Annuities Can Reduce Your Risk

Updated: September 1, 2015

  • Variable annuities accumulate assets (usually very inefficiently). Immediate annuities distribute assets you have accumulated.
  • An immediate annuity protects you against living too long (life insurance protects you against not living long enough).
  • You can benefit from an immediate annuity’s insurance protection even if you don’t live a long time – you have the peace of mind that comes from knowing you won’t outlive your assets.

Immediate Annuities Can Help You Get A Full Life Out Of Your Nest Egg

So, you are thinking about retiring… or maybe you have already retired… or you know someone who is (or is about to be) retired.

Your earned income will be lower than you are used to, maybe a lot lower. Yet, you intend to keep on spending – you will have to get the money somewhere!

You have accumulated significant assets – you expect to live on the income they generate, and maybe use some of the principal, too. You have two important decisions to make:

  1. How to invest the assets; and
  2. How much to draw from the assets1

When you think about drawing upon your assets and income after you retire, you have two critical worries:

a) Will the draw be large enough to support my living standard? And
b) Will I outlive my assets?

This article is the first in a series introducing immediate annuities as a tool for retirement resource management2. In this article, we will describe how immediate annuities work. In the rest of the series, we’ll discuss the various kinds of immediate annuities, and outline how you can use them most effectively to manage your nest egg.

Immediate annuities defined and described

Annuities have a bad name among many investment advisors, and among many investors – largely because of the infamous variable annuity, that vastly over-sold (and under-needed) asset accumulation vehicle. Many brokers and “investment advisors” made (and continue to make) significant personal fortunes from commissions “earned” on sales of these expensive products to people who would have been better off in virtually any other investment. Variable annuity buyers pay dearly for the privilege of deferring taxes into the future – frequently the commissions and fees overwhelm the potential savings.

From its very beginnings, however, an immediate annuity has been a distribution vehicle, a mechanism for doling out the fruits of your saving discipline. In this role, the annuity truly shows its mettle. The humble immediate annuity can help you reduce the risk of outliving your assets.

How? Let’s develop a conceptual understanding of immediate annuities.

You can think of an immediate annuity as a reverse life insurance policy. Life insurance protects you against not living long enough. An immediate annuity protects you against living too long.

In a standard life insurance policy, a person (the insured) contracts with a life insurance company to pay his family a large sum of money in case he dies prematurely. The insurance company assembles a group of people (a pool) who wish to buy life insurance. The insurance company sets its premiums to cover the benefits it expects to have to pay out for the pool that year, plus a fair profit. In any year, only a small fraction of the people in the pool will die, and the insurance company knows that fraction (or at least, its actuary3 does).

Now think about the retiree who wants to draw steadily from her accumulated assets for the rest of her life. The retiree risks living too long (as opposed to the life insurance customer, who risks not living long enough).

Just as with life insurance, the insurance company can turn this into a (nearly) no-risk situation by assembling a pool. If the pool is large enough, and the actuary is good enough, the company will know exactly how many customers will live to be 100, and how many will die next year. From this, it is easy (for the actuary!) to calculate how much the company will have to pay out each year until everyone in the pool has died.

Think back to the retiree’s two worries:

a) Will there be enough income? And
b) Will I outlive my income?

The insurance company has solved the second problem with risk pooling – it guarantees to pay each of its immediate annuity purchasers throughout their lifetimes. If you buy an immediate annuity you will not outlive the payments.

Table 1 compares life insurance and annuities. For each type of policy, there are winners, who receive large returns, and losers, who receive valuable “consolation prizes.” In the case of life insurance, all pool members pay an insurance premium to the insurance company. The lucky winner dies during the term, and his family receives the death benefit4. All of the losers survive – they console themselves with the knowledge that if they had died, their families would not have suffered from the loss of their incomes.

Insurance

Bet

Winner

Loser

Winnings

Consolation

Term Life Insurance

Premium

Dies during term

Lives through term

Death benefit

Family was safe

Annuity

Investment

Lives a long time

Dies before life expectancy

Extra-ordinary return on investment

Didn’t outlive assets

In the case of the immediate annuity, all members of the pool make an irrevocable investment with the insurance company. The winners live longer than expected, but don’t outlive their assets, receiving many payments. The losers die before they expected to, and receive few payments. The premium they paid is gone, not available for their heirs. However, the “losers” benefit from their immediate annuities in a very real way: they have the peace of mind of knowing they won’t outlive their assets.