Retirees with borderline savings and ‘iffy’ financial skills can take comfort with an immediate annuity. They needn’t worry about juggling their investment withdrawal rates that preserve income for their lifetime.
If the alternative was living off certificates of deposit, the interest rates that insurers typically use to calculate immediate annuity payments are higher than CD rates. And also, each annuity check includes an untaxed return of principal portion – whereas all of the CD return is taxed as interest income.
And, of course, how much you receive for your monthly annuity payout depends upon your age, gender and the investment amount. The older you are when you begin and the more you put down, the bigger your payments become.
Unfortunately one sure hazard that fixed annuity payout’s can’t avoid is inflation.
What damage can inflation do?
Investing in a fixed income annuity avoids the risks of market downturns, but the fixed payout can really suffer in buying power as the years go on. That’s because inflation erodes the value of those payout dollar so that monthly payout buys less over time. Just a 3% inflation rate – see figure -shows that if you begin payouts at age 65, the purchasing power of your monthly payout drops about 25% by age 75, and 50% by age 89.
Inflation- adjusted annuities?
Some insurance companies offer a way to combat inflation with adjusted annuity payouts. This can be true inflation-indexed life annuities tied to the Consumer Price Index (CPI) or simply fixed cost of living adjustments (COLAs). Can this be the solution?
Unfortunately, for the same investment, when you buy an annuity with inflation protection, the monthly payments start far below those of the regular fixed income variety. Although these adjusted payments would slowly increase over the years, it may take about your remaining life expectancy to get to the breakeven point with those of the fixed types.
What may be a better option?
A better way to address the inflation problem is to avoid putting all your money into an immediate annuity. Instead, invest some money in a diversified, low-cost portfolio of stock and bond index funds with some investments that thrive under inflation – such as precious metals.
Live on the fixed annuity payout as long as possible. As inflation starts taking its toll on your payout, supplement the ‘loss to inflation portion’ by withdrawing money from your investments.
This approach keeps you in control of more of your money, and if you die early, leaves a legacy for you loved ones.
Note: Annuities once annuitized cannot be surrendered for value. Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty. Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses. Note that CDs are FDIC insured while annuities are not and guaranteed by the claims paying ability of the issuing insurance company. CDs have penalties for early withdrawal and annuities have surrender charges for withdrawals in excess of a specific amount prior to term. Interest form CDs and from annuities are taxed as ordinary income. Investments in stocks, bonds, precious metals and instruments representative of their indices may result in gain or loss. There will be transaction charges to buy and sell and ongoing management fees. Read the prospectus carefully prior to investing in any fund to understand the risks and expenses.
If you’re a man aged 65, your life expectancy is 84 but you still have a 50% chance of living longer. And if your family history shows a lot of longevity, you may easily surpass even that.
 CDC Health United States, 2012 http://www.cdc.gov/nchs/data/hus/hus12.pdf#018