Lifetime Annuities for Dummies
Lifetime annuities have been around since ancient times when Roman citizens and soldiers turned over lump sum payments to the Emperor in exchange for an annual stipend to be paid over their lifetimes. Since then the lifetime annuity concept has found its way into corporate and government pension plans, and into the modern marketplace of retirement investment alternatives. Retirees who have been pinched by declining values in their 401(k) plans are turning to lifetime annuities to add more security in their lifelong need for income. In spite of their long history, and their growing popularity, lifetime annuities are still an enigma to most people, so here is a primer on lifetime annuities explained for dummies:
The Lifetime Annuity Concept
Lifetime annuities are a form of insurance contracts issued by a life insurer. Instead of providing protection against the risk of dying to soon, they protect individuals against the ever increasing possibility of outliving their retirement income sources. So, whereas the purpose of life insurance is to create capital in the event of death, the lifetime annuity’s purpose is to distribute capital as periodic payments over a prescribed period of time or for a person’s lifetime. In the case of a lifetime annuity, the life insurer assumes the risk of the individual living too long.
How does a Lifetime Annuity Work?
An individual makes a lump sum deposit to a life insurance company which then uses actuarial assumptions to determine the amount of income that can be paid out, typically on a monthly basis, for the person’s lifetime, or for a specified period of time. The key factors used for determining the payout rate are the age of the individual, the individual’s life expectancy (taken from actuarial tables), the amount of deposit, and the current cost of money (interest rate). From this, the insurer establishes a payout rate which is fixed for the whole term of the contract.
Note: Once the payout period begins, anytime between 30 days or one year after the deposit, the conversion to income become irrevocable, which means that the individual no longer has access to the principal.
The payout, which typically comes in the form of a monthly income payment, consists of interest earned on the principal as well as a return of the principal itself. The insurer has calculated the payout so that the whole principal balance will be returned to the annuity owner by the end of the payout period which could be a specified number of years or for the individual’s life expectancy. Should the individual live beyond life expectancy, the insurer will continue the payout even though the principal balance may have already been exhausted. This is the risk that the life insurers assume with lifetime annuities.
Have it your way
Lifetime annuities can come in different shapes and sizes depending on the individual’s needs and financial situation. A single individual might use a single life form which simply pays out a fixed amount of income for the life of the individual. An individual who is married could use a joint and survivor arrangement whereby the annuity payments would continue to be paid after the death of one of the spouses. The payout on a joint life annuity will be slightly lower than a single life annuity the difference of which the life insurer uses to insure the risk on the second life.
A refund option is available that, in the event the annuitant dies prematurely, will pay the remaining balance to a designated beneficiary in the form of installment payments. Selecting a refund option will also lower the payout rate slightly.
Is a Lifetime Annuity Right for You?
People nearing or at retirement look to lifetime annuities for their security and predictability. No other retirement vehicle can securely guarantee an income that cannot be outlived, so lifetime annuities are very unique in that regard. Still, they are not for everyone. While it is important to know how lifetime annuities work, it is even more important have a thorough understanding of your own needs and financial situation to determine if they are right for you.
If you find yourself in one or more of the following situations, a lifetime annuity may be suitable for you:
You are concerned about outliving your income sources –
At the same time 401(k) account values have been declining, life expectancy has been expanding creating a perfect storm of concern over having the financial resources necessary to sustain an income over 25 or 30 years.
You have a sufficient amount liquid assets –
A lifetime annuity is irrevocable. Once it starts, your principal is committed to the life insurer, so it’s vital that you have funds in short term investments or savings that can be used for emergencies and other unexpected expenditures.
You are retired –
Or, better yet, you are able to wait until sometime into your retirement to begin income payments. The longer you can wait, and the older you are, the higher the income payout.
You want to remain invested in stocks and bonds after you retire –
Many retirees today are willing to assume some risk in order to keep their assets growing. By combining an investment portfolio with a lifetime annuity, they can be assured of a stable income during market price fluctuations.
Compare Before You Buy
Lifetime annuities are offered by dozens of life insurance companies, so there is a lot of room for comparison. It’s fairly easy to compare lifetime annuity products because you are simply comparing payout rates. Payout quotes can be obtained easily by phone or online. The most critical factor for comparison, however, is that strength and stability of the life insurance company which is the basis of your guaranteed income stream. It is strongly suggested that you restrict your comparison to only the most highly rated insurance companies (A rated or better by A.M. Best or Moody’s).