How to Make Sure You Don't Run Out of Money in Retirement


An annuity is a stream of fixed payments that's guaranteed, often for as long as you live. Having an annuity can make retirement more secure, but it's hard to recommend them as investment vehicles, because almost every annuity on the market is a terrible investment. They tend to be sold by salesmen, so they're often loaded with fees. And, because being upfront about the fees would make them hard to sell, these fees are obscure (often outright hidden) and are typically different for every product, making it especially hard to comparison shop. (See also: Should You Get an Annuity?)

But my experience these past few years — helping older relatives with their finances, and starting to take the little pension I earned as a software engineer — has given me a new perspective on annuities. Having an annuity is more than just nice: It's wonderful! It's just buying them that's usually terrible.

Fortunately, there are a few that are worth buying. You don't hear about them often, because they don't siphon off a big chunk of your investment to pay a salesman, so salesmen don't push them.

Why annuities are great

It used to be that anyone with a good job retired with an annuity in the form of a pension. This is how I've gotten my recent experience with just how great it is to have an annuity: All my older relatives are now receiving pensions.

You never outlive your income

The main thing that's great about an annuity is that having one means you're never going to be broke. Even if you overspend and run down your savings, even if the stock market crashes or you make terrible investment decisions and your investment portfolio takes huge losses, you'll still get that monthly check for as long as you live.

You don't need to have an annuity to arrange that — you can live off capital in a way that makes it last the rest of your life — but an annuity makes it much easier.

They can raise your income

The other thing that's great about an annuity is that it can, at least potentially, be more money to live on. See, the only safe way to live off capital is to just spend the income from your investments. But that's not much money (especially these days).

If you knew how long you were going to live, you could spend down your capital so that you'd die with just enough money to pay off your last month's bills. But since you don't know how long you're going to live, you have to make a conservative estimate, holding back enough capital so that you won't go broke even if you live to 100. (Of course even that might not be enough. What if you live to 114?)

The company that provides your annuity has a much easier job. They don't need to know whether you'll live to 97 or kick the bucket at 67. They count on the fact that the average person will live an average life span. They can arrange the terms of the annuities so that the payouts don't exhaust the total pool until the last person dies. The fact that some people die the month after their pension starts means that there's enough money to pay for the people who go on to live for decades.

Offset against that is the fact that the company that's providing your annuity needs to make a profit, and it also needs to hold back a reserve against the possibility that it'll get unlucky and a bunch of their customers will live longer than average — but both of those factors are relatively small.

Annuitize, but how much?

If you accept the idea that you probably ought to have an annuity of some size, the next question is: How big should the annuity be?

At one extreme, you could just annuitize all your money — take all your savings and investments (except your checking account and your emergency fund) and buy an annuity. Then you'd know what your income would be for the rest of your life and you could budget for it.

I recommend against that. There are many reasons why it's worth having some capital. Your capital earns an investment return and it also provides a measure of safety as a backup to your emergency fund. It makes it possible to fund expenses beyond your bare-bones budget. Perhaps most important, having some capital saves you money in all kinds of different ways — because you have funds on hand, you can take advantage of deals, you can avoid high-interest borrowing, and you have money to put down a large security deposit in cases where that will save you money.

At the other extreme, you could annuitize none of your money and just live off your capital. I've just explained the downsides to that.

You want to be somewhere in the middle. With a modest annuity, you're protected from running your income down to zero, and yet you can preserve some amount of capital.

My advice is this: You should annuitize enough to cover your rock-bottom expenses, the lowest amount you could live on indefinitely. That way, you're putting yourself in a position where you can be sure you can get by no matter what happens to your investments, while preserving enough of an investment portfolio to fund your other life goals — travel, making a major purchase, leaving an estate to your heirs, etc.

Before you start shopping for annuities, be sure to take into account any annuities you already have. But unless you're old, and even then only if you had a pretty good job at a pretty big company for many years, you probably aren't going to have a great pension. (If you're only kind of old, and worked at a pretty big company for a few years before they all phased out their traditional pensions in the early 2000s, maybe there's a small pension waiting for you. If so, that's great. Even if it's not enough to live on, it's a very positive contribution to your retirement income.)

However, most people reading this probably won't get a good pension.

Fortunately, there is an annuity you very likely do have.

The annuity you already have

You almost certainly already have an annuity in the form of a national pension scheme, such as Social Security. The amount of Social Security you will get depends on your own employment history. For most people, it will provide a large fraction of the "rock-bottom expenses" I recommend you cover with an annuity, but you can generally expect there to be some gap.

If you have an employer-sponsored pension, even a small one, it may well cover the gap. If you don't, I recommend that you cover it with an annuity that you buy.

How to buy an annuity

As I said at the beginning, most of the annuities you can buy are terrible investments, but there are good ones. It is possible to buy an individual annuity and get an OK deal. It's just hard because the companies that sell them make it virtually impossible to compare one annuity to another.

