Create Your Own Pension With Immediate Annuities

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People love pensions because of the security that they offer – a steady, guaranteed stream of income that you can’t outlive. Another way to achieve this reliability is to buy an immediate annuity, also called an income annuity. It lets you convert a lump-sum payment into a regular stream of income payments that can last for your lifetime, or the longer of you or your spouse’s lifetime.

Although there are many factors that come into play, very generally immediate annuities pay about 6-7% of the lump-sum back to you every year. So if you bought a $500,000 lifetime annuity, you might get $35,000 every year until you die. You can also play with the quotes at for different ages and survivorship scenarios.

This is much higher than the “safe withdrawal rate” of 4% that many financial folks quote as the amount of your nest egg that you can spend each each without running out of money before expiring. 4% of $500,000 is only $20,000 per year. More info on safe withdrawal rates can be found here.

But remember, with an annuity the $500,000 is gone. If you live another 50 years or just one, after you die there is nothing left to inherit. Also, annuity providers are like life insurance companies in that you really need to make sure they are stable enough that they’ll be around to pay you! Look for ratings from A.M. Best Company, Moody?s, and Standard & Poor?s.

The last article I mentioned when talking about how pensions will be gone soon also suggested annuities as a possible reform to current retirement plans:

If defined benefits are on their last legs, then it would make sense to try to incorporate their best features into 401(k)’s. The drawback to 401(k)’s, remember, is that people are imperfect savers. They don’t save enough, they don’t invest wisely what they do save and they don’t know what to do with their money once they are free to withdraw it. Quite often, they spend it.

Here there is much the government could do. For instance, it could require that a portion of 401(k) accounts be set aside in a lifelong annuity, with all the security of a pension. Behavioral economists like Richard Thaler have demonstrated that you can change people’s behavior even without mandatory rules. For instance, by making a high contribution rate the “default option” for employees, they would tend to deduct (and save) more from their paychecks. If you make an annuity a prominent choice, more people will convert their accounts into annuities.

If you think of pensions as annuities, you can use this to get a feel for how much those pensions are worth! For example, let’s say you’re a teacher and about to retire with a pension paying 70% of the average of your highest 3 years of income. If that number is $50,000, then you’ll be receiving $35,000 every year. If you refer back a few paragraphs, you’ll remember that’s the same as having saved up half a million dollars! Now you see how pensions are so expensive.

Although I’m still far from retiring, I have started considering using part of my savings to by an immediate annuity in order to cover my most basic spending needs and reduce the risk of retiring early in the event of a turbulent stock market. It would be almost like buying my own Social Security safety net 🙂 But I’ll also need to learn more about how this plan should affect my current asset allocation. Some papers that are on my (really, really, long) reading list can be found here.

(There are also probably some tax considerations that I’m ignoring here.)

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  1. I’ve read recommendations that you can consider immediate annuities part of your bond allocation during retirement. Say your target allocation is 40% stock and 60% bonds — convert half of the bond dollars to an IA to hedge against running out of money.

  2. A major consideration with annuities is the fees involved. If you are someone who invests in index funds because you despise the fees of various managed mutual funds, annuities seem like an odd place to go, since they are packed with fees.

  3. immediate annuities are a pretty good deal, because if you live to 120 years old, you’ll still get the income. Of course, the tradeoff is that if you die early, then the bank wins, but you wouldn’t really care since you’re dead. I think the scariest thing about an annuity is that it’s a huge one-time decision that locks you in for the rest of your life.

  4. Fees are a concern primarily with variable annuities, a different animal which adds on annual management fees, an upfront “mortality and expense” fee, and surrender fees. These are the ones you hear horror stories about. Immediate annuities seem to be more straightforward, although it’s hard to compare with mutual funds. In many cases the fees are rolled into the monthly payment quote they give.

    My fear is that I would only really need an annuity in the event of a severe and prolonged stock market crash. But would the insurance/annuity company also survive that same crash?

  5. One other risk with a annuity that provides a fixed dollar income is the risk of inflation.

    Personally, I like rental property better than annuities. For the same $500k, you should easily be able to get $20k/yr, even after paying a property management company. The rentals should provide you some degree of protection against inflation. The concern would be that once you were well into old age would you still have enough of your faculties to oversee the rentals (e.g. imagine you live to be 100).

