Income Annuities Provide Invaluable Longevity Insurance but Are Still Underused

By Ken Nuss

Few adults would go without auto, home, life or health insurance. But the kind of insurance that protects against the risk of running out of money in old age is still greatly underutilized.

ItΓÇÖs called a deferred income annuity or a longevity annuity.

Most people planning for retirement should strongly consider an income annuity, and a new Brookings Institution study confirms that.

The concept is simple. The buyer deposits a lump sum or series of payments with an insurer. In return, it guarantees to pay you a stream of income in the future. ThatΓÇÖs why itΓÇÖs known as a deferred income annuity.

You can choose when your payments will begin. Most people choose lifetime payments starting at age 80 or older. Guaranteed lifetime income is a cost-effective way to insure against running out of money during very old age.

The main disadvantage is that the annuity has no liquidity. YouΓÇÖve transferred your money to an insurance company in exchange for a guarantee of future income. People who canΓÇÖt afford to tie up any of their money shouldnΓÇÖt buy a deferred income annuity.

Given that traditional company pensions have largely gone away, there should be great demand for income annuities, Martin Neil Baily of Brookings and Benjamin Harris of the Kellogg School of Management write in a new study.  But there isn’t.

People overestimate their ability to invest money wisely. TheyΓÇÖre also concerned that if they donΓÇÖt live long enough, the annuity wonΓÇÖt be worth the cost. But thatΓÇÖs a wrong-headed view because itΓÇÖs the insurance thatΓÇÖs the most valuable aspect of the annuity, according to Baily and Harris.

And the topic is confusing to consumers in part because of the terminology. Annuities include both income annuities as well as fixed, indexed and variable annuities that are primarily savings or investment vehicles, they point out.

Why do deferred income annuities work so well? Income deferral is a key part of the equation. The insurer invests your money so it grows until you begin receiving income. For instance, if you buy an annuity at age 55 and donΓÇÖt start income payments until 85, you reap the advantage of 30 years of compounded growth without current taxes.

The longer you delay taking payments and the older you are when you start taking them, the greater the monthly payout.

Second, buyers who do not live to an advanced old age subsidize those who do. Such risk-sharing is how all insurance works, whether itΓÇÖs home, auto or longevity insurance.

A deferred income annuity provides unique flexibility in retirement planning.

Suppose you plan to retire at 65. You can use part of your money to buy a deferred income annuity that will provide lifetime income starting at 85, for example. Then, with the balance of your retirement money, you only need to create an income plan that gets you from 65 to 85 instead of indefinitely.

You donΓÇÖt have to deal with the uncertainty of trying to make your money last for your entire lifetime.

The Brookings study makes a similar point. An income annuity can substitute for bonds in a portfolio. For instance, suppose a coupleΓÇÖs allocation is 60 percent equities and 40 percent bonds. The couple could safely sell all their bonds and use the proceeds to buy an income annuity.

Holding an annuity provides stability in a retirement portfolio….making it unnecessary to hold bonds, or hold the same amount in bonds.

Also, since you know youΓÇÖll have assured lifetime income later on, you can feel less constrained about spending money in the early years of your retirement.

If youΓÇÖre married, you and your spouse can each buy individual longevity annuities. Or you can purchase a joint payout version, where payments are guaranteed as long as either spouse is living.

What happens if you die before you start receiving payments or only after a few years when the total amount of payments received is less than the original deposit? To deal with that risk, most insurers offer a return-of-premium option that guarantees your beneficiaries will receive the original deposit premium.

This is a popular option, but it does reduce the payout amount slightly when compared to the payout amount without the return-of-premium guarantee.

If you donΓÇÖt have a spouse or anyone else you want to leave money to, you wonΓÇÖt need this option.

The Brookings report, Can Annuities Become a Bigger Contributor to Retirement Security, can be downloaded at https://www.brookings.edu/research/can-annuities-become-a-bigger-contributor-to-retirement-security/.

Annuity expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate income annuities. It provides a free quote comparison service. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities. More information, including updated interest rates from dozens of insurers, is available at https://www.annuityadvantage.com or (800) 239-0356.