What the heck is an annuity and why would I want one? (Part 1)

What is an annuity?

Do you work for a company that offers a corporate or government pension? The Bureau of Labor Statistics reported in 2013 that only 13% of non-union private-sector workers were covered by a traditional pension. Union and public-sectors workers are covered in much greater numbers, but if you aren’t working under a union contract or for a government or school district, the likelihood that you’ll get income in retirement from your pension is low.

If you’re among the unlucky majority that don’t have a pension, what can you do? One way is to be a diligent saver in your 401(k). But again, the numbers here are disappointing – the median 401(k) balance for those in the 55-64 age bracket (those getting unnervingly close to retirement) is only $72,000. That plus social security is not going to make for a very comfortable retirement.

Did you know that you can buy a pension? Essentially, that’s what you’re doing when you purchase an annuity. Quite simply, you are trading a lump sum for a stream of income. In a corporate pension, your employer sets aside a sum of retirement funds that is used to generate a monthly income that starts when you retire. The only difference with an annuity is that you are the one coming up with the money. The simplest form of an annuity provides income until you pass away.

An example will give you a better idea of how an annuity works. Joe is 67 years old and puts $50,000 into an immediate annuity (we’ll give some definitions below, but this is an annuity that begins to generate income as soon as you buy it). It will last for Joe’s life span and will give him a monthly income of $279 or $3,348 per year. The best one-year CD rate that I could find recently was 2.86% - that same $50,000 would produce $1,430 per year ($119/month).

How does the annuity pay more than twice the monthly payment? That $3,348 per year is composed of three things: interest on the $50,000, something called mortality credits (which we’ll explain in a moment), and some of it is a return of the $50,000 back to you over time. Remember, with the CD, the $50,000 is still sitting in the account – if you choose to withdraw it after two months, you may pay a penalty, but you certainly can get to the money. With the annuity you no longer have access to the principal once you start receiving income.

The life expectancy of a 67-year-old male is currently 84 years – or another 17 years. Let’s see how the annuity stacks up to the CD over that time. One way to look at it is to see which generates the most money over those 17 years. The annuity makes 204 monthly payments of $279 or $56,916. The CD, however, produces 17 years of interest (we’re going make the ridiculous assumption that interest rates don’t change for the entire 17 years) at $1,430 per year, totaling $24,310. But you still have the $50,000 sitting in the bank, so you’d essentially have $74,310, handily beating the annuity.

But a better way to evaluate the two investments is to see how long the CD would last, if you needed an income of $279 per month. We’re going to assume that interest is paid each year, and after the interest is credited, you remove $3,348 to create the same income as the annuity. At the end of the first year, you’d have generated $1,430 in interest, then removed the $3,348 in income to leave $48,082 in your account. The next year the CD would generate $1,375, removing $3,348 would leave $46,109. And so on. The account would slowly dwindle until at age 86, you’d have $2,467 in the account, which would generate $70 in interest, leaving you $809 short of your income need. But the annuity would continue spitting out $279 in monthly income, as long as you live. Just beyond the life expectancy is the break-even point. For our example, if Joe lived to age 85 or beyond, the annuity is a clear winner. If he passes away any time before that, the CD would be the better investment (at least for his beneficiaries).

Many people, when they first look at the situation above, put it in the context of the insurance company winning or losing. “If I die before I’m 85, the insurance company wins – if I live longer, I win.” The reality is that the insurance company is acting a bit like an administrator. The equation is that those annuity purchasers that pass away prematurely generate the money used to pay those who live longer than expected. That’s what the insurance company calls, “mortality credits.” And it’s why the annuity payments can go on for years past a person’s life expectancy.

This type of annuity is the most straightforward variety. Though there are a great many types of annuities out there, essentially, they all fall into several categories. The first distinction is when the payments will start. Our example was an immediate annuity, but you could also purchase a deferred annuity. This type of investment allows you to put money into it over time, then turn it into a stream of income (called annuitization) sometime later. With a deferred annuity, income accrues in the account, much like our example of the CD. It’s tax-deferred (meaning taxes will be delayed until you begin to withdraw funds), and a bit more flexible. Rather than losing access to the principal as with an immediate annuity, you can get some or all of your cash any time up until annuitization (the act of turning the lump sum into monthly payments), which is optional. That means when you get to retirement, you can choose to turn the money into a stream of income, or remove your funds (though if you do make a withdrawal you’ll pay taxes on any income, and an IRS penalty of 10% on income if you withdraw before age 59½).

The second distinction is how the annuity is invested. There are two varieties: fixed and variable. In the fixed type, principal does not fluctuate, and you’ll get a fixed rate of return, much like a CD. This rate of return may be fixed for a period of time, say 3 years, then you’ll get a new rate, at whatever prevailing interest rates are being offered at that time.

A variable annuity puts your money in mutual fund-like investments. The performance of those investments will dictate your return. The value will fluctuate (sometimes a great deal with riskier investments), but returns can be much higher than with a fixed annuity.

There are also some options when determining how long the income lasts. We’ve looked at an example where the annuitization is done on one life (Joe’s). But you can base it off two lives (say, Joe and his spouse). If Joe passes away at age 73, his wife would continue to receive income until she dies. This option will decrease the monthly income Joe, and then his wife, would receive. Instead of the $279 in our example above, Joe could expect perhaps $236 per month (as would his wife if she lived longer).

In our next article, we’ll look at some of the pro’s and cons of an annuity. Why would you want one?