One of the biggest fears of a retiree is running out of money during retirement. This could happen because of excess risk in the portfolio, uncertain economic events, or because you outlived your investments. An immediate fixed annuity can help protect against this financial uncertainty.
With this kind of annuity it’s impossible to outlive your annuity income. An immediate fixed annuity is a lifetime annuity – you will receive your payments until you die. It is meant to insure against you running out of income during your living years.
This annuity is also known as a SPIA – single premium immediate annuity.
The key thing to understand about an annuity is that you turn over your money to an insurance company in return for regular payments. That lump-sum of money you give up will no longer be yours. What you get in return is a monthly payment for life.
What is an Annuity
An annuity is an insurance product. It’s a contract you draw up with an insurance company who wants your lump-sum of cash in return for a fixed periodic monthly payment.
Here, I am specifically referring to a fixed lifetime annuity. There are a ton of different annuity products out there but for the average medical professional only a few apply.
Just like you can buy life insurance to protect your survivors in case of your death, you can buy an annuity which is an insurance to guarantee that you’ll never run out of an income while you’re alive.
When you think of an annuity, think of a pension plan. The pension you get from your medical group or social security is set up very similarly to a fixed annuity.
Fixed Lifetime Annuity
I am an insurance company; you pay me $100,000 and in return I will promise you a specific monthly income until you die. That’s a fixed annuity.
Just like health insurance and disability insurance, you can get much fancier and add all sorts of layers of complexity. Each of these will differ depending on which insurance company you contract with.
Factors Affecting Cost
The factors which determine how much money you’ll get every month are:
- interest rates
- mortality statistics
- type of annuity
- your age
If I start my fixed immediate annuity at age 30 then my payment will be smaller because my expected lifespan is higher. Starting at age 65 would provide me with larger payments.
If current interest rates are low, as they are in 2018, then my monthly payments will be lower over my lifetime. Laddering an annuity can help protect against this as I’ll discuss towards the end of this post.
If you happen to have a particular medical condition which should shorten your life expectancy then it’s worthwhile to shop around with different insurance companies to find a better rate. Because if you don’t live as long, your monthly payments should be higher.
The word guarantee here has to do with the specific state in which you live in. If you purchase certain annuity products and the insurance company goes belly up, then your state will often step in and guarantee a certain amount of that money.
The guarantee might be a certain percentage of the annuity contract and up to a certain amount.
An immediate annuity is when I turn over money to an insurance company and start receiving payments from my money immediately.
A deferred annuity is when you pay a lump-sum upfront or make regular annual payments in order for the annuity payments to start at some point in the future.
Immediate Annuity Rates
There are various immediate lifetime annuity calculators which you can play with online. This website has a simple calculator to give you an idea of your ongoing monthly income in return for a lump-sum.
For $100,000, I, as a 40-year-old male, can receive monthly lifetime payments of $380.
I won’t get into what 10-year-period-certain means. But each of these could have the right use for the right client. A good financial adviser or broker should be able to guide you in the right direction.
Here is another one by USAA.
In the USAA calculator I entered a $250,000 lump-sum payment. This allows me an immediate fixed annuity payment of $927 per month.
If I live until age 95, I will have received nearly $600,000 in payments over this long lifespan.
Obviously, if you are getting $900/month starting at age 40 until you die and you end up living until age 90, that $900 will have very little value.
But this is no different from the pensions many of us are promised by our employers. I don’t know of any inflation-adjusted pensions available to medical professionals.
Social security, however, is an inflation adjusted pension.
The Insurance Company
An annuity is a contract between you and an insurance company or sometimes a financial institution.
It’s important to select the right insurance company because plenty have failed in the past. Your annuity contract is only as good as the insurance company which promises you your payments.
As a secondary layer, fortunately, you have the state which guarantees annuity contracts. It’s important to know to what extent this guarantee is good for and how it’s affected if you take up residence in another state or move overseas and become the resident of another country.
What They do with the Money
The insurance company is a business. They take your money and invest it, hoping that they will earn more than they will give you.
They also hope that you die early. Or that interest rates go up. Or that inflation increases.
30 years from now when the insurance company is still making $900/month payments to you, inflation will have helped them. They are paying the same $900 payment with money that’s inflated numerically.
Insurance companies are rated. It’s in your best interest to select a highly rated insurance company. At some point I should look into how many previously A+ rated insurance companies went broke.
You can look up the rating system by institutions such as Moody’s or S&P.
Each entity has their own rating system and you can read about that on various websites. Though, it would be wiser to take the advice of a good broker who has experience dealing with these companies.
Vanguard has chosen American General Life Insurance Company of Delaware as their annuity insurance provider. I haven’t checked the various annuity products offered by Vanguard but, remember, they are just the reseller of whatever AGL is offering.
Laddering an annuity is similar to laddering other investment products which are affected by interest rates – think, CD’s and bonds.
An annuity ladder can get complicated but in this low-interest rate environment, an annuity ladder is a wise way of structuring your annuities. What you are trying to do is capture the higher rates as they become available. Instead of a lifetime contract, you’d have to opt for a 5-year annuity.
For example, instead of buying a single immediate lifetime annuity with $500,000, you might buy a 5-year annuity with $100,000 and repeating this every 5 years for a total of $500,000.
Taxes & Annuities
Annuities are great for estate planning, especially for those with very high net worths. They can also be useful for someone with a massive windfall such as when selling a business for millions of dollars. An annuity, in this case, can help soften the blow from taxes.
But an annuity isn’t a way to escape taxes, at least not with a fixed immediate annuity. If you pay $100,000 in after-tax dollars towards an annuity then you aren’t taxed on the income unless you end up getting paid more than what you put in.
If you use your traditional IRA to pay for your annuity, then you will be held to all the usual IRS and tax rules regarding such tax-advantaged accounts and pay the taxes accordingly.
The Income from an Annuity
I understand how a CD or a stock index fund earns money. I either get some interest payment or I earn money from the dividend yield and sell off some appreciated stock for further profits.
An annuity is able to pay you an income because you gave up a large chunk of cash and because they can pay you a certain percentage from the spread of investing that money.
From the USAA example above, $500k invested would earn me $926/month for 45 years. That’s $11,100/year or a rate of return of 2.2%.
A 10-year CD could provide me with a rate of return of 2.75% or $13,750 a year.
A 30-year treasury bond could provide me with a 3.13% annual rate of return, or $15,650.
For those obsessed with ever-lower SWR’s, this kind of retirement income product might provide some peace of mind.