(Dow Jones) Many retirees are in a terrible bind. The stock market's volatility scares them, but conservative investments like money-market accounts or bank certificates of deposit yield almost nothing right now.
Along comes the immediate annuity. You hand over a chunk of money to an insurer, and get a hefty payment for life. Currently, a 65-year-old paying $100,000 gets about $7,500 a year.
Last month the White House's Middle Class Task Force recommended immediate annuities as a way to reduce "the risks that retirees will outlive their savings."
Taking that advice mightn't be a great move right now.
Due to today's ultralow interest rates, the payouts on these pension-like products are less generous than in recent years. And unlike buying a bond, which can be sold at any time or rolled into another bond when it matures, with an annuity you are locking in this low rate forever. That argues for delaying an annuity purchase as long as possible or buying several annuities over time, locking up your money in small chunks.
You are essentially making a bet on how long you will live when you buy an immediate annuity. If you don't live that long, they are a poor investment. For those who live into their 80s and beyond, however, the payoff can be attractive.
Buying an immediate annuity is a very different proposition from buying a bond. If you buy a $100,000, 10-year Treasury bond yielding 3.6%, you'll collect $3,600 a year for 10 years and get your $100,000 back at the end-assuming you don't have to spend some of the principal to supplement your income along the way.
With a traditional immediate annuity, the $100,000 you kicked in initially is gone forever. That is why the insurer is willing to give you a much fatter monthly payment.
How long do you have to live before an immediate annuity pays off?
Suppose a 65-year-old man buys a $100,000 annuity that pays $7,500 a year and he lives 20 additional years, his life expectancy. Because there isn't a return of principal at death, the equivalent yield on the investment is 4.48%. (Because some of the payment is regarded as a return of principal, only a portion of it is subject to income tax.)
The math gets much sweeter if our 65-year-old lives longer, however. If he dies after 25 years, the effective yield rises to 5.87%; at 30 years, 6.61%.
On the other hand, if you die in five years, you will receive only $37,500 back of your $100,000. Since investors worry about dying prematurely, insurance companies sell immediate annuities that guarantee the annuity payments will continue for a set number of years. But you'll get lower annual income payments-$7,291 for our hypothetical 65-year-old buying an annuity with 10 years of guaranteed payments.
The other problem with immediate annuities is today's low payouts. That is why many financial advisers recommend that you stagger your annuity purchases over six or so years. The idea is to lock in some of the income you need right away. If interest rates rise, your future purchases of annuities will deliver bigger annual income checks for the same payment.
"I am an advocate of a slow-purchase strategy," says Moshe Milevsky, an associate professor of finance at the Schulich School of Business at York University in Toronto. "You don't want to lock into a low interest rate on something that's irreversible."
Mr. Milevsky and some other academics think annuities are smart purchases for a portion of the nest eggs of people who don't have old-fashioned pension plans. In 2008, Americans bought $7.6 billion in immediate annuities, up 26% from the previous year.
Whether you buy now or later, steer clear of insurers with less-than-stellar financial ratings. Stick with those with triple-A or double-A claims-paying-ability ratings, such as Berkshire Hathaway Life Insurance Co., Massachusetts Mutual Life Insurance Co., New York Life Insurance Co., Northwestern Mutual Insurance Co., TIAA-CREF and USAA.
You also can protect your annuity investment by buying from different carriers and staying within the coverage limit available in your state. In the event of an insurer's insolvency, industry-backed guaranty funds provide at least $100,000 for such annuities; visit www.nolhga.com for links to your state association's Web site, where you can find the exact limit in your state.
Copyright (c) 2010, Dow Jones. For more information about Dow Jones' services for advisors, please click here.