Retirement Income Strategies with Annuities

Originally published in Forbes.

Income annuities come in a variety of shapes and sizes. Knowing which makes the most sense for your situation can be overwhelming. In this article, I will explore how income annuities work and what options are available.

When do income payments start?

Annuities can be either immediate or deferred. An immediate annuity begins income payments within one year of the purchase date, while a deferred income annuity does not begin payments until at least one year after the purchase date. A deferred income annuity purchased at retirement with income beginning at age 80 or 85 is referred to as “longevity insurance.” After the Treasury Department updated regulations in 2014 to facilitate the use of longevity insurance inside retirement plans, longevity insurance is now also known as a QLAC or a Qualified Longevity Annuity Contract. In practice, deferred income annuities are used less as a form of longevity insurance and more for prepaying retirement and removing market risk. In such a case, one might purchase a deferred income annuity at age 55 for income to begin at 65.

Do income annuities cover one life or two?

True to their name, single-life income annuities only cover one person’s life. With such an annuity, income payments continue until the annuitant’s death. On the other hand, a joint-life annuity continues payments for as long as at least one of two members survives. Joint annuities are often set up for spouses, but marriage is not required. Since payments are expected to last longer, the joint protection comes at the cost of a lower initial payout rate. A joint-life and 100% survivor annuity provide the same payment as long as one person is alive. With a joint-life and 67% survivor annuity, the payment would reduce by 33% upon the first annuitant’s death, allowing for a higher initial income level.

What are the different 'flavors' of payouts?

A life-only income annuity is the purest form with the highest payout and the most mortality credits. Payouts are highest here because the purchaser is taking the most “hit by a bus risk” – the common fear of signing an annuity contract and then being hit by a bus and killed on the way out of the office. Life-only annuities are popular with academics because acceptance of this risk makes more funds available to the longer-surviving members of the risk pool.

In practice, annuity buyers are typically uncomfortable with a life-only annuity. Numerous outlets suggest that less than 10% of income annuity sales represent life-only versions.

A variety of other flavors would lower the payout rate but may otherwise make the income annuity a more palatable choice:

• 10-year period certain annuity - Pays for life. If you die before 10 years is up, your beneficiaries continue receiving payments for the full 10 years.
• Cash refund provision – Provides a cash refund of the difference if an annuitant dies before receiving income equal to the initial principal payment.
• Installment Refund – Works very similarly to the cash refund, except beneficiaries receive the difference in installments rather than a one-time refund.

Are payments fixed, or do they grow over time?

There are generally three options regarding income annuity payments, the first of which is the only fixed option.

1. Fixed or nominal income annuity: These annuities will pay the same income amount as long as the contract requires. The purchasing power of the income payments will decrease over time as there is no growth for inflation.
2. COLA: A cost-of-living adjustment (COLA) provision would have income payments grow at a fixed compounding rate each year. For instance, if I feel that 3% is a reasonable assumption for future inflation, I might choose a COLA adjustment of 3% with the intention of preserving the purchasing power for my annuity income.
3. CPI: You could add a provision that the income growth rate of the annuity payments precisely matches the Consumer Price Index (CPI). When inflation is low, income grows more slowly, as do living costs for the retiree. When inflation is high, income grows more quickly. Not many companies currently offer CPI-adjusted income annuities, and so the pricing may not be competitive, making this option less attractive. This option could still be attractive for someone who is particularly worried that inflation will be higher than the markets expect. In particular, a CPI-adjusted income annuity really is the closest thing we have to a “risk-free asset” for retirement income. With these annuities, it is also important to check the contract carefully about whether there is a cap on the inflation adjustment. For instance, with a cap of 6%, even if inflation is 9% in any given year, income payment will only grow by at most 6%. This limits the attractiveness for an individual who is really concerned about high inflation in the future.

Those seeking inflation protection, specifically from the annuity, should go with options two or three. It is important to recognize, though, that increased future payments mean a lower initial payout rate. In my next column, I’ll demonstrate how income annuities are priced.