Immediate annuities offer income, beware of risks

You can use your money to buy soup, yogurt or ice cream. Each comes in so many flavors that it may take you a while to figure out which one you want, if any. But you do have choices and are not stuck with one type.

You can also use your money to buy an income for life. You do that when you buy an immediate annuity from an insurance company. Now more than ever, you also get to choose ways to receive that income.

We thought of the analogy with supermarket products because it illustrates a welcome trend toward more choices but, unavoidably, more complexity in immediate annuities. These annuities are increasingly being pitched to retiring Baby Boomers rightfully worried that their savings won't be enough to last them in retirement.

An immediate annuity is basically an insurance product that converts a lump sum (the premium you pay) into an income for life (payments you receive, such as every month, until you die). It works as a "private pension" and is in essence insurance against living too long and running out of money.

Fans of immediate annuities point out that, if you invest your money yourself, you run the twin risks of achieving insufficient returns (or even suffering losses) and of living beyond your life expectancy, making it likely you'll run out of money.

Insurance companies, on the other hand, can rely on the law of averages, figuring that for all those who live longer than expected, a similar number will die sooner. Therefore, they can base the annuity payouts to you on prevailing interest rates and average life expectancies. (In effect, those who die sooner than expected end up subsidizing those who live longer.)

It's more complicated than that because the payments you receive are reduced by a number of costs, not to mention the profit the insurance companies expect to make. And not even the most ardent proponents of immediate annuities recommend you put all your money in them, just a portion.

But overall, an immediate annuity does provide you with more lifetime income than you're likely to obtain on your own, many independent observers agree.

Now, the bad part. With the basic life-only immediate annuity, payments stop after you die and your heirs get nothing, no matter how big a premium you paid and how little you may have received in payments before your death. And with a typical fixed annuity, payments are by definition "fixed" and won't keep up with inflation.

(Most immediate annuities sold today are "fixed," with the size of the payments pre-determined and guaranteed by the insurance company. With "variable" immediate annuities, payments also are guaranteed for life, but their size will depend on the performance of the investments you choose. With good investment results, you may get protection against inflation. But you also risk that bad results will lower your income. For this discussion, we'll concern ourselves only with fixed immediate annuities.)

For years, insurance companies have been offering fixed payout options that guarantee a minimum number of payments, even if the annuity purchaser dies soon after buying the policy. And now, a growing number of companies are adding a host of other features, including inflation-protection, access to principal and flexibility in receiving payments.

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