Annuity Pros and Cons: Should You Opt for a Deferred or Immediate Annuity for Longevity Protection

Americans fear outliving their money more than they fear death. A staggering 61% of survey respondents said they were more scared of outliving their assets than they were of dying, according to a 2010 study of baby boomers from Allianz. The research found that this percentage climbed to 77% for those age 44 to 49, and rose even higher (82%) for those in their late 40s who had dependents. So when planning for retirement, Americans must guard against the risk of outliving their money (often referred to as “longevity risk”) — a fear that can be addressed by annuities, experts say. “These are specifically products for the purpose of paying income when you live past your life expectancy,” says Michael Kitces, partner and director of research at Maryland-based Pinnacle Advisory Group. “That’s the problem annuities are meant to solve.” But with a dizzying array of annuities out there it can be difficult to decide which product is right for you. Annuities 101 All annuities are contracts with an insurance company in which you pay a premium or a series of premiums, then receive payments at regular intervals for a specific period of time.  Broadly, annuities can be divided into four categories:

• Fixed – annuity payments are the same every month
• Variable — annuity payments vary with investment returns
• Immediate — annuity payments begin immediately
• Deferred — annuity payments begin at a specified date in the future

While some view annuities as an investment, experts suggest this financial product is simply a means for providing income you can’t outlive in retirement. “This is a form of insurance; this is not wealth maximizing,” says certified financial planner David Blanchett, who is head of retirement research at Morningstar Investment Management. “People view annuities from an investment perspective, but really it’s a hedge — a hedge against a risk that can devastate you financially if you live into your 90s and haven’t saved enough to live that long.” So if seeking guaranteed income, many financial planners suggest retirees consider fixed annuities, as their payouts don’t rely on underlying investments like variable annuities do. Within the fixed annuity category are immediate and deferred annuities, whose payments begin right away or after a certain period of time. In a recent Journal of Financial Planning article, Blanchett breaks down the differences between these two types of annuities, outlining their advantages and disadvantages. In his study, Blanchett suggests that, in theory, deferred annuities offer a more attractive hedge against longevity risk (versus immediate annuities). However, based on current payout rates for each annuity type, immediate annuities appear to be slightly more attractive for retirees today. Taking a more detailed look at the two types of annuities can help you decide which is the right product for you. Deferred Annuities — Pros and Cons Deferred annuities, in theory, represent a more efficient means of transferring longevity risk than immediate annuities, because these annuities only provide an income if you live to a certain age, Blanchett says. For example, if you’re worried about being able to afford living past age 85, buying a deferred annuity that kicks in at age 85 can ensure you’re covered financially during your later years in retirement. “This reduces the cost of the insurance, because a good portion of individuals will not survive to the benefit commencement date, and even for those who do, the benefit payments may only last a couple of years,” Blanchett writes. Despite its lower cost, if you are 65 years old and purchase a deferred annuity with payments beginning at age 85, you will need to have enough savings or investments to last you another 20 years until those payments begin. Immediate Annuities — Pros and Cons If you’re worried about spending too much during the first several years in retirement, or would just feel safer having a steady income stream now, then an immediate annuity might be the product for you. “If you’re tired of managing your money, this is an excellent way to do it,” Blanchett says. In addition, immediate annuities offer more attractive payouts, due to the competition in the marketplace. Immediate annuities are fairly established in the market, unlike deferred annuities, which have only emerged within the last decade. “The immediate annuity market is incredibly liquid and there are lots of participants,” Blanchett says. “When there’s more competition, it creates better [payouts] for consumers.” In addition, immediate annuities cost more than deferred annuities — although they are also providing more income. For example, if you’re 65 years old today and live until you’re 100, an immediate annuity would give you 35 payments for 35 years. A deferred annuity would give you 15 payments, starting at age 85. “So 35 payments cost more than 15. The caveat is that I didn’t actually need the annuity for the first 20 years; I really just needed money for the last 15 years,” Kitces says. “If all I care about are the payments for the last 15 years, I get all the guarantee I was trying to get at less cost [with a deferred annuity], because I wasn’t trying to buy income that I didn’t need.” Making Your Decision — Should You Buy an Annuity?  What Kind? Before deciding to purchase an annuity, you should consider other options that don’t require spending a large chunk of money. In fact, did you know that you are probably already going to get an annuity?  “Today, the best immediate annuity for retirees is Social Security,” Blanchett says. “The first thing you should do is delay claiming Social Security.”  In fact, Social Security benefits can increase up to 32% if you wait until age 70 to start collecting them. This may translate to an additional $300,000 in benefits over the course of a couple’s lifetime or $100,000 during an individual’s lifetime, Once you have determined your existing lifetime income sources — like Social Security, then you can assess your need for an annuity.  “Ask, ‘Do I want more guaranteed income?’ Then and only then, you decide what kind of annuity you should purchase,” Blanchett says. You might want to start by getting estimates for how much income — deferred and/or immediate — your savings can buy with a lifetime annuity calculator.