You've done a good job building your 401(k), and retirement is not far off. The question now: how to make sure that nest egg generates sufficient income to sustain you through a retirement that might last two or three decades.
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For years, retirement income has been something of a holy grail for retirement experts who worry about longevity - the risk that you will outlive your money. One solution is the income annuity.
An income annuity offers a simple proposition: turn over a chunk of cash to an insurance company, which then sends you a monthly check for as long as you live.
Income annuities don't play a big role on the stage of retirement solutions - but they have been in the spotlight lately. The U.S. Treasury Department has proposed policies that would make it easier to use income annuities within 401(k) retirement plans or Individual Retirement Accounts (IRAs).
And income annuity sales rose 6.6% in 2011 to a record $8.1 billion, according to LIMRA, an insurance industry research and consulting group. That's still a very small fraction of the overall retirement market, which had $17 trillion invested at the end of the third quarter last year, according to the Investment Company Institute. But it is movement just the same.
Savers may be drawn to the higher immediate rates of return that income annuities provide when compared with traditional fixed-income investments, like bonds and bank certificates of deposit. For example, a 65-year-old man who bought a $100,000 immediate annuity would receive $562 per month for life, according to Vanguard. That is an initial annual payout of 6.7%; far higher than any safe bond yields right now.
That's made possible by the "mortality credit" baked into annuities - a term that refers to the money paid in by customers who die earlier than their life expectancy; that money goes into the overall pool and can be paid out to other annuitants.
"With expectations of low market returns for the next decade and longer, immediate annuities may be one of the few investment silver linings for investors looking to make their nest egg last their life time," said Harold Evensky, president of Evensky & Katz Wealth Management.
But income annuities have not taken off. Many retirement investors do not like the idea of handing over their money to insurance companies. And most immediate fixed annuities keep the same monthly payouts forever; they do not rise with inflation. So if the man in the above example lived to be 84, he would still be getting $562 a month, and his rate of return would have dropped to 2.74%, according to Vanguard. His rate would fall over the long term because the monthly amount would never increase with inflation or growth of principal.
Furthermore, some savers worry about the risk of taking on a lifetime insurance partner that could go out of business.
However, like any insurance product, income annuities are regulated by state insurance boards and backed by insurer-funded state guarantee associations. (The conditions for these guarantees vary by state, so it is important to understand how much protection is available in the state where you live.)
Another way to feel more comfortable with the risk is to spread an annuity investment among multiple carriers. And even the staunchest advocates of income annuities do not recommend annuitizing all retirement assets. "Most research suggests anywhere from 20% to 50%," Evensky said.
OBAMA ADMINISTRATION SUPPORT
The Treasury recently unveiled a series of proposed regulations and rules aimed at promoting the use of annuitization. Some of the proposals involve enhanced features in traditional defined benefit retirement plans.
But one focuses on a little-used form of annuity known as a longevity policy - essentially a deferred annuity that can be bought well ahead of retirement with payouts delayed to an advanced age.
The deferral feature focuses specifically on that frightening outlive-your-money longevity risk - and it makes the policies much less expensive. For example, Metlife says that for $43,000, a 65-year-old man could purchase a longevity policy paying $2,000 monthly starting at age 85, compared with $398,000 for a policy generating the same payout immediately.
The Treasury plan aims to encourage people to buy longevity plans with their 401(k) and IRA assets by relaxing the so-called required minimum distribution rules that kick in when they turn 70-1/2. The proposal would allow savers to exempt the value of their longevity policy from assets used to calculate those mandatory withdrawals.
"We hope this guidance will open up both the employer retirement plan market and the IRA market to the option of longevity annuities," said Mark Iwry, senior adviser to the Secretary of the Treasury. "Because of the way the RMD rules interact with the longevity annuity, both of those spaces have been - as a practical matter - largely closed to longevity annuities."
But annuities in workplace plans face several hurdles. Here are a few:
-- No comparison shopping. Retirees who buy an annuity through a workplace plan would be relying on the employer to have negotiated the best possible deal on rate of return and fees. "You are relying on your plan sponsor to have negotiated in good faith with the insurance company," says Jody Strakosch, national director of strategic alliances for annuities at MetLife Inc.
In the retail market, it is easy to comparison shop immediate annuities online by plugging in information on how much income you want to generate, whether you want inflation protection, a joint and survivor feature, and whether the annuity payouts would be immediate or deferred. Vanguard has created an online marketplace for annuity shopping (http://link.reuters.com/gar86s); other examples include ImmediateAnnuities.com (http://www.immediateannuities.com/) and Annuity.com (http://annuity.com/).
-- Complexity. "It's hard enough getting employees to understand the investing side of 401(k) plans," said Metlife's Strakosch. "We definitely have challenges getting people to understand annuities."
-- Lack of flexibility. A particular strength of 401(k) plans is their portability. It is easy to roll over an account to a new employer plan if you change jobs, or to a standalone individual retirement account. But annuities - which are lifetime insurance contracts - present special portability challenges, said John Ameriks, who heads up Vanguard's Investment Counseling & Research group. "It's a much less flexible product than the other investment options in a workplace plan," he said.
"Can I roll it over?" he said. "Do I have to leave it with my former employer when I leave, or does the insurer offer a rollover IRA product? If they do, how is that priced? Do the features or price change?"
Ameriks thinks the use of annuities will continue to grow over the next decade. "But it won't be an avalanche. It will be a marginal, slow-burn change." (Editing by Linda Stern, Jilian Mincer and John Wallace)
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