Inevitably, when you start preparing for retirement you are going to become acquainted with annuities. That’s probably because they can do something that is very important for retirees: guarantee lifetime income.
(And it’s also probably because you will start talking to a financial advisor that recommends an annuity to you.)
So how does an insurance company guarantee lifetime income through its annuities? I’m going to get to that as you’ll see later in the article. But first, let me tell you why lifetime income guarantees are becoming more important.
I believe one reason that annuities are becoming more popular is due to the downfall of the company pension. It used to be the case that you would work for a company, retire, and then have a lifetime pension to supplement your Social Security income in retirement.
Employers found out that it was much cheaper to drop the pension obligation with new employees. Instead, they offered 401(k) plans as an alternative to attract good employees. The pension plan was a defined benefit type of plan: the benefit was the lifetime income and that amount was defined.
The 401(k) is a defined contribution. You pick what percentage of your income you want to contribute each year. And the employer defines what type of contribution they will throw in. The contribution is defined. The end results (the portfolio’s value and corresponding income you can pull from it) are up in the air.
Thus, 401(k) plans became the primary retirement vehicle for most Americans.
The 401(k) Plan Does Not Provide Guaranteed Lifetime Income
One short fall of the 401(k) plan is it will not guarantee lifetime income. This can be overcome, as I will show you.
The 401(k) puts the responsibility and planning for retirement square on your shoulders. You cannot depend on your employer to guarantee the amount of income you can pull from your 401(k) in retirement. That is dependent on how the underlying investments inside your 401(k) perform.
This is not necessarily a bad thing because some of the pension “guarantees” employers made to their employees are now not panning out. Consider what is currently happening with pension plans that were supposedly great deals for union members.
If the company (or companies as in the case of Multiemployer Pension plans) that guarantees the pension benefit does not properly fund the pension, then it probably won’t be able to meet the obligations. Sorry, retirees.
This is happening to former employees of some city municipalities across the United States too. It has happened to former city of Detroit employees.
I wouldn’t be surprised if there will be more cuts for Detroit.
Under the old system of relying on a pension from a former employer, you are relying on that employer to properly fund a lifetime income for you. There’s nothing you can do if that employer cannot fulfill its promises to you.
However, with the 401(k) you are in the driver’s seat. If you drive responsibly you have a better chance of reaching your destination. If you drive recklessly, you have a worse chance. But at least you are behind the wheel.
Now one thing the 401(k) will not do is guarantee lifetime income. The 401(k) is just the “umbrella” over your investment portfolio that allows it to defer taxes until you withdraw funds. The amount of income you can pull off this portfolio will be dependent on how successful your investments perform.
To fix this problem many people turn to an insurance company to guarantee lifetime income. They take a portion of their 401(k) and roll it over to an IRA annuity that has lifetime income benefits. The insurance company then guarantees the income. And it should be noted, that “guarantees” are based on the claims paying ability of the insurance company.
(Kind of like how pension “guarantees” are dependent on the strength of the underlying investments comprising the pension fund.)
So how does the insurance company guarantee lifetime income?
The insurance company takes your money (called a premium) and promises a certain payout. The payouts will be listed in the policy (this is your contract with the insurance company). Whatever the company promises in the contract, it is contractually obligated to fulfill. This is a huge benefit for retirees that want to make sure they don’t outlive their assets.
(And you should probably choose a payout strategy that will at least return your original investment if you don’t live long enough to get it back incrementally.)
Insurance companies use actuaries to determine how much they can pay out from their annuities. Actuaries are statisticians that look at numbers to determine what they must charge in premium to guarantee a specific level of income. (I’m glad someone will do this job, and I’m glad that someone is not me.)
The actuaries look at the statistics of life expectancies. They know on average how long a group of people will live. They can then determine the amount of premium they need to collect to guarantee a lifetime income to their clients.
As far as investments go, insurance companies are typically conservatively invested. This is important because the insurance company’s investments are what fund the income they pay out to its customers.
They typically match their investments against their obligations. That’s just a fancy way of saying, if they have a long-term obligation (like paying you lifetime income), they will use your premium to purchase a long-term asset that can help fund that obligation.
It’s really that simple, and yet it is that important. With pension plans becoming a thing of the past, annuities are being used more to replace them.
And it should be noted that using an annuity for retirement income is not a way to make a lot of money on your investment. It is a transfer of risk strategy. The risk that you will outlive your money is transferred to the insurance company.
In fact, the only way you will make serious money on an income annuity is if you live longer than the actuaries expected. In other words, they will have paid you back all your money and are now reaching into their pockets to meet the contractual obligations they made.
So that’s how insurance companies use annuities to guarantee lifetime income for retirees. They can be a tremendous help for some people when planning their retirement income. For other people in different circumstances, they may not be such a good idea.
If you have retirement questions, feel free to leave them in the comments below. If you have a more private question, feel free to email me at [email protected]
And if you want to personally ask me a question, then you can get on my calendar for a 20 minute phone conversation by CLICKING HERE and claiming a spot on my calendar for us to talk.