How annuities provide guaranteed lifetime income
With the decline of traditional pension plans, retirees today and in the future have more responsibility than past generations for their own retirement income. No matter how much people save for retirement, there’s always the question of having enough, especially with longer life expectancies.
Retirees who depend on savings accounts and 401(k)s also have to be careful of withdrawing too much because the overall account can lose value if the investments inside those accounts lose value.
Other than Social Security, most retirees nowadays have only one option to receive a guaranteed stream of retirement income they can’t outlive: annuities.
What is an annuity?
An annuity is a contract with an insurance company. You give the company either a one-time payment or series of payments, called premium, and in return you receive a guaranteed lifetime income stream.
In most cases, annuities can provide a lifetime stream of income for much less than you could using a retirement account or a portfolio of investments. First, most annuities shield your retirement savings from stock market losses that can deplete your savings, which means you must start with a higher amount to account for that possibility.
Second, the insurance company not only assumes the investment risk of your premium but also the longevity risk of how long it makes income payouts. Insurers pool the money of thousands of investors, so they’re spreading the risk out. Insurers can base income payments not just on a projected investment return, but also on life expectancies. Knowing that some annuity holders will die sooner than others, insurers are able to boost annuity payouts beyond what investment returns alone can support by transferring money from those who die early to those who die late.
How do you receive lifetime income from an annuity
There are several ways to generate guaranteed lifetime income with an annuity.
You can purchase an immediate annuity. You give an insurance company a one-time premium payment. This is usually a large sum, such as $50,000, $100,000, or more. The company subtracts fees from that premium, then calculates your lifetime income payment based on your age and gender. The older you are when you buy the annuity, the higher your income payments.
You can purchase a deferred annuity. A deferred annuity is a contract in which you make a premium payment, then allow the insurance company to hold onto that money until a later date. During that period, the annuity earns interest to its account value, which grows tax-deferred. When you want to convert the account value into an income stream, called annuitization, the insurance company will calculate an amount based on your age and gender.
You can purchase an income rider. A fairly new feature being added to many deferred annuities is an income rider. This is an optional benefit that can be attached to an annuity for an additional annual fee. It provides a lifetime income stream that you can turn on in the future. It also gives you the flexibility of stopping income and restarting it again. The value of an income rider grows at a contractually guaranteed rate, called a roll-up rate. Unlike the annuity’s account value, the rider’s value is not available for a lump sum, only as a source of lifetime income payments.
You can purchase a variable annuity with a guaranteed minimum withdrawal benefit (GMWB). Variable annuities are different than other types of annuities because they allow you to invest in subaccounts, which are mutual fund-like investments. This offers the potential to generate a higher return, but it also adds risk because your account value could decrease in value depending on the performance of your investments. That’s why some variable annuities offer a GMWB rider for an extra fee that will guarantee a minimum amount of income regardless of how the annuity performs.
The annual income you receive from the annuity is called the payout rate. If you purchase an immediate annuity, this is the percentage of premium you paid upfront. With a deferred annuity, it’s a percentage of your account value at annuitization. If you opted for an income rider, the payout rate will be a percentage of the rider’s value when you begin taking income.
For example, if you invested $100,000 in an immediate annuity with a 6 percent payout rate, you would receive $6,000 annually until you pass away.