Shopping for a Fixed Annuity
If you're looking for a reliable stream of income you can't outlive, you might want to consider an immediate fixed annuity. Don't confuse this kind of annuity with the more familiar (and, typically, more costly) deferred variable annuity. With a single-premium immediate fixed annuity, you invest a lump sum with an insurance company and begin receiving payments right away, either for a specific number of years or for life.
This can be a simple solution for retirees who are looking for regular income today, not at some point in the future. But finding the right one for you will take some up-front analysis. Here are some basics to get you started.
A closer look at immediate fixed annuities
If you're considering an immediate fixed annuity to complement your retirement portfolio, you'll want to evaluate the annuity's internal rate of return. This is the periodic rate of return you receive over a specific time horizon when all interest payments and return of investment principal are included.
You should compare the annuity's internal rate of return to what you might expect on a laddered portfolio of CDs and/or high-quality bonds. With bonds, the "internal rate of return" is usually called its yield to maturity. So you'll need to calculate the yield to maturity on a laddered-bond/CD portfolio that's designed to generate the same monthly payments for the same lump sum investment over the same time horizon.
Of course, you need to have a set time horizon in order to make a comparison. That's not so hard if it's a "period certain" annuity—meaning payments are guaranteed for a limited number of years, rather than your entire life. With a "life" annuity, where payments are guaranteed for life, you have to make some assumptions about how long you'll live (more below).
You might want to enlist some help as you make your calculations and comparisons. If your investment is big enough, it's a good idea to have your CPA or another third party (other than the annuity provider) crunch the numbers for you.
A simplified example
Let's say you're 65 years old and have a $300,000 lump sum available to purchase an immediate fixed life annuity. You find that in exchange for the immediate payment of $300,000, you can get $24,000 per year for as long as you live.
At first glance, $24,000 per year on $300,000 looks like an 8% yield (24 ÷ 300 = 8%). Sounds great. But remember, a life annuity pays out both taxable interest and tax-free return of principal, leaving a zero balance based on built-in assumptions about how long you might live. If the annuity assumes that at age 65 you'll live for 18 more years, for instance, the annuity's internal rate of return, or yield to maturity, would be roughly 4.45% (if you live that long).
In other words, if you drew down $2,000 at the beginning of each month ($24,000 per year) in both interest and principal on a $300,000 lump sum, you would need to earn an average annual return of 4.45% to make it last exactly 18 years.
However, the longer you live beyond your actuarial life expectancy, the better the annuity deal becomes. If you live 25 years to age 90, your annual compound rate of return goes to about 6.61%. And if you live 30 years to age 95, your annuity's yield to maturity jumps to 7.31%—not a bad rate compared to current high-quality bond yields of similar maturity.
Obviously, if you chose a payout based on your own life expectancy with no survivor benefits and died after the first year, it would be a pretty good deal for the insurance company.
The big advantage
But the key point is you can't outlive the income from a life annuity. With a do-it-yourself alternative such as a bond or CD ladder, you're stuck trying to calculate yield to maturity based on an unknowable date in the future—the day you die. Insurance companies are able to spread that mortality risk across all their annuity holders.
Besides, you likely wouldn't be able to earn much more on a laddered CD or high-quality bond portfolio even if you did know in advance how long you would live. What's more, in order to manage a monthly payout from a bond or CD ladder with a rate of return similar to an immediate fixed annuity, you'd either have to put in a lot of work (not to mention transaction costs) or pay a professional to do it for you (such fees are already built into the fixed annuity payout).
There's a lot to be said for the convenience of receiving a hassle-free check every month for the rest of your life, while leaving the investment risk and management to someone else, at least for a portion of your portfolio.
If you think an immediate fixed annuity makes sense for you, you'll want to compare the annuity payments offered by different, highly rated annuity providers for the same lump sum investment—or conversely, how big the lump sum needs to be to generate your desired level of monthly income. Just as four auto dealers may give four different prices for the same new car, different insurance companies may give you different quotes for the same annuity, reflecting the underlying costs and fees associated with each company's offering. (The guarantee of income for life depends on the issuing insurance company's ability to pay claims, so be sure to choose a financially strong company.)
Most immediate fixed annuities offer additional features, such as inflation protection, single life with period certain (which is where you accept a lower annuity payment for life in exchange for the promise of at least a minimum number of payments to your beneficiaries), joint survivor benefits (typically a lower payment based on joint life expectancy, in exchange for the promise of continued payouts to the surviving joint party), and so on. All else being equal, adding these features will reduce the monthly annuity payout for the same initial lump sum (or require a larger lump sum for the same payout). You may find these additional features worth the costs, depending on your needs and objectives.
Be sure to compare apples to apples by using the same scenario for each quote. For example, you don't want to compare a single-life monthly payout at one company with an annuity that has a cost of living adjustment (COLA) provision and survivor benefits at another.
What about interest rates?
Prevailing interest rates will significantly influence the lump sum required to generate a particular level of income. When rates are extremely low, committing a large lump sum to a life annuity is generally less attractive—think of it like locking in a 30-year long-term CD.
If you believe rates are due to rise in the near future and you don't want to commit all your cash right away, one approach would be to split your fixed annuity purchase into several pieces—perhaps purchase one-third now, another third in a year, and so on. Or, you might purchase a five- or 10-year period certain annuity, which would likely require a smaller lump sum for the same level of required monthly income, and wait to see what happens after that.
One drawback with splitting your purchase into several pieces is that fixed annuity contracts can have "break points" at which the annuity payout becomes more attractive. For example, you might receive a better internal rate of return on a $150,000 lump sum purchase than you would on a $50,000 lump sum purchase, all else being equal.
Also, if you're leaving money in stocks and bonds while waiting for rates to rise so you can get a better deal on an immediate fixed annuity, don't forget about the offsetting impact rising rates might have on those assets.
The bottom line
Shopping for a fixed annuity need not be overly complex. But it will require some effort on your part. For more information on the potential benefits of integrating a single-premium immediate fixed annuity into your retirement spending plan, please read Give Your Retirement Spending A Boost.
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Please note that, subject to the requirements of Internal Revenue Code (IRC) Section 72, a portion of the annuity payments to you may be taxed as current income at ordinary income tax rates. As this may or may not be beneficial, depending on your tax bracket, please consult a tax or accounting professional.
Unlike a CD, which is an FDIC-insured bank product, an annuity's payment guarantees are only as strong as the financial position and claims-paying ability of the issuing insurance company. Consult the insurance company's ratings for its financial strength, and read the annuity contract and/or prospectus before investing.
Guarantees are subject to the financial strength and claims-paying ability of the issuing insurance company (not Schwab).
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Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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