Guaranteed Income for Life

Retirees who watched in horror as their account balances plunged along with the stock market now face a new challenge: how to generate enough income to pay their bills.

A widely accepted rule of thumb suggests that if you hold initial withdrawals to 4% of your nest egg during the first year of retirement and increase that dollar amount by 3% in each of the following years to keep up with inflation, you won't run out of money over a 30-year retirement. Now even that strategy may not be cautious enough, and you may have to rethink your plans for retirement income.

Depending on the extent of your losses, you may want to freeze your withdrawals at current levels, skipping the annual inflation adjustment until the market rebounds. Or, if you suffered significant losses of 30% or more, you may want to restart your 4% withdrawal schedule based on the new, lower balance. But that can take a big bite out of your income. Say you started with a $1-million retirement stash and had been withdrawing more than $40,000 a year. If your savings shriveled to $700,000, you'd now have to get by on just $28,000 a year.

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There is, however, another way to stretch your income and increase your annual withdrawals to 8% or more of your savings. And you can still be assured you won't outlive your money. A study by the University of Pennsylvania's Wharton Financial Institutions Center found that by purchasing an immediate annuity, you could create a stream of secure lifetime income for 25% to 40% less than it would take to generate the same income from a traditional portfolio of stocks, bonds and cash using the 4% withdrawal rule. (That's because with an annuity, you're tapping both your principal and your earnings as well as pooling your risk with other annuity owners.)

Say you're a 65-year-old man with a $1-million nest egg that has shrunk to $700,000. If you use half of your money to buy an immediate annuity, you would receive nearly $29,000 a year in payouts. (A woman would get slightly less because of her longer life expectancy.)

With the remaining $350,000, you could continue to invest in a diversified portfolio of stocks, bonds and cash, and withdraw 4% a year. That would produce another $14,000 annually. Together with the annuity payouts, your retirement income would total about $43,000 a year -- $3,000 more than under the original 4% withdrawal scenario, even though your portfolio is now worth 30% less.

There's a catch

Naturally, there is a downside: With an immediate annuity, you give up control of the money. And although you get the maximum monthly income with a single-life annuity, it stops paying out when you die. If you die prematurely, you forfeit a chunk of your initial investment (which is then returned to the investment pool to pay the benefits of other annuity holders).

Most couples choose a joint annuity that continues to pay out as long as either of them is alive. Although the annual payout is smaller than the payout from a single-life annuity, it ensures continued income for the surviving spouse. And if you're concerned that you may both die before you have recovered your investment, you can choose an annuity that promises to refund any unused premium or to continue to pay out to your heirs for a certain number of years. However, each contingency benefit reduces the amount of your monthly check (see the box below).

HOW MUCH YOU CAN EXPECT FROM A $350,000 ANNUITY

Below is an estimate of how much monthly income you would receive for the rest of your life, depending on your age and gender, based on a $350,000 investment in an immediate fixed-rate annuity. Additional options include continuing payments to a beneficiary for up to 20 years if you die before then; refunding any unused premium to your beneficiary if you die before receiving the full amount of your investment; or paying 100% of your benefit to a surviving spouse (the example below assumes you and your spouse are the same age).AGE (MALE)LIFE ONLY20-YEAR PAYOUTREFUND OF PREMIUM100% TO SURVIVOR65$2,394$2,088$2,264$1,96470$2,714$2,151$2,494$2,20175$3,183$2,191$2,797$2,487AGE (FEMALE)LIFE ONLY20-YEAR PAYOUTREFUND OF PREMIUM100% TO SURVIVOR65$2,241$2,041$2,151$1,96470$2,497$2,138$2,397$2,20175$2,883$2,181$2,624$2,487Source: AnnuityShopper.com

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How Much to Invest

Immediate annuities are not liquid investments, so it's important not to tie up too much of your retirement savings. You'll still need to set aside money for emergencies as well as funds to invest to offset the effects of inflation.

John Ameriks, head of the investment counseling and research group at Vanguard, recommends working backward to figure out the appropriate amount to allocate to an annuity. First, add up your regular expenses and then subtract any guaranteed income you already receive, such as a pension and Social Security benefits. If there's a gap, consider filling it with an annuity.

To estimate how much you would have to invest to generate the monthly income you need, go to www.annuityshopper.com. For example, a 65-year-old man who wants an extra $1,500 per month would have to invest about $219,000 at today's rates in a single-life annuity, or $267,000 if he wants payouts to continue as long as he or his 65-year-old wife lives.

Emil and Elsa Nagy of Durango, Colo., worked with financial planner Paul Lemon to do a similar calculation last September, when Emil was 72 and Elsa was 68. The couple had lost money in the stock market in early 2008, and their bond portfolio wasn't generating enough income to cover all of their bills. A prescient Lemon thought the market might fall further and suggested they shift half their stock portfolio to an immediate annuity to boost their income.

Because the Nagys normally monitor their expenses using Quicken software, it was easy for them to determine the additional income they needed to bridge the gap between their regular bills and their income from a pension and Social Security. "We wanted some long-term security for the next 20 years," says Emil. "But we don't feel we have that many years to wait for the stock market to rebound."

Because annuities are long-term investments, Lemon recommends that retirees stick with companies that have financial-strength ratings of A+ or higher, which often pay out as much as or more than lower-rated companies. For an extra layer of protection, he divided the Nagys' annuity purchases among four different companies so that none exceeded the $100,000 limit imposed by Colorado's guaranty association, which protects investors if an insurer becomes insolvent. (Some states have higher protection limits; see www.nolhga.com for links to each state.)

Although they could have gotten a higher monthly payout by choosing a joint-life annuity alone, the Nagys decided to add a guarantee to pay out for at least 20 years, ensuring that their four children will continue to receive benefits even if both Emil and Elsa die before then.

