It's not news that the employer-funded pension, once a major component of a worker's retirement plan, is fast becoming a thing of the past. But for those looking to recreate a pension's security and life-spanning regularity, there is hope with a variation of a classic insurance product — the so-called "fixed" annuity.
Also known as single-premium immediate annuities, this retirement vehicle will not help the critically under-saved or be of much use to the affluent, says Rande Spiegelman, vice president of financial planning with the Schwab Center for Investor Research. But he says “for the vast middle” they may offer relief from the dual fears of out-living one’s savings and making bad investment decisions.
"With a single premium immediate annuity you are done," says Bob Rockwell, a certified financial planner with Clackamas County Bank in Sandy, Ore. "You’ll get guaranteed payments for life or whatever period you contract for. There are no moving parts."
Unlike deferred annuities, which are savings products, an immediate fixed annuity is a pure payment security — there is no variance in price, and no opportunity for appreciation. While other types of annuities have drawn the ire of consumer advocates and the Securities and Exchange Commission due to their reputation for high fees, undue complexity and occurrences of sales abuse, immediate fixed annuities have a lower profile, given their lower commissions and conservative make-up. But their "snooze factor" is their primary appeal. When used correctly they allow an investor to sleep well at night while not overly enriching the agent who sold them.
The way they work is simple. The purchaser hands over a lump sum of cash to the insurance company. In exchange the insurer returns that cash through a series of payments, typically monthly, which remain fixed and which it guarantees will last as long as the purchaser does. For instance, a $300,000 lump sum might generate $2,000 in monthly payouts. Since it is an insurance product, there are variations on the theme, each with its own added cost.
However, in the crudest sense, immediate fixed annuities are bets on the life expectancy of the purchaser. If the person dies before all their money is returned to them, the insurance company keeps what remains in the contract whether that happens ten years, thirty years or 2 weeks after an annuity contract is written. If annuitants outlive the insurer’s life expectancy tables, they wind up earning a nice return.
So who would want this deal?
"People who expect to live a long time," says Mark Ferris, a certified financial planner in Old Saybrook, Conn. He adds that if they have been smoking or hitting the bottle hard all their lives, a monthly check for life may not be received long enough to make the deal worthwhile.
"Sometimes even individuals with a pension and Social Security want something more, something guaranteed that will meet their living expenses once they stop working full-time," says Rockwell. His clients have also used immediate annuities to smooth out their cash flow for a specified number of years — as with an early retiree who doesn’t yet qualify for Social Security or penalty-free withdrawals from an IRA.
"Typically our [immediate fixed annuity] clients want to match specific monthly payments to a specific fixed obligation like a mortgage," says Ellen Rinaldi, a principal in Vanguard’s Retirement Services Group.
But because those payments are fixed, Rinaldi cautions, "purchasers need to realize inflation will eat into their purchasing power over time. The longer the life span, the bigger that bite will be." This, and the need for liquidity to meet large unexpected expenses like medical bills is why no one recommends they make up 100 percent of a purchaser’s assets. Rinaldi advises committing no more than 20 to 30 percent of assets to immediate fixed annuities.
Life expectancy and the current level of interest rates along with age, sex, and underwriter fees factor into the calculation for the periodic payments any one purchaser’s lump sum will generate. Since these payments are fixed, the contracts are more attractive when purchased during periods of high interest rates or just as rates begin to fall. They are not so attractive when interest rates are low or rising.
Comparing different insurance company’s quotes is fairly easy. "With an income annuity, everything is wrapped up inside the payment," says Rinaldi. Both Vanguard and Fidelity Investments, for instance, offer instant quote calculators on their Web sites for easy comparison to other firm’s proposals. Another online calculator may be found at ImmediateAnnuities.com. These calculators allow users to enter different lump sum assumptions, and see what the expected payments would be like after fees. Sites such as AnnuityAdvantage.com and AnnuityScout.com offer no calculator but supply helpful but often eye-glazing details on the specifics of different insurance companies’ products.
While maximizing the expected payment is a purchaser’s primary objective, the insurance company’s credit quality is critical. If the payments are to last a lifetime, the insurance company also has to last a lifetime. Insurance company ratings may be found through Standard & Poor’s, and A.M. Best.
After comparing annuity quotes, it is highly advisable to compare the cash flow projections to those of a laddered bond portfolio (a series of fixed-income instruments with a range of maturities) to see where the greatest return advantage lies. Even though bond portfolios nullify the single-decision ease of the annuity contract, they may offer a higher after-tax payout for the added effort. Income portfolios can also be constructed to adjust for inflation and if their owners die, the assets obviously go to heirs not the brokers who manage them. Making the comparison is something the annuity salesperson should be able to help with, though Leon Rousso, a certified financial planner in Ventura, Calif., suggests letting a bond strategist work up a proposal separately to ensure a fair comparison.
For those overwhelmed by numbers, and uncertain whom to trust, Spiegelman suggests paying an objective third party like a certified public accountant to review calculations and comparisons before committing.
Immediate fixed annuities certainly will not cure an underfunded retirement, and they come with drawbacks, but they can be useful in stretching what savings one has to ensure it lasts a lifetime, thus recreating the security of the company pension plan of yore.