As more Boomers retire and seek guaranteed sources of income for life, sales of immediate annuities are picking up—primarily fixed immediate annuities. First quarter fixed immediate annuities sales were up 21 percent, or $1.7 billion, versus the year-ago period, according to LIMRA International, a Windsor, Conn.-based association of life insurance and financial services companies. Meanwhile, total fixed immediate annuity premiums sold in 2007 hit $6.8 billion, up 33 percent versus 2002.
“One of the prime strategies today is to put a portion of assets in a fixed immediate annuity,” says LIMRA analyst Dan Beatrice. “This enables retirees to invest their remaining assets more freely.” Indeed, independent research suggests that fixed immediate annuities are good for retirees. Separate studies from Conning Research, Hartford, and Moshe Milevsky, finance professor at York University, Toronto, indicate that including an immediate annuity in a portfolio—together with stocks, bonds and mutual funds—can decrease the probability that a retiree will run out of money, and can improve risk-adjusted returns.
An immediate annuity is a contract with an insurance company. Policyholders invest a lump sum in return for insurance company-guaranteed income, generally paid out in monthly increments for as long as they live. If the policyholder dies, the insurance company keeps the balance of the proceeds—unless arrangements are made to pass those proceeds on to loved ones, typically in exchange for lower monthly payouts. With one of the most common contracts, called “10-year certain and life,” monthly checks keep coming for a minimum of 10 years. If the annuitant dies before the 10 years are up, checks continue to go to a designated beneficiary for the remaining period. These contracts can also be set up so that a surviving spouse continues to get the payments for as long as he or she lives—or for a period of 15 or 20 years.
Whereas variable immediate annuities let policyholders invest in securities like mutual funds—and receive a variable payout tied to returns on those securities—fixed immediate annuities provide a fixed payout rate for life. Compared with sales of fixed immediate annuities, sales of variable immediate annuities (IVA) are almost negligible, says LIMRA. IVA sales totaled $313 million in 2007, down from $367 million in 2006. Insurers pay 3 percent to 4 percent upfront commissions on the sale of immediate annuities. That compares with about 6 percent upfront on their cousins deferred payment annuities, which are savings accumulation retirement vehicles.
“The time is right in terms of people starting retirement,” says Lisa Kuklinski, MetLife senior actuary. “Reps are starting to understand that the immediate annuity provides a proven level of income as part of a retirement portfolio. Some financial planners are using the annuity, based on their calculations, to insure their client’s money will last during the income phase.”
John Diehl, financial planner with Hartford Life, Wayne, Pa., recommends anchoring a client’s retirement portfolio with guaranteed sources of income. And he says an immediate annuity, or a deferred variable annuity with a lifetime guaranteed withdrawal benefit, is the best way to do that. Then policyholders can tap other investments to help maintain current lifestyles and increase wealth to keep pace with inflation. “Most people invest in stocks and bonds or mutual funds when they are saving for retirement,” says Diehl. “But they need to invest to have income for as long as they live.” Someone who rolls over a 401(k) into an IRA, for example, needs to segment assets, he says. One of those segments should provide a guaranteed source of income to cover basic expenses such as food, clothing, housing and medical expenses.
Doing The Math
Because retirees are allowed as many IRA rollover accounts as they wish, they might open up several IRAs upon rolling over a 401(k), Diehl notes. Ordinary income tax, which can go as high as 35 percent, is owed on IRA distributions. But the remaining money in the IRA accounts grows tax-deferred. “If you have $5,000 a month in basic expenses and get $4,000 from a pension or rollover IRA and social security, you have a $1,000-a-month gap,” he says.
To cover that gap, he suggests, for example, putting about $148,000 in an immediate annuity that will pay $1,000 monthly for a 65-year-old male. Or, the client could put $192,000 in the annuity, so the surviving spouse could receive the $1,000 in monthly income for as long as he or she lives.
Lifestyle expenses, such as travel, entertainment and maintaining a comfortable living situation, can be funded in taxable accounts by tax-free municipal bonds and dividend-paying stocks or stock funds. In the tax-advantaged rollover IRAs, retirees might invest in bonds or bond funds and stock funds that generate a lot of short-term capital gains, which otherwise would be taxed as ordinary income.
LIMRA’s Beatrice adds that many advisors are using short-term immediate annuities for monthly income until they collect Social Security. This way, social security payments can be delayed, allowing retirees to reap higher payments later in life.
Among the benefits of immediate annuities:
- The policyholder only pays taxes on about 40 percent of the immediate annuity income. The rest is considered a return of principal.
- Today's payouts from some of the strongest insurance companies stack up favorably against fixed income investments.
- Newer contracts offer cost-of-living adjustments so that the income will increase with inflation. For example, Michael Gallo, senior vice president of New York Life Insurance and Annuity Corp., says that with his company’s expanded inflation protection, the “Annual Increase Option,” the policyholder’s initial income starts lower. But the payments should increase each year by 1 percent to 5 percent, depending on the percentage chosen.
- Many insurance companies now let policyholders withdraw cash from the immediate annuity, according to Beatrice. In the past, this was prohibited.
- Some insurers allow persons with serious health problems to get special medically underwritten immediate annuities. Because the policyholder’s life expectancy is shorter, he or she may qualify for higher payouts.
The Ifs and Buts
Still, there is no free lunch with immediate annuities. Once someone signs the insurance contract, the policy can’t be surrendered. Plus, states nationwide have been making both annuities and sales of investment products to seniors the focus of increased regulation.
Florida, for example, adopted a new law on July 1 that more than doubled penalties for specific, willful and unfair or deceptive life insurance and annuity sales practices. The law also requires an insurer or insurance agent to have an objectively reasonable basis for believing that an annuity recommendation to a senior consumer is suitable. Plus, it stiffens penalties for making misleading representations to induce a consumer to cash in funds from a current investment or insurance product to purchase another product.
Furthermore, not all immediate annuities are alike, so advisors need to shop around for the best payouts from the financially strongest issuers. The strongest companies are rated A+ and A++ by A.M. Best.
Rande Spiegelman, a financial planner with Charles Schwab in San Francisco, stressed the importance of scrutinizing an annuity’s payout rate. Financial advisors should seek a rate that is based on the individual’s actuarial life expectancy rather than a payout rate that is based on expectations that the client will outlive his or her life expectancy. For example, a male aged 65 who invests $300,000 in a single life immediate annuity will get $24,000 a year, or $2,000 per month, for as long as he lives. That translates into an 8- percent payout rate for life—even if the policyholder lives to be 150 years old. Based on the actuarial tables, the 65-year-old man has an 18-year life expectancy, however, so his payout rate should be more like 4.16 percent.
Another drawback: Depending on where you live, you may pay a state premium tax on your annuity. Steve Cooperstein, a Pacific Grove, Calif.-based actuary, said fixed immediate annuity income payments don’t keep pace with inflation. Although a number of contracts come with inflation riders, the inflation-adjusted payouts initially are lower. It can take eight to 10 years to break even on standard immediate annuity payments, he said. There are, however, a couple of solutions to this problem. A financial advisor can construct a fixed immediate annuity ladder. With a ladder, annuity purchases are staggered over time. So when interest rates rise, the retiree can lock into a higher payout rate for life.
A better option, at least according to Cooperstein, is to invest in a variable immediate annuity. Over a lifetime, with the proper allocation of stocks, bonds and other asset classes, income payments should more than keep pace with inflation. In addition, most variable immediate annuities have a guaranteed payout annuity floor as protection in case the financial markets perform poorly. There is more potential for return with a variable immediate annuity,” he says. “The payouts are better in the long run.”
