Monday, August 10, 2009

Annuities: guaranteed income, but the particulars matter

On Mondays, we post a question from a reader and answer from Dan Danford. Today's question centers on annuities. If you have a question you'd like to see answered, post it in the comments section here or send it to us on Twitter @family_finances.

QUESTION: I am 62, and looking at investing in a fixed annuity. They seem like a good deal, but I’m confused by the different types of annuities offered. What type do you think is the best? I have a 401 (k) with about $500,000 in it, and I will be receiving some social security and a small pension. I’d like to preserve some of my funds for my children.

Annuities are investment contracts sold by insurance companies. They come in many shapes and sizes, but we'll focus on the fixed annuity today. In its usual form, a fixed annuity trades your stack of money for a stream of monthly payments. That stream could start today or some date in the future. It's called a "fixed rate" annuity because the interest rates (and payments) are set by the contract, and don't change in the future.

So the interest that you earn, and the payment schedule and amount, are all part of that initial contract. In a way, the buyer is trading an uncertain future for a certain stream of payments. For most of us. that's an appealing idea because we hate uncertainty! That's why these types of contracts are popular with the public.

But, like many things, popularity isn't always a good measure of character. A downside of buying "certainty" is that you give up flexibility. Once you've locked in those rate and terms, you're stuck with them for the rest of your life. What if you need emergency cash? What if interest rates rise dramatically, or inflation rages at 8 to 10 percent a year? What if you die suddenly after only collecting eight payments? Though unlikely, these things have happened in the past, and they left fixed annuity holders in a (genuine) fix.

Based on the statistics, you have many years of "life expectancy" left. Don't be quick to jump into an annuity (even if the seller seems sincere and charming). If you eventually decide an annuity makes sense for you, keep a sizable nest egg out to meet future emergencies. With the contract you do buy, seeks a couple of important provisions: annual inflation adjustments for your monthly payments, and five- or ten-year certain (a guarantee that your beneficiaries collect payments after you are gone).

It also makes sense to check the insurance company's rating because your ultimate guarantee is their success in business. They can't honor contracts unless they are still operating. Last, and this is a big issue, get quotes from several different companies. Each company sets their own terms and makes their own predictions about future investment returns and lifespan. You'll be surprised at how much difference that makes in your guaranteed monthly payment.

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