It seems somehow terrible in its implications, but something most people will need to worry about is longevity risk. One of the biggest fears of investors is outliving their savings and becoming destitute. When you buy a life insurance policy, you pay an insurance company payments for a long time, and they pay you heirs a lump sum when you die. Immediate annuities reverse this process. That is, you buy an immediate annuity with a huge lump sum, and the insurance company agrees to pay you payments as long as you live.
As you would expect, there are alternatives to this type of payout structure, such as receiving higher payments for only a limited period or taking lower payments with the right of survivorship for a spouse. The immediate part of the name comes from the fact that you start receiving payments immediately. Many investors choose to enter into these sorts of contracts when they retire to lock in a lifetime of gains and guarantee an income for life.
With a fixed annuity, retirees risk a progressively lower standard of living because of inflation. With a variable annuity, retirees risk