The last two years have not been kind to baby boomers who plan to retire soon or to retirees living off their retirement nest eggs.  Many are facing a major challenge these days: how to obtain enough income to cover their living expenses following the dramatic drop in portfolio values and the very low interest rate environment.  This educational article describes one way that could help many retirees increase their income.

An recent independent study showed that with an “immediate fixed annuity”, you can create a guaranteed stream of income over your lifetime with up to 40% less money than it would require to obtain the same income from a portfolio of bonds, stocks, and cash!

For example, a typical retiree’s portfolio may have 40 to 60% in bonds and cash with bonds earning 5% or less and cash providing low to negligible returns. If the retiree put one -half of this money into an immediate annuity, interest earnings could be anywhere from 7% to 9% (or more) depending on the age and sex of the retiree(s) and state lived in.

Let’s look at an example with the retiree a 70-year old woman with a 1 million dollar retirement account that has lost 25% in value, dropping to $750,000. With an annual  withdrawal rate of 4% of the portfolio value being the accepted standard for having reasonable probability the portfolio will last through retirement, it is clear this woman will have a substantial decrease in income—from $40,000 down to $30,000 annually.

If she purchased an immediate annuity with half of the depleted $750,000 portfolio value, or $325,000, the annuity would provide $26,000 a year income. The remaining $325,000 in her portfolio of stocks and bonds would yield an income of $13,000 annually at the 4% withdrawal rate. The result, total annual income from the $750,000 portfolio would increase from $30,000 to $39,000, $9,000 more than she would be receiving before purchasing the annuity and just $1,000 less than she was receiving before her portfolio shrunk in value!

The reason this is possible is because your annuities lump sum principal and the strong earnings—the result of the much higher interest rate—are both tapped along with the pooling of risk with thousands of other annuity owners.

An additional advantage beyond the increased and guaranteed income is that the immediate annuity is very tax efficient compared to other income vehicles such as corporate bonds, thus further increasing net cash flow.  Its benefits can even include additional tax savings from social security income depending on a variety of factors beyond the scope of this article.

One way to determine how much to invest in an immediate annuity is to add up your total monthly expenses and then subtract all the monthly income you already receive including pension and social security benefits. Then fill any gap with an annuity.

For those unfamiliar with immediate annuities, you provide the insurance company a lump sum of money, and it provides a check to you for a guaranteed amount every month for the rest of your life.  The money in your new immediate annuity will grow at a contractually agreed upon rate while you receive your monthly income.  

As with any good thing, there is usually something you must give up. When you invest in an immediate annuity, your money is now out of your control—you cannot get it back for any reason. When you pass away (and your wife  if a joint annuity), the insurance company retains what is left of your premium. So there is nothing left to pass on to heirs. This would be fine for people needing increased secure income, are not concerned about leaving an estate or have other funds to leave to heirs, and/or not wanting to deal much with managing investments on their own. 

Clearly, annuities are not for everyone. Further, most people should use annuities for only a select portion of their nest egg—retaining the remainder of their money in liquid form such as in stocks, bonds and cash for use in emergencies, for other needs and wants, and to position for growth to offset inflation.

A few insurance companies offer various annuity options that can be added. They include (1) providing a part of your remaining lump sum premium to your heirs if you pass away within a certain designated time, and (2) an annual cost-of-living adjustment. The downside is that your annuity payouts would be less.

How to purchase:  Start with the Vanguard Group (800-462-2391). Their rates are very competitive and they are one of the most reputable and solid companies financially.  Another good source with which to search and investigate a wide number of companies within your state is ImmediateAnnuities.com.   Stick with high rated companies, A+ or above with A.M. Best

Consider purchasing annuities from several companies spaced over time. This would do several things: (1) spread any default risk across several companies, (2) lock into higher annuity interest rates that are likely in the future, and (3) get higher payouts from newly purchased annuities as you get older.

The Bottom Line:

• An immediate annuity can substantially increase retirement income and guarantee it for life
• It can serve as a “pension” using part of your nest egg
• You lose control of the money and cannot get it back except through the annuity payout schedule over your lifetime
• It is important to retain liquidity with a portion of your nest egg
• Stick with highly rated companies, an  A+ financial strength rating or better with A.M. Best