Using Annuities to Guaranty Retirement Income for Life
The Risk of Outliving One's Retirement Savings
Thanks to better health overall and improved health care, people are living longer after they retire. In times past, retirement usually lasted a relatively few short years - people retired from work and died a few years later. However, today people are living longer with increasing numbers reaching their nineties or even a hundred before dying.
A person who retires in their mid-sixties and lives to their late nineties will have spent almost one third of their life in retirement. While, assuming the person continues to enjoy good health, this can be great, it also presents the problem having enough savings to live on for that long a period.
Everyone Needs an Income to Survive
An income is essential in modern society as it is the means by which people support themselves economically. For most of us our income comes in the form of compensation for our labor. However, income can also be generated by income producing assets such as rents from land and buildings, profits generated by a businesses or interest collected on money lent.
Most retirees survive on a combination of the income generated from the savings and investments accumulated during their working years and the drawing down of the savings and investments themselves. A few have savings and investments of such size that they generate enough income to meet the person's needs. However, most people do not have sufficient wealth for this and eventually have to start withdrawing the savings and liquidating investments to meet the shortfall. If the person doing this lives long enough they will eventually find themselves both broke and too old to go back to work.
Life Insurance Protects Income During Working Years, While Annuities Protect Income in Retirement
Life insurance companies have an insurance solution which guarantees a person an income for life no matter how long they live. The insurance in this case is called an annuity. In a way, an annuity is the opposite or flip side these companies' main product, life insurance.
Life insurance provides a large payment to the dependents of people who do not have sufficient savings and other assets to support their families in the event of their death.
Life insurance is intended to provide survivors with sufficient financial means to maintain their standard of living in the event of the income provider dies before accumulating the necessary assets to support them in the event of the wage earner's death.
On the other hand, annuities, which guaranty an income for life, protect individuals against living too long and using up all of their assets before they die.
Life insurance is based upon the fact that, out of a given large group of people, we can predict approximately how many, but not which ones, will die in a given year. The insurance company then collects a relatively small sum from each individual and uses the proceeds to pay the survivors of those few who die.
With annuities, the insurance company collects a large amount (usually much or all of the life savings accumulated by an individual) from each individual in a large group of, generally older, individuals.
The insurance company knows that a certain percentage of the people in the group will die before using up their savings. Another, larger portion, in the group will get back most of their money and a few will outlive their savings.
The insurance company then invests the pool of funds and uses the income and principal to provide each individual with a fixed monthly income for life with the surplus funds obtained from those who die early going to those who live past their savings. In addition to paying out the life time incomes, the insurance company also tries to structure the investments and payout formulas to insure a profit for the insurance company as well.
Again, as with life insurance, the company can fairly accurately calculate how many people will fall into each of the three groups but cannot identify which individuals will die soon and which will out live their savings.
Annuities and Life Insurance Offer Peace of Mind
Of course, I have greatly simplified the process in the example above but the idea, in both cases, is to pool money obtained from a large group and then use it to compensate the survivors of those who die early in the case of life insurance and those who live longer than planned in the case of annuities.
In both cases the individuals buying the life insurance or annuities are concerned about being one of the ones who either dies too soon or lives too long and suffers (or their survivors suffer) life without sufficient income. This is why they are willing to pay for something they hope they will not have to use. In both cases what they are really buying is peace of mind.
Three Types of Annuity Purchases
In the discussion to this point I have talking about a classic single payment immediate annuity with a single payment and a fixed monthly income for life. This is known as a single premium immediate annuity because the buyer makes one very large premium payment and immediately begins receiving a monthly income for life.
Companies also offer what is known as a single premium deferred annuity in which the buyer purchases the annuity with a single large payment but elects to defer or hold off receiving monthly payments until some future date.
For those who can afford it, this method results in a larger monthly income once the buyer begins receiving payments. This is because the purchase amount will be invested and grow between the time of purchase and the time payments start thereby providing a larger amount to work with.
There is also a second, and more important, reason and that is that the longer the buyer delays starting to collect the income the shorter his or her remaining life will be which means that the insurance company can afford to pay a higher monthly income to the individual knowing that they will be paying it for a shorter period than if they had started the income payments when the premium was first paid.
A third type involves multiple premium payments over a period of time before the annuity contract is activated and the buyer begins receiving a fixed monthly income.
This type of annuity is designed for people who cannot afford to pay the entire premium all at once and wish to make a series of smaller payments.
Like the single premium deferred annuity, the payments are invested and grow and the start of the income phase is deferred both of which enable the insurance company to be able to safely pay a higher monthly income for life than would be the case if the buyer made a single payment and started receiving income immediately.
Other Types of Annuity Products
Like other products, companies offer a standard model which what I have just described and premium models which come with more frills and cost more (in this case cost more means the monthly income is lower than it would be with the standard model.
Frills can include a guaranty to get one's money back for their survivors in full if they die early in the term (usually within five or ten years of the start of payments), the income can be paid to two people and continue until the second one dies, an inflation hedge that calls for adjusting the monthly income payment upward to keep pace with inflation and other little extras.
There are also variable annuities which are similar to traditional annuities in some respects but operate differently from fixed annuities in other respects. Because variable annuities operate differently in many ways they are best left for a future Hub.
Annuities can be a valuable investment tool for retirement in that they can be used to guaranty that one's income will not drop below a certain level.
My Other Hubs on Retirement Considerations
- Role of Annuities in Retirement Income Planning
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