  6. Jonathan’s last comment point is well taken. As he says, you’d obviously have to buy this option only from AAA rated insurance firms. But as we all know, even apparently very healthy companies can blow up (e.g. Enron) and I’d put banks and insurers firmly in that category. Think about it. Banks and insurers have about a zillion derivatives going at any one time. They try to build these portfolios so they’re perfectly hedged, but sometimes the whole market can move against you (see Long Term Capital Management).

    Secondly, insurers employ people with large brains and buy rooms full of humming computers to calculate their odds. You can obviously bet they’ve set these products up to benefit them. After all, they’re in the business to make money. This is not to say they are bad products – only that given a large enough sample, individuals are going to lose out.

  7. I’ve thought about immediate annuities myself. Im far from retirement and the company I am with now does offer a pension but I doubt I will be there for the next 40 years. Taxes and the fact that the money cannot be inhertied in case of early death are why I was hesitant. Good to hear that I wasn’t the only looking at these, pushes me to research more. Thanks Jonathan.

  8. I like the idea of using an immediate annuity (or series of immediate annuities) to either cover your fixed monthly expenses or to progressively supplement a career with declining income.

    In both cases, it’s not so much geared to eek out the absolutely best ‘return’ but to allow you to sleep at night with less worry.

    Some states have an annuity guaranty association. In most states they will pay out to a max. annuity value of $100,000, so people recommend that you put in less than this per annuity.

  9. Jonathan: “But would the insurance/annuity company also survive that same crash?”

    Wow, that’s a good point. I had thought about annuities some since I’ve holdings with TIAA-CREF and many of their accounts are ‘made to be annuitized’ anyway (they are in fact variable annuities and not mutual funds).

    The idea that the conditions that would make me most need the annuity equal the conditions most likely to fail the annuity company had not been something I considered heavily.

  10. Don’t you think it’s a bit early to get an annuity?

    One would you think after you max out your IRA, and 401K (For both spouses), then you purchase a variable annunity, which is basically a 401K. That’s about 41K invested a year right there.

  11. If you random pick an insurance company, you’ll probably get hit with pretty big fees for an annuity. Mutual fund companies have been getting into the annuity arena and you can get very low cost annuities from Vanguard and Fidelity now.

  12. I think Vanguard’s income annuities are backed by AIG, but I would assume that they would be one of the more competitive ones. No reason not to comparison shop, eh?

    Some annuities now adjust with CPI.

    Heather – So you could by, for example, five $100,000 annuities? I’m sure they would cost more, but interesting.

  13. I haven’t done any extensive research on annuities, but the bad press on some of them definitely has given me a poor perception. However, I can see where some sort of annuity may be a reasonable part of someone’s retirement plan. The guaranteed income is clearly the primary motivation, and the prospect of outliving your life expectancy and benefiting from the resulting “premium” is nice to think about.

    Like all investments, this one will undoubtedly require you to make some assumptions (how long will I live, will interest rates go up or down, what is the potential opportunity cost versus having it in an alternative investment, etc).

    However, with about 30 years to go before retirement, interest rates being historically low, and a lot of $$ needing to be generated, it’s a bit far from my thoughts at the moment. I don’t recall your age, but I’ll be very interested to see if your research makes you feel it’s a good investment to divert some of your funds to now. When looking at the calculator you suggested, it wouldn’t even give me an estimate until age 40…which gives me the impression that it’s likely something for consideration later on.

  14. I have read more horror stories with annuities than I’d care to say. I’m certain I will get a pension plan and between a Roth IRA, 401k, pension, social security, rental property, taxable investments, it just doesn’t fit in my plan.
    Because of all the fees and problems with IA, If for some reason I changed my mind I’d go with vanguard.
    I don’t have any fear of not getting a pension at my job, but if I didn’t have a pension and I was certain social security was going away I’d still probably skip out on the IA to be honest.
    If the fear is stocks, that’s what most fixed-income is for, if the fear is equity and fixed-income, that’s what rental property is for.

  15. At an amount of $500,000 it would seem better to go the route of a Charitable Remainder Trust. There are some upfront and ongoing costs, but you can minimize them by using a Community Foundation or some other charitable entity.

