How a lifetime income annuity works

  @Money March 6, 2013: 6:00 AM ET
NEW YORK (Money Magazine)

Would you please explain, in principle, what a lifetime income annuity is and how it works? -- Don Williams

When the topic turns to annuities, people's eyes glaze over, their heads nod and before long they're in a deep slumber.

To avoid that reaction (I hope), I'm going to try a different approach to explaining how annuities provide income income for life -- and why anyone retired or on the verge of retirement might want to consider buying one.

Imagine for a moment that you're 65, retired and you want some of your savings to provide a secure income throughout retirement. And let's further assume that you have a bunch of 65-year-old friends who want the same thing.

So you form a group and agree that each of you will kick in the same amount of money -- $10,000, $100,000, whatever -- to an investment account and share equally in however much that account earns.

To increase your income from the pool, you and the other members also decide to distribute some of the principal each month, taking care to apportion it slowly so the account doesn't run dry too soon.

Finally, you and your compadres agree to one more condition: Whenever someone dies, the earnings and the principal draw that would have gone to the deceased are instead divvied up among the surviving members, providing them with extra income they wouldn't have had without this arrangement.

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Well, a lifetime income annuity (or immediate annuity as it's also known) you buy from an insurance company works much the same, with a few important differences.

For one thing, income annuities cover not just a small group of people of the same age investing the same amount of money, but tens of thousands of people of different ages (though they tend to be in their 60s or older) investing a variety of amounts.

Another big difference concerns the monthly payments one receives. In the arrangement above, the payouts can't be fixed in advance. After all, the group doesn't know how much the investment account will earn each month, nor when members will die, providing survivors with that extra income.

Insurance companies, by contrast, will tell you in advance how much an income annuity will pay each month. They can do this because they have actuaries who use mortality statistics to project how many annuity owners will die each year and investment analysts who forecast investment returns. That allows insurers to set in advance a sustainable level of payments.

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But perhaps the biggest difference is that no group of individuals pooling and investing money can guarantee that its members will continue receiving payments regardless of how long they live. There's always the risk that a few group members will make it to such an advanced age that the pool of assets will be exhausted while they're still alive. (Yes, the group could make the payments so tiny that the chances of the money running out are minuscule. But then the income all but the longest-lived members stood to receive wouldn't be very attractive.)

Insurance companies, however, can make that guarantee.

The reason is that state insurance regulators require insurers to set aside reserves to cover any shortfalls in the event insurers' actuaries and investment analysts miss the market with their forecasts.

Is that guarantee absolute? Of course not. There's always the risk that an insurer could fail. But historically that risk has been very small.

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And there are ways to protect yourself against even that slim possibility. Specifically, you can spread your money among a few annuities issued by insurers with high financial strength ratings and limit the amount you invest with any single insurer to the maximum coverage offered by the insurance guaranty association in your state.

The bottom line, though, is that an income annuity offers something that no other investment can -- insurance against the risk of outliving your money.

However, since you must give up access to the money you invest in an annuity, you don't want to put all your retirement savings into one. (There are annuities that allow you at least some access to your investment, but you'll receive less income and undermine the benefits of buying an annuity in the first place.)

Related: How to make your retirement savings last

That's why I think most people who want more guaranteed lifetime income than Social Security alone can provide ought to consider combining a lifetime annuity with a traditional portfolio of stock and bond mutual funds.

If you'd like an estimate of how much monthly income you can receive today based on your age, gender and the amount you have to devote to an annuity, you can check out our Income For Life calculator.

The size of annuity payments depends in large part on the level of interest rates. So given today's low rates, annuity payments are skimpier than they've been in the past.

Some people argue that that means you should wait until rates rise before buying an annuity. But trying to time the market for annuities makes no more sense than attempting to time the stock market.

A better move is to invest any money you intend to put in annuities gradually, buying a few over time rather than plunking down all your cash at once. Besides assuring that you don't commit all your dough when rates are at a trough, such a strategy will also give you some time (and experience) to better assess just how much annuity income you really need.

I hope this explanation gives you a better understanding of how annuities work and helps you decide whether one should play a role in your portfolio after you retire. If not, then maybe you at least had a nice snooze. To top of page

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