What the heck is an annuity and why would I want one? (Part 3)
- kirkmartin
- Mar 1, 2020
- 4 min read
Okay, an annuity sounds like a pretty good deal. How do I pick the right one?
If an annuity sounds like something that might fit into your financial menu, the first thing to determine is what type of annuity makes sense for you. To reiterate from a previous article, there are several varieties. The first distinction is when you are looking to create income. An immediate annuity begins to spit out cash shortly after purchase. This would be handy as you hit retirement and want to turn a lump sum into an immediate income stream.
A deferred annuity is designed for the saver whose goal is years away. The advantage here is tax deferral – pushing taxes on the gains from the annuity into the future when withdrawals begin. This flavor also has more flexibility. When retirement finally arrives, perhaps income won’t be needed. The deferred annuity gives you the choice to annuitize (turn on the income stream) or take a lump sum at some future date.
And the lengthiest annuity is sometimes called longevity insurance. It’s designed for an individual, generally in or near retirement, that is looking to insure against running out of money in the future. What it does is create income far into the future. For example, a 65-year-old might purchase longevity insurance to begin payments when he (or she) is 85. Because of the extended time frame, and the distinct possibility that many people in this age bracket won’t make it all the way to age 85, the return is quite high. A $100,000 lump sum might begin throwing off $3500 a month at age 85. That makes planning between 65 and 85 a little simpler knowing that there’s a large pot of income waiting for you. And if you don’t make it to 85, there isn’t much need for the income.
The second distinction between types of annuities is fixed or variable. This describes what’s in the annuity. The fixed annuity has a fixed return, much like a CD or a bond. The variable annuity is invested in mutual fund-like vehicles that have a variable return. While a fixed annuity gives a much greater security and surety of return (you know what you’re getting to a great extent), the variable annuity deals with inflation much better and has a higher potential for gain (or loss). Both have their places, but for replacing an income, I lean more toward the fixed annuity.
Once you’ve decided on a type of insurance (immediate fixed annuity, for example, or a deferred variable annuity), your next decision is to pick out a provider. One way to determine the appropriate provider is to compare expenses from different companies.
It can be difficult to determine expenses in an annuity, but lower-expense examples come from the no-load providers: Fidelity, Vanguard and T. Rowe Price. The lowest expense ratio doesn’t always mean the best annuity contract. Beyond expenses, you want to look at the annuitization schedule. This is how much income will be distributed per $1000 invested, based on your age.
You want to find a happy medium between low expenses and an annuitization schedule that will pay you more income in retirement. Once you’ve found that balance, you’ll want to determine how much you’d like to put into your annuity.
For this, I’d turn to one of the online retirement calculators. The best of these are from the usual suspects: Fidelity, Vanguard, T. Rowe Priceand AARP. They run the gamut from screens and screens of input to just entering a few pieces of information. The more data entered, the more accurate the end results.
These calculators all focus on how much you’ll need in retirement. Which is a good first step. But after you’ve determined your retirement needs, you’ll need to determine how much of a lump sum you’ll need to provide a specific level of income. For that you’ll need an annuity calculator. Each of the annuity providers I listed above has a calculator that’ll show you how much income a given sum will generate. For a more general picture, immediateannuity.com will estimate the necessary lump sum, as well as provide quotes from various financial services companies.
To recap, you’ll first want to determine what your income needs will be in retirement. The closer you are to the magic age, the more accurate your numbers tend to be. But either way, that’s your starting point. Once you’ve determined what your income need is, you’ll want to add up your pension and social security income (which can be estimated using ssa.gov). What’s left is your income need in retirement. If an annuity sounds like a worthy alternative, take that number to immediateannuity.com and you’ll be able to estimate how much of a lump sum you’d need to invest to generate the income stream you’ll need in retirement.
While it can seem complex to figure out where you’ll stand in retirement, taking a few preliminary steps to create a plan for income can give you some peace of mind. Just take it in stages: determine your retirement income need, calculate your income sources, then you can use an annuity to fill the gap between those numbers.
Here's a quick example of the process:
1. Current Annual Income = $ 85,000
Income needed in retirement = $ 60,000
2. Sources:
Social Security Income = $ 22,000
Spouse’s social security = $ 12,000
Pension income = $ 8,000
3. Gap:
($60,000 - $22,000 - $12,000 - $8,000)
Income needed from an annuity = $ 18,000
4. Lump Sum needed:
Amount to annuitize = $290,000
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