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Fixed Annuities for Early Retirement
You’ve made it! You’ve reached financial independence by building a substantial nest egg, and you’re thinking about retiring early to pursue your passions.
There’s only one problem: you don’t know how to turn your nest egg into a stream of income sufficient to pay your day-to-day bills. You’re too young to receive Social Security or pension benefits, you’d face a tax penalty if you were to dip into your 401K before age 59½, and you won’t want to sell stocks to raise cash each time you get a cable TV bill.
A good solution to solve this problem is to use immediate fixed annuities.
Definition of Immediate Fixed Annuity
An annuity is a contract sold by an insurance company which agrees to make payments to its buyer, typically after retirement. With a fixed annuity, a certain payment amount is guaranteed. With an immediate annuity, the payments start immediately or soon after the annuity contract is purchased.
For example, a 50-year old male living in New York with a $1.2 M nest egg and $2500 per month in day-to-day expenses can buy an immediate fixed annuity paying $2500 per month for life for a one-time premium of $598,544 (per www.immediateannuities.com). He can then feel comfortable aggressively investing the remaining $601,456 of his nest egg since the annuity will cover his basic living expenses.
Use of Immediate Fixed Annuities by Early Retirees
Immediate fixed annuities are useful to early retirees because it allows them to pay a portion of their nest eggs to an insurance company in exchange for fixed guaranteed payments that start immediately.
By using enough of their nest eggs to buy an immediate fixed annuity large enough to pay their day-to-day expenses, early retirees can buy enough cash flow to live without the need to constantly sell assets.
Early retirees can then invest the rest of their nest eggs in riskier assets with higher growth potential. They can sleep soundly knowing their fixed annuity payments will cover their day-to-day expenses.
Selecting an Insurance Company to Buy From
While annuities are often maligned due to their complex nature and high fees, immediate fixed annuities are one of the simplest annuities, and their fees are often lower than other annuities.
Thus, early retirees shopping for immediate fixed annuities can easily comparison shop among the many insurance companies offering these products. In selecting an insurance company to buy from, there are two main criteria: the guaranteed payout amounts, and the financial stability of the insurance company.
There are a number of online sites that enable early retirees to get quotes for immediate fixed annuities. A popular online site is www.immediateannuities.com.
Since you will be receiving the annuity payments for a very long period of time, possibly measured in decades, you want to select an insurance company that will remain in business for a very long time.
The conventional way to assess the stability of insurance companies is to review their credit ratings, which are issued by A.M. Best, Fitch Ratings, Standard & Poor’s, Moody’s and Weiss Ratings. To minimize the risk of default, you want to select an insurance company with the highest credit worthiness rating.
Even if you pick a highly-rated insurer, that company could still fail. If that were to happen, your State Guaranty Association will transfer your annuity to another insurer, and will insure your annuity up to a certain amount (typically $100,000 or more). See http://www.nolhga.com/ for more information.
Once you have a number of online quotes, know the credit ratings of the insurance companies, and have compared the amount you want to invest with the amount insured by your State Guaranty Association, select the insurer offering the best combination of guaranteed payout amount and financial stability.
Options to Consider
Inflation is a real risk to the purchasing power of early retirees due to their long time horizons. To protect against inflation, you can select an immediate fixed annuity with a payout guaranteed to increase by a certain percentage each year (e.g., 3%). Or, select an annuity with a payout guaranteed to increase by the rate of inflation (e.g., as measured by the Consumer Price Index). In both cases, your initial payout will be less than that of a comparable annuity without inflation protection.
Early retirees can select from a number of annuitization options for receiving their payments. Single people often select a “single life only” annuity offering regular income payments for life, ending at their death. Married couples often select a “joint and survivor life only” annuity offering regular income payments for as long as either spouse is living. The payments made to the surviving spouse can be a percentage (e.g., 50%, 66.7%, 75% or 100%) of the payments made while both spouses were living. The “joint and survivor life only” annuity payments will be lower since they will often be made for longer.
Other annuitization options are also available, including “single life with a guaranteed number of years”, “joint and survivor life with a guaranteed number of years”, or “guaranteed number of years”. Payouts for each of these options will differ based on the actuarial assumptions that are used to calculate them.
Immediate fixed annuities are very expensive. Indeed, they can be one of life’s biggest purchases. To minimize the risk of making a sub-optimal purchase, it can be wise to diversify your annuity purchase.
One way to diversify your annuity purchase is to buy a number of different annuities from different insurance companies. This way, the failure of any one insurer will be less harmful. Also, you can keep your purchases from any one company below your State Guaranty Association’s limit.
Another way to diversify your annuity purchase is to buy a number of different annuities at different times. Since a big factor in determining the guaranteed payout amount is the rate of interest, buying annuities at different times helps avoid buying all your annuities at the worst possible time. This may be especially relevant advice today because interest rates are at historically low levels.
Yet another way to diversify your annuity purchase is to buy a number of different annuities with different options. For example, you could buy a first annuity with inflation adjustment in case inflation explodes later, and a second annuity without inflation adjustment but a higher initial payout.
Buyers who use non-qualified dollars to buy immediate fixed annuities benefit from the exclusion ratio at tax time. Under IRS rules, annuity payouts may consist of a tax-free part that is a return of the net cost of the annuity and the taxable balance.
See IRS Pub. 939 “General Rule for Pensions and Annuities” for more information.