Is it better for clients to leave money to loved ones or put their money in an “immediate” or “income” annuity for guaranteed lifetime income?

An “immediate” or “income” annuity is a contract with a life insurance company that lets clients invest money—often in a lump sum—in exchange for periodic income for life.

Only about 3% of insurance policies sold are immediate or income annuities, according to the latest reports issued by LIMRA in Windsor, Conn.

There’s good reason for this.

Policyholders often can’t get access to cash once they sign the annuity contract. Plus, if they die before their principal is exhausted, any money left, unless they make other arrangements, generally goes to the insurance company. Even if the immediate annuity permits limited withdrawals and/or lets beneficiaries collect the proceeds for a specific period when the policyholder dies, lower payouts result.

Lee Lockwood, a finance professor at the University of Chicago, found that those with children generally don’t invest in immediate annuities for this reason. In addition, today’s low interest rates make annuities less attractive.

“People with plausible bequest motives are likely to be better off not annuitizing any wealth at available rates,” Lockwood noted in a study, published in 2010 by the National Bureau of Economic Research.

Lockwood’s study flies in the face of other financial research that shows putting about 20 to 25 percent of retirement income portfolio into an immediate annuity can dramatically reduce a client’s risk of running out of money.

Annuities can generate more stable lifetime income and greater potential inheritance for heirs at a given risk level when compared with a portfolio comprised of traditional assets, according to New York Life Executive Vice President Chris Blunt.

Although Blunt, as an insurance executive, has good reason to tout annuities, other studies have substantiated his conclusions. For example, a study by Youngkyun Park, analyst with the Employee Benefit Research Institute, Washington, D.C. published in May 2011, indicates that a 65 year-old retiree who keeps 20 percent to 25 percent of assets in a longevity annuity and, say, 80% or 85% in stocks and bonds has a 90% chance that the money will last a lifetime. A longevity annuity is designed to pay out at an advanced age.

Bunt’s study indicates that investors who incorporate income annuities can realize:

  • Reduced income risk. You can’t run out of money, even if you live well beyond life expectancy.
  • Greater capacity to bear risk in the rest of a portfolio – Because income annuities are not correlated with market swings, they can smooth out overall performance.
  • Reduced withdrawal pressure – Income annuities can offer higher cash flows than other types of fixed income investments.

There may be some benefits to having a small percentage of retirement investments in an immediate annuity. But it also makes sense to keep some of your clients’ powder dry. Higher interest rates generally translate into higher monthly payouts.

In today’s low-rate environment some financial professionals do split funding of annuities to capture higher interest rates going forward. With split funding, an immediate annuity provides a current income stream for a specific term during the early years of retirement and a deferred annuity would have the potential to provide a higher future income stream.

Barbara Walker Green, president of Advance Wealth and Retirement Planning Concepts, Houston, often uses split-funded annuities. She makes good use of annuities with riders that provide for lifetime income and long-term care coverage.

“In retirement, most people rely on a combination of social security, retirement plans and personal savings income,” Green says. “A split annuity strategy can help supplement these income sources and add stability.”