    A CRT could potentially let you pay out 6% to you and your spouse for your lifetimes and then to your children for their lifetime and then the remaining principal would go to the charity(s) of your choice – it could even be your own family foundation.

    Here’s the benefits:

    1. Fund the CRT with highly appreciated assets and bypass the Capital Gains.

    2. Receive a Charitable Deduction for the full $500,000.

    3. Higher payout for Joint beneficiaries.

    4. Income for your children after you are gone.

    Granted, the investments inside the CRT could fluctuate, but you could choose the allocation that best fits you.

    If you are in a high tax bracket, the tax benefits could be substantial.

    If you don’t want something so involved, a Charitable Gift Annuity might be in order, but the payout would not be as advantageous, nor are the tax benefits as pronounced.

  16. Whoops!

    Reread my hasty post. On my #2 of the benefits, it should have read that you can take a portion of the amount as a Charitable Deduction based upon the payout rate, the Federal Rate (AFR) you use and your tax bracket.

    Not sure what I was drinking at the time 🙂

  17. The present value factor of a single life annuity for a male aged 65 using relatively conservative interest rate assumption of 5.75% is 10.72. Thus, without regard to fees, your $500,000 translates into an annuity of $46,660. Unfortunately, fees reduce this by 11-13%.

    Since the present value factor relies on an average, and is only really applicable to a group of people, it would be really nice if you could put your money into a trust with a group of others, and have the trust pay you with much lower fees. And if the trust was professionally managed, you’ll probably do better than 5.75% interest, perhaps 7%. In that case the present value factor is 9.77, and $500,000 gets you $51,200.

    But just in case something happens, and the market fails to do well, or members of your group live a little longer than expected, it would be nice to know that the trust is insured somehow. If the trust were sponsored by a company, then implicitly, the company will provide extra funds to keep the trust, and if they fail, then there is the PBGC.

    Between lower fees and better asset return, you’ve earned an extra $10,000/year guaranteed by working through an employer sponsored trust.

    I guess the more common name for such a trust is a pension. Immediate annuities are just poor excuses for a replacement.

  18. Jonathan, I have a question about 401 K rollover which I am hoping you can answer.I currently don’t like my 401K plan which does not have any company match and they also charge a lot of fees (Asset charge,Admin Fees) which is eroding my account.I have infact stopped contributing to it but still have a substantial amount invested.Do you know if I can transfer my current 401K to a rollover account even when I am still employed with the company.Your opinion on this will be helpful if you have any idea ?

  19. Pensions are insurance for long life. Insurance by it’s nature is a bet. It is an attempt to spread risk of living toooo long. If you live a long time you win, if you die “early” you lose and if you live to the “expected” age then the result should be about neutral (ok maybe not with the insurance companies profit margin). It is the opposite of term life insurance.

    How much risk do you want to take and how much can you afford to risk. This is a very personal question since you are placing a bet on your life expectancy. There are annuities that will refund the unused principal if you die early, but you pay for that feature. Like most insurance products there isn’t a single right answer and a single solution for all people. For some people it is not an acceptable path. (For example, not everyone buys term life insuance).

    At age 62 (where much of the population begins retirement), mortality is relatively low (especially for white collar workers) so the annuity return is pretty low. Doing a good job of managing you money might be a better strategy. This is especially true if you have chronic illness that will likely shorten your life expectancy or have a family history that looks terrible (i.e. heart disease at an early age in your parents and uncles and aunts) and you smoke….etc.

    If you look at immediate annuities when you get to age 70 or older, then the returns start to look attractive. Death rates become significant, so the returns of annuities start to look attractive (assuming that you live as long as expected). But again you have to ask what do you want to risk and how much.

    There was some concern about inflation and it is possible to get an annuity that increases with time; however, the person with an average life span comes out behind rather than neutral (even if there were no profit for the insurance company and no adiministrative costs), but those that live a long time win big.

  20. I looked at a couple companies before I purchased an immediate annuity for my mother to cover her living expenses. New York Life had the best rates – paid $150 a mo more than Vanguard. Her bond portfolio would have been depleted in 6 years given the rate of w/d but we were able to receive almost the same payout guaranteed for life with the IA. She has other assets to pass on to heirs so the inheritance factor or loss there of was not a concern.

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