This is especially true for the sorts of annuities that are most like a pension: The ones set up so you make a payment every month starting in your 30s or 40s, then get a check every month starting when you're 65.

Those are called deferred annuities (because you defer getting your money until age 65), and they're always terrible. They always have what are called "back-end" fees — money that the salesman gets to keep when you figure out that you've made a terrible deal and want to get (some of) your money back. The rules on back-end fees are always different.

To make it even harder, these sorts of annuities are usually bundled with some sort of life insurance (supposedly so that if you die before you retire your estate won't "lose" all the money paid into the annuity) — and of course the details of those insurance policies are always different as well.

Comparison shopping

It is possible to buy an annuity in a way that does allow you to compare them. Don't buy one with monthly payments. Instead, save and invest the money in the stock market yourself during your working years. Then, when you're ready to retire, buy what's called a "single premium immediate annuity" — you put up a big chunk of money today, and then start receiving monthly payments immediately that last for the rest of your life. (The monthly payments, of course, should equal the gap you identified between your Social Security and your rock-bottom budget.)

That is something that's easy to compare: How much do you have to pay today for a stream of income that starts next month and lasts the rest of your life? You can get a few quotes and pick the best deal.

These sorts of annuities usually don't have the life insurance policy that supposedly protects against your dying before you start taking payments, because the payments start immediately. That's good. Bundling in life insurance just makes it harder to compare prices. If you need life insurance, buy a life insurance policy separately.

Be very careful of letting them include any sort of survivor benefit, because that can also make the annuities harder to compare (although as long as the rules are exactly the same, it is at least possible). One alternative, if you need a survivor benefit, is to buy a life insurance policy that will pay off enough for your spouse to buy his or her own annuity.

As an aside, let me mention that the annuity salesmen among you are going to jump in and point out that you're giving up an important tax advantage if you only consider an immediate annuity. This is technically true, but in fact is pretty unimportant. Let me just say this: If you are maxing out your 401(k), and your IRA, and your Roth IRA, there is an opportunity to tax shelter a bit more money through an annuity contract. In practice, I'm willing to bet that the tax advantage will never equal the fees you're going to end up paying.

If you do save your money in a 401(k) or IRA, there are tax rules for using that money to buy your annuity. Follow the rules and you won't owe any taxes when the money is used to buy the annuity. You will, however, pay taxes on the annuity payments when you receive them (just like you would if you'd taken distributions from the tax-deferred plan directly).

Where to buy

Pretty much any life insurance company will sell you an annuity, but I only know of two places to get a good one: Vanguard and TIAA-CREF. (There used to be a third, but Berkshire Hathaway got out of the business a few years ago.)

The main problem with buying directly from an insurance company is just that their annuity sales operations are organized around their annuity salesmen, who will immediately start trying to sell you something that's more profitable (to them) than a single premium immediate annuity — that's the step you avoid by going through Vanguard or TIAA-CREF. (They also have enough buying power to get especially good rates, because they bring in large numbers of customers.)

If you're sure you can bear up under the sales pressure, there's no reason not to get quotes directly from the insurance companies. (Just because I don't know of any other good places to buy one doesn't mean there aren't any.) Insurance companies that sell annuities will be very easy to find — just do an internet search for information about annuities and you'll get a dozen ads for them and for online tools to compare their offerings.

You're handing over a large fraction of your wealth and counting on the insurance company to be around for the rest of your life, so you want to have considerable confidence in the financial soundness of the company you pick. I would not consider any company rated less than A by the insurance grading firm A.M. Best, and I'd be happier with one rated A+.

Buy when rates are high

To buy an annuity, you have to put up a pretty sizable chunk of cash. (Vanguard quotes the cost today to a 65-year-old male buying a single premium immediate annuity of $1,000 a month for the rest of his life as being $180,052.)

Unless you're rich, the cost of an annuity that covers your rock-bottom expenses is going to be a large fraction of your entire retirement savings — which is OK, because it's going to be a large chunk of your entire retirement income.

The insurance company that sells you your annuity is going to invest that sizable chunk of cash in a portfolio of stocks and (mostly) bonds, and then use the dividends from those stocks and (mostly) the interest payments from those bonds to pay your annuity. Because of this, an annuity is much cheaper when interest rates are high.

If you bought an annuity right before the financial crisis, you made out very well. If you wanted to buy one in the past eight or nine years, you probably found that they were incredibly expensive. But in the current era of rising interest rates, annuities are becoming more affordable again.

Still, if you're approaching retirement age, understand that there is no rush. Figure out your rock-bottom expenses — and then live with that budget as an experiment. Maybe you'll find that you'll need more than that in retirement. Maybe you'll actually need less. Do some comparison shopping. Take your time. Then, when you've got a pretty good handle on the expense of your retirement lifestyle, at a time when interest rates are up a bit and you're ready to quit working, go ahead and buy that annuity.

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