the pooling of money by you, me and a bunch of our friends that is then invested, with the results being shared among those who are participating.
Further, to provide an income stream, we all agree to pay out some of the principal in the fund each month, being careful of course to do it in a manner that doesn't empty the fund.
And as one final condition, in order to protect the income stream of all participants, we all agree that when someone dies, the remainder of the fund is divided up among the still living participants to continue to provide income to them.
That's pretty much how a lifetime income annuity that you buy from an insurance company works, so hopefully that basic explanation removes some of the mystery.
There are of course a few important differences between our informal hypothetical example and insurance company issued immediate annuities.
For one thing, immediate annuities cover a large group of people from many different places of various ages and all investing differing amounts of money (think diversification).
Another big difference is that while in my example above we can't say for certain what the monthly income stream will be, insurance companies can tell you in advance how much an income annuity will pay each month.
How can they do this? Because they have actuaries (smart folks) who use mortality statistics to estimate how many annuity policyholders will die each year and investment gurus (more smart folks) who project investment results. That enables them to determine upfront the payments they can make.
But maybe the most important difference is that insurance companies can virtually guarantee that annuity owners will continue to receive monthly income payments regardless of how long they live, something our hypothetical group can't do.
The reason they can do this is that state insurance regulators require insurers to set aside in reserve a certain amount of money just in case those smart guys' (remember the actuaries and investment gurus?) forecasts are off base.
Notice too that I said they can "virtually" guarantee it. There is always some risk an insurance company can fail. We've all heard of some that do. But frankly, historically speaking at least, the risk of that happening has been pretty small.
Definitely, however, do your homework on companies you may buy from (there are ratings services for this) and consider purchasing smaller annuities from multiple companies to spread that risk even thinner.
All that said, I don't believe anyone should "put all their eggs in one basket" and invest all of their money in lifetime income annuities anymore than it would be advisable to put all your retirement funds in any other investment vehicle.
A better approach for those who desire some amount of guaranteed lifetime income, or better said, desire more than what Social Security may provide, is to at least consider a lifetime annuity product as part of your investment strategy in conjunction with other investments, such as stocks, bonds, real estate, etc.
But don't rule out investing in a lifetime income annuity either, as no other investment can insure you against the risk of you outliving the money, something we call "longevity risk", like immediate annuities can.
Hopefully this helps make understanding immediate annuities a bit easier. If nothing else, maybe it will help avoid unnecessary foot stomping, growling, eye rolling and blank stares.
