Thursday, May 03, 2007

Annuities - yes, no or maybe

It all depends. First, I must clarify what annuities we are talking about in this post. This post will not be discussing variable and equity indexed annuities that are insurance products with investments as sub accounts. What I will write about are immediate fixed annuities that are used to generate a stream of income.

At some point I will post my thoughts about variable and equity indexed annuities but will defer to later because of their minimal usage in my practice.

Immediately fixed annuities are a financial products issued by insurance companies. They provide a guaranteed income stream (guaranteed as long as the insurance company has the ability to pay) to one or more people, in specific amounts for a specified period or for life (we will only talk about life).

They are an important product to consider when planning for retirement because they will provide another source of steady income along with social security to retain ones standard of living similar to their active working years. Income payout is based on a guaranteed, fixed interest rate when purchased.

If you want to avoid the risk and uncertainty of the stock market based products and feel more comfortable with a known amount of income then an immediate fixed annuity might be right for you. An immediate fixed annuity is the opposite of life insurance. The payout occurs during ones lifetime not at death.

The amount of guaranteed income paid is dependent on three variable; (1) the interest rate at the time of purchase, (2) the ages of the annuitants and (3) the amount of money given the insurance company. Obviously the income will be greater the greater all of the three variable are. Because there are many insurance companies selling annuities one must shop around for the best deal.

The best deal might not be the best decision because the income stream is only as good as the insurance company that is backing it up especially since the payments could be over many decades. Make sure to check out an insurance companies rating through rating service such as AM Best. Only purchase through those companies that are highly rated.

What are the positives and negatives of a immediate fixed annuity.
Positives
As discussed above they provide a steady stream of income to supplement social security, pensions and other investments. As pensions are disappearing another steady source of income is necessary for most people. That guarantee can be very important for piece of mind and planning purposes.

A good rule of thumb is 50% of retirement income should come from guaranteed sources (annuities, social security and pensions). This percentage could vary widely given one's overall financial situation and tolerance for the unknown.

You cannot outlive the annuity. If one has a family history of long life then an annuity might be the right choice.

Negatives
The money used to purchase the annuity now belong to the insurance company. They takes the risk to invest it and provide the guaranteed income. At the death of last annuitant the income ceases and nothing goes to beneficiaries unless the annuity provides for certain guarantees. If one dies early then an annuity might not have been the best choice for the annuitants' beneficiaries. If one is concerned about passing on a legacy to beneficiaries then purchasing an annuity would not be appropriate.

If the annuitant is not in good health an annuity is not a good option.

The money used to purchase annuity is gone so you cannot rely on it anymore if there are emergencies.

One faces interest rate risk when purchasing an annuity. The interest rate is fixed at the purchase date which is one of the determining factor of the income streams. If interest rates go up in the future and stay up then income stream will be negatively impacted. One way around this is to purchase a number of annuities at different times rather than one lump sum at the same time.

Most immediate fixed annuities are not adjusted for inflation. If the annuity is paid over decades then the purchasing power of the income stream will gradually erode because of inflation (see one of previous posts about the impact of inflation). Social Security has an advantage over most annuities because of cost of living increases.

Some immediate fixed annuities do have inflation riders but it will mean a lower payout in the beginning but might be the right choice if the lower payment does not affect the standard of living in the beginning.

I do think immediately fixed annuities do have a place in retirement plans for most people.

1 comment:

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