The challenge of retirement is how to spend time without spending money. This funny quote subtly suggests that the retirees are often under the fear of outliving their money. Purchasing annuities during retirement is a way to ensure a steady income during the golden years. Just like any other investment product it has its own risks and advantages and it pays to learn a bit about it.
A good investment vehicle should ensure three factors: i) safety of principal ii) good rate of returns and iii) liquidity. Single Premium Immediate Annuities (SPIAs) ensure the first two but sacrifices the third one. SPIAs is a type of fixed annuity suitable for retirees to ensure a fixed income during their retirement. It is an annuity contract where a lump sum amount called premium is paid by an annuitant for which the insurer will promise to pay a certain fixed amount of money periodically for the rest of the annuitant’s life. In short, the annuitant will get a steady flow of cash from the insurer for the lump sum payment he has made. Under no circumstances can he reverse this contract and take his money back.
As the money paid is irretrievable its better to understand all the risks involved before purchasing such annuities. Knowing the risks in advance will be of great help while shopping for a good / right deal. Some of the risks involved in SPIAs are as follows:
- Annuity contract is irreversible
- Inflation may erode the purchasing power of the withdrawal amount
- The insurer may become bankrupt
Its always better to prevent than repent. Follow this checklist before committing a big portion of your savings to purchase SPIA and ensure that you are getting a good deal:
Annuitize only a part of your portfolio
The biggest risk of annuities is that it is irreversible. The lump sum paid to the insurer becomes illiquid and under no circumstances would the annuitant be able to reverse the agreement and recover his money. No matter what happens to him, he has no control over the money after he pays the one time premium amount to the insurer. Therefore, it is better to annuitize only a part of the portfolio and to keep the remaining in the form of CDs, bonds, treasury bills, stocks or cash and so on to meet the unexpected heavy expenses.
Opt for annuity where withdrawal amount gets adjusted for inflation
Immediate annuities become less dependable to retirees if the amount is truly ‘fixed’ and if it does not get adjusted with the cost of living index; inflation erodes the purchasing power of the ‘fixed’ cash flow and thus in the long run it may not be sufficient to cater to the basic needs. Therefore, even though it requires bit higher initial premium payment it is always better to purchase the annuity where the withdrawal amount gets adjusted with inflation.
Check the financial strength of the insurance company
SPIAs are purchased with the intention of having steady and secured cash flow throughout the annuitant’s life. But what if the insurer goes belly up? Just as there is uncertainty about an individual’s life, so is the case with an insurance company. The insurer may be financially sound at the time of purchasing the annuity, but anything may happen in a long horizon of 20 – 30 years. Even giant insurance companies too can fail – just recall what happened in AIG. So before purchasing an annuity check the insurance company’s financial strength with various rating agencies such as A.M.Best, Standard and Poor’s, Fitch or Moody’s.
Know the state guarantee association coverage limit along with the rules
The fear about insurer’s credit worthiness need not keep you away from purchasing an annuity because each state has a guarantee association that will step in if the insurance company becomes bankrupt. So it is good to know the coverage limit (varies from $100,000 to $500,000) and rules of these guarantee associations which vary from state to state.
For example, the insurance coverage limit is up to $300,000 in Arkansas. If the insurance company becomes insolvent then the guarantee association will provide the coverage up to this limit provided the annuitants reside in Arkansas. If the annuitant, who has taken an insurance while he was a resident of Arkansas, moved to some other state and if the insurance company becomes insolvent then he will not be covered for this loss.
New York offers highest coverage of up to $500,000; further it covers the risk of all annuitants, those who are residents of this state either when the insurance company becomes bankrupt or when the annuity was issued. So in this case moving to another state is not an issue if you purchased your annuity in New York.
Consider diversifying between insurance companies
If you are planning to purchase an annuity with a big lump sum then it is better to spread the risk among different issuers. It has been advised that one should purchase an annuity insurance preferably from either a small insurer or one who is too big to fail (or if possible from both). Then the state guarantee association coverage will be large enough to cover the smaller portion of the contract taken with the small issuer and the taxpayer will bail out the too big to fail company’s contracts. (recall how insurance giant American International Group was bailed out by the government in 2008).
Retirement planning is not all too easy and here every investment product has its own merits and demerits. It is good to understand that there is not one thing called perfect financial product, which everybody can rely on. Every product has its own merits and demerits. Further, not all products conform to the requirements of every individual and so one has to assess their individual situation before making any decision.