How to Protect Your Retirement With Income Annuities

Publish Date:

Saturday, December 15, 2018 10:44 am EST

News Organization:

Barron's Online

Policy makers, academics, and industry executives agree: The challenging task of getting decades' worth of savings to last a lifetime can be made more manageable with a single product: an income annuity. Annuities, however, have long suffered an image problem—for reasons both deserved and exaggerated—so investors have been slow to embrace them. But that could soon change, as individuals grapple with increased market volatility and rising interest rates.

Financial advisors and retirement experts have long advocated having some guaranteed source (preferably plural) of lifetime income to supplement Social Security. Guaranteed income, of course, offers peace of mind; it also lets retirees take more risk in the remaining parts of their portfolio, and/or enables them to tap their nest egg at a higher withdrawal rate.

Generally speaking, the best way to create a guaranteed income stream is through a simple income annuity: Invest a lump sum that the provider will turn into a stream of payments right away, known as an immediate annuity, or in the future, via a deferred income annuity. These are about as fancy as a bond with a coupon.

Income annuities, however, haven't been popular outside of policy and academic circles. They account for just 5% of the $203.5 billion in total annuity sales last year, according to LIMRA Secure Retirement Institute. Mention annuities and people think complexity, opacity, and high costs. That's in large part because the more popular annuities offer variable (rather than set) income, and come with enticements like guaranteed minimum benefits, payouts linked to an index, or cash refunds—perks that can carry a high cost.

Yet, when a long list of academics—including behavioral economist and Nobel Prize winner Richard Thaler—talk about the merits of annuities, they are referring to no-frills, fixed-income annuities.

York University finance professor Moshe Milevsky recommends buying into a qualified longevity annuity contract, or QLAC. These typically pay out at age 85 and can be bought inside tax-deferred accounts, such as 401(k) plans, allowing investors to benefit from low-cost institutional pricing. Even though annuities themselves are tax-deferred, there's another big benefit to owning one in a retirement plan: Up to $130,000 in a QLAC (or a quarter of the account balance, whichever is less) can be excluded in the calculation for required minimum distributions when retirees hit 70½.

Less than 10% of 401(k) plans, however, offer any sort of annuity option, according to an annual survey by the Plan Sponsor Council of America. If it's not on your menu of options, Milevsky recommends talking to a plan sponsor or administrator, and/or buying it through an individual retirement account.

Income annuities also have been less appealing during a nine-year bull market with abnormally low volatility and interest rates near record lows. But the recent cracks in the bull market, reduced expectations for stock returns, and rising rates may warrant a closer look at income annuities, especially if the 10-year Treasury bond's yield continues to climb and crosses 4%, says Dan Houston, chief executive of Principal Financial Group, which sells retirement products including annuities and target-date funds. At that yield, income annuities represent about an 8% return using present value calculations, with no volatility, Houston says. That looks a lot more attractive than the mid-single-digit returns on stocks that strategists are forecasting, especially given that those gains come with volatility.

Who, What, When, How?

Here's who probably doesn't need an income annuity: People who have a pension that, along with Social Security, meets most of their retirement income needs. Also, those wealthy enough to not be worried about running out of money, even if their retirement exceeds 50 years, according to Milevsky.

Most retirement experts recommend putting no more than a quarter of savings into an income annuity. It's also worth talking to a financial advisor on whether to use pre- or after-tax income to purchase them; each potential buyer's situation is different.

A deferred income annuity offers the most for your money because it affords a bigger payout from "mortality credits." These accrue as insurers pool assets of investors, some of whom will die before receiving any income. Milevsky recommends beginning to buy the initial tranche of annuities—say about $50,000 worth—10 or 15 years before you might need to draw on the income, and purchasing more as needed, as you find yourself spending more or are in better health than you anticipated. "That way, you learn the sweet spot of what you need. As retirement evolves and you realize you are spending more than you thought, you can get more [coverage]," Milevsky adds.

This idea of buying slices of income for later in retirement is also where the next iterations of target-date funds are headed, says Principals' Houston. As investors put money into such funds, some of it could go toward purchasing income annuities that will pay out in the future.

More often, retirees buy income annuities to cover their expenses until they turn 70, so they can delay taking Social Security and reap the 8% annual increase in benefits, plus get the inflation adjustment, says Kelli Hueler, founder of Hueler Cos., which operates a platform that sells low-cost income annuities, some to retail customers.

Several carriers, including Nationwide, AIG, and Lincoln Financial Group, offer low-cost, simple income annuities. Pricing varies but currently Hueler says low-cost or institutionally-priced simple annuities can pay out 6% more, on average, than others. "That bumps you up considerably from what you would earn on a CD, and it is guaranteed for life," Hueler observes.

The way to shop is to compare monthly payouts of income annuities with the same features. Currently, a 65-year-old man can buy a $50,000 deferred single life income annuity that pays out $605 a month, starting at 75 ($562 for a woman). Buying that annuity at 55 and having it start at 80 would more than double the payout to $1,257 a month for the man and $1,140 for the woman, according to the Hueler Cos.

Typically, the most basic annuities offer the biggest payouts. At the moment, a 55-year-old can get $1,380 in monthly income, starting at 80 and also get an extra 10-year-fixed feature that allows for his beneficiary to continue getting the monthly payment if the annuitant dies within 10 years of the payment starting. Such deals are one reason Hueler recommends shopping around frequently, noting that prices change based on an insurance carrier's book of business at any given point.