Don't overlook inflation

Securing a guaranteed stream of income for the rest of your life may bring peace of mind, but it does not guarantee that you will maintain your future buying power. With most immediate annuities, your monthly payout remains the same year after year. It won't fluctuate with the stock market or with changing interest rates, but it will buy less as inflation erodes your purchasing power.

As an alternative, you could choose an immediate annuity with payouts that increase with inflation. In exchange, you'd have to accept a lower payout in the beginning. But if you lived for a long time, the payout adjustment could make a big difference.

For example, if a 65-year-old couple bought a $100,000 fixed-rate immediate annuity from Vanguard, they would receive $7,083 a year for the rest of their lives. On the other hand, if they bought an inflation-adjusted annuity with payouts that increased by 3% per year, as the Nagys did, they'd receive just $5,111 a year initially. But by year 13, when the hypothetical couple was 78 years old, payouts from the inflation-adjusted annuity would outpace the fixed-payout annuity. At age 85, they'd get $8,962 a year, and payouts would rise to more than $10,000 a year when they were 90 -- about $3,000 more than the fixed-rate annuity.

Ameriks says getting the extra money when you're older is much more important than having the extra cash upfront. "To me, it fits with the logic of immediate annuities -- that you're worried about living a long time and running through the rest of your savings," he says. "This is an insurance policy, and it should be about what happens when you need this to be there to protect yourself."

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Although selecting an inflation-adjusted annuity may be a smart choice, it's not a popular one. At New York Life, sales of income annuities jumped 55% over the past year, but few people selected the inflation adjustment.

"It's frustrating to us," says Chris Blunt, executive vice-president in the retirement-income-security division of New York Life. He says most buyers focus on initial payouts rather than long-term results, even though the inflation adjustment can provide much better protection in the long run. "If you polled financial advisers, 99.9% would say that inflation protection is the right thing to do given how long people can live," Blunt says. "Even an inflation rate of just 2% can cut your real spending power in half if you give it a long enough time horizon."

Try an annuity ladder

Another way to adjust for future inflation is to "ladder" annuities by buying additional fixed-rate annuities every few years. This can help in two ways: The older you are when you buy the annuity, the higher the payout (because your life expectancy will be shorter). And future interest rates may be higher than today's near-record low rates (adding more bang to your annuity-purchasing buck).

Gregory and Noreen Basso of Stockton, Cal., both in their mid sixties, bought an immediate annuity this year to supplement their monthly Social Security benefits. Because neither of them has a pension, they wanted to lock in additional guaranteed income to cover their bills, especially after last fall's stock-market rout. "Last year I turned 67 and decided it was time to stop worrying," says Gregory. "At this age, it's not like you can start over and find another source of income."

The Bassos chose a New York Life annuity because of the company's strong financial rating (A++ by A.M. Best, its top rating). They selected an annuity without inflation protection so that they could benefit from higher payouts immediately. "We looked at the numbers, and it was eight to ten years before the inflation-protected payout caught up" with the fixed payout, says Gregory. But the Bassos plan to buy additional annuities every few years to build up their guaranteed income and maintain their purchasing power.

The annuity-ladder strategy gives them a lot more flexibility. They can invest the rest of their money in the interim and perhaps end up with enough left over to leave something to their three children and nine grandchildren. But a ladder also lets them increase their annuity income as their monthly expenses rise. "No matter what else happens to my money, I don't have to worry," says Gregory.

Flexible alternatives

Although most retirees like the idea of guaranteed income, many balk at the idea of giving up control of their money with an immediate annuity. As a result, an increasing number of retirees have been turning to another type of insurance product, called a deferred variable annuity, that allows you to invest in the stock market through mutual-fund-like accounts. For an additional fee, you can guarantee a minimum payout, no matter how the market performs (see Savings Guarantees You Can Trust).

Deferred variable annuities offer two types of guarantees. With a guaranteed minimum withdrawal benefit, you can take out up to a certain amount every year -- 5% of your initial investment, for example -- no matter how your investments perform or how long you live. Some annuities let you boost the annual guaranteed withdrawal amount if your account value increases.

Another variation, known as a guaranteed minimum income benefit, also allows you to withdraw up to a certain amount each year (again, 5% is typical). Plus, you always have the right to convert to a lifetime income stream based on the original investment amount, even if the balance in the account has fallen below that level. Although you give up control of your money then, you may be able to increase your annual withdrawals to 8% or more. The older you are when you annuitize, the higher your payouts.

Both of these options provide a lot more flexibility than immediate annuities. You don't give up control of the money, and you can eventually cash out the annuity if your investments perform well and your account balance is worth more than the guarantees (although you may owe a surrender charge of up to 7% of the initial balance in the early years).

But that added flexibility comes at a steep price. Fees on these guarantees typically range from 0.6% to 1.25% of your initial investment -- on top of a standard annuity fee of about 1.4% per year, plus the underlying mutual fund fees. Nevertheless, deferred annuities with guaranteed benefits have been popular with people who retire in their fifties and sixties and who need to tap their savings right away, but who also want to benefit from long-term stock-market growth.

Many major insurers are scaling back on the guarantees they are offering on new contracts -- and that's bad news for annuity buyers. "The industry has hit the rewind button in an effort to develop more-rational living and death benefits," says Gerry Murtagh, manager of Ernst & Young's Retirement Income Knowledge Bank. "The market has already seen significant changes as key players rethink pricing, change the nature of existing riders and develop new, more conservative products." Since December 2008, Murtagh says, 90% of the top 20 insurers that sell variable annuities have altered their guarantees.

For example, some companies have lowered their guaranteed withdrawals. Others have raised fees or minimized their risk by limiting the types of funds in which you can invest. And some have discontinued guarantees entirely.