As your 401k balance plummets during a bear market, the idea of a guaranteed income stream--exactly the promise in that annuity brochure that arrived in the mail--sounds like a pretty good deal. With an increasing number of companies shifting to 401k plans or their equivalents, persons facing retirement often find themselves weighing a simple choice. Should they roll the pot over into an IRA and try to manage their way to a respectable rate of return, or should they buy an annuity and lock in a regular payment. Each retirement strategy has its advantages. Of course, each has its drawbacks, too.
An annuity is any stream of agreed-upon payments over a specific period. The simplest form is an immediate pay annuity. You give a company--usually an insurance company--a pile of money, and the company guarantees you regular payments for as long as you live (or for a certain number of years, whatever you decide). There are other kinds of annuities and variations on each bell or whistle, but the two major differences are not all that helpful for retirement planning. With deferred annuities, the payments start sometime in the future, generally after providing you a fixed rate of return during the waiting period. In addition, both immediate and deferred annuities can be variable annuities.
Variable annuities promise tax-deferred growth and exposure to equities. Of course, those are the same attributes as your IRA account, which provides more flexibility and without higher fees charged by the insurance company for managing the account. The bottom line with annuities is that it’s probably better to stick with straightforward stuff: immediate regular payments for the rest of your life.
Traditional IRAs give you all sorts of investment options: stocks, bonds, mutual funds, real estate, commodities, plain old certificates of deposit.
Immediate annuities give you only a fixed rate of return, and there is no potential upside to an annuity. In fact, its guarantee against a downside promises there will be no upside.
By comparison, the stock market had a return of 26 percent in 2003 followed by returns of 9, 3, 14 and 3.5 percent in the next four years. All of those rates of return bettered inflation for those years.
The immediate annuity is guaranteed. Your only risk is the failure of the insurance company carrying the annuity. One way to mitigate that risk is to divide your annuity investment among several insurance companies.
The various investments in an IRA carry different levels of risk. You can hedge risk factors by dividing your IRA investments among various asset classes--some money in stocks, some in bonds, some in CDs, etc. But unless you put all of it into CDs, you run the risk of losing some principal through investment losses.
Any investment growth within an IRA is tax-free; losses are not tax-deductible. Distributions from both IRAs and annuities are taxed as ordinary income.
However, if you are able to buy the annuity with money from a taxable account, a portion of each payout will be classified as a return of principal and will be tax-free.
After you reach 59-1/2, the control of IRA distributions is up to you. If you have a medical emergency or need a new roof, take out a little extra. If you want to “catch up” the following year, cut back on travel and trips to the theater and take out less.
That’s not an option with an annuity. Money in an IRA will be passed on to your heirs. An annuity payment stream simply stops. You can buy an annuity that continues making payments to your spouse after you die if you accept a smaller payment while you’re alive. Beware: There is no adjustment if your spouse precedes you in death.
If you live a long time, your annuity payments will be worth less because of inflation. For example, $600 a month might have seemed like a lot to a retiree in 1980; not so much if that person is 92 years old and depending on that income stream today. But the payments, at least, are still coming.
IRAs give you the opportunity to tap into investment gains to gradually increase your distributions and at least stay even with inflation. But if investment losses sap the account, there may be no increase to be found. One way to hedge for inflation in an annuity is to buy an inflation-adjusted policy. You receive less money initially, but it will increase every year until the payments end.
The Combo Plan
One option is choosing both. Put some of your retirement plan distribution into a form of an immediate pay annuity, guaranteeing you a steady stream of income for life. Invest the rest in an IRA, providing you the chance to use investment returns to keep your retirement income ahead of inflation.
- Kiplinger's Retirement Report, "An Annuity That Pays Now And Forever," Kathryn A. Wilson, July 9, 2009
- Immediate Annuities
Dale Bye has spent more than 40 years in journalism, including 25 supervising reporters and editors at metropolitan newspapers and eight years as senior managing editor at a national sports magazine. He directed five newspaper-sponsored personal finance fairs. His fields of expertise include business and personal finance, sports, fitness and theater. Bye holds a Bachelor of Journalism from the University of Missouri.