The Case For (and Against) Immediate Annuities

Right now your retired clients face a number of conundrums as they search for reliable sources of income. The interest paid by conservative fixed-income investments is barely keeping pace with the rising cost of retirement expenses, and that's before inflation. Even if those in their golden years can get by on current yields, they have to decide whether they should keep their money in short-term instruments or lock it up for the long run. Finally, many seniors now fear outliving their money more than they fear death itself.

One simple solution is the immediate annuity. They aren't widely used today, so you might have some explaining to do when you introduce them to clients. The Insurance Information Institute says that immediate annuities account for less than 3 percent of all annuity dollars invested.

On the other hand, you won't be alone in your efforts. Annuity firms are bombarding soon-to-retire boomers with marketing messages about “income for life.” Your clients are also hearing from Uncle Sam on this topic. The General Accounting Office is trying to persuade retirees to use “income-preservation strategies” (such as benefit annuitization) to ensure a more secure retirement. Also, legislation has been introduced that would make a portion of immediate annuity payments tax-free.

A recent study at the American Council of Capital Formation's Web site (www.accf.org) claims that, had this legislation been in place over the last 10 years, we would have seen even further rises in gross domestic product, employment and the S&P 500.

So what are immediate annuities, and how can they satisfy the income needs of retiree clients?

The Basics

In its simplest form, a single premium immediate annuity is an agreement between your client and an insurance company. In exchange for accepting your client's money, the company promises to make payments according to terms established in advance. The payment amounts depend on an increasing array of factors, including:

• The length of the guaranteed payment period: Your client's life span, a fixed period of time or a combination of both.

• Whether another's lifespan is included: If a spouse is eligible to continue collecting benefits after the client's death, the periodic payment will be reduced.

• The age of your client: The older your client's age, the greater his or her payments each month if these payments are based on the client's life expectancy.

• Your client's gender: Men tend to have shorter life expectancies and, therefore, get a slightly higher average monthly payment with a life expectancy-based payment option.

• Fixed or variable rate: Fixed-payment rates are most common, but variable immediate annuities (which offer variable rates of return and payment that are tied to underlying investment account performance) are becoming more prevalent.

• The client's state of residence: Some states charge a “premium tax” on annuity payments.

The Downsides

In the spirit of upfront disclosure, it may be better to first discuss why you and your clients might not want to purchase immediate annuities.

There's nothing left at the end: Unlike a fixed-income instrument that promises return of principal at maturity, holders of immediate annuities will get a big fat nothing when the agreement expires due to death of one or more beneficiaries or the end of the fixed term. Single clients with no desire to leave a financial legacy might be OK with this arrangement (the client might say something like, “What do I care? I'll be dead!”). But other retired investors may hesitate before kissing a big lump of their retirement kitty goodbye.

It's a major commitment: If a buyer of an immediate annuity later has a cash crunch that far exceeds his or her monthly payment, the chance of getting a majority of the initial deposit back is almost non-existent. A friendly banker may offer a loan against the future payment stream or the rights to the cash flow could be sold. But either option would entail a significant haircut for your client.

Today's big check won't go as far tomorrow: Interest rates are sure to fluctuate in the future, but the cost of living will probably go in just one direction — up. Income for life is a catchy phrase — but the longer the life is, the less valuable that income will be.

Proponents of immediate annuities correctly point out that optional features designed to mitigate these fears are readily available. But addressing “what-ifs” with custom add-ons usually comes with a cost of lower current income for the buyer.

What's to Like

If you can get past these drawbacks, it may be worth it. These are the features of immediate annuities that will whet your clients' appetites for income — especially if the money in question represents just a portion of their investable assets.

More money now: Retirees looking for safe, predictable income can get a big boost from immediate annuities when compared to other options. If a 65-year-old Florida man has $100,000, here is the estimated annual income he will probably get from a U.S. Treasury note, municipal bond and an immediate life annuity from a major provider:

And even if interest rates were to rise in the near future, holders of traditional fixed-income investments would be hit by a corresponding drop in the resale value of their securities. One way immediate annuities strongly resemble other long-term fixed-income vehicles is how much you, the advisor, get compensated to offer them. Don't expect more than a few percentage points on the initial deposit, especially for a competitive offering from a reliable insurer.

Paycheck replacement: Some retirees are uncomfortable with the idea of managing a large lump sum, even if it only involves a laddered bond portfolio. The leap from their last paycheck to their first immediate annuity payment can be seamless. Plus, your client's annual income in retirement may exceed their best year's working earnings — especially when combined with a Social Security check.

More income, less taxes: Finally, the most beneficial feature may also be the one that is the least known. Next month, we'll provide details on the taxation loophole known as the “exclusion ratio.” More money, less worry and lower taxes can make an appealing package for retirees, so stay tuned.

Writer's BIO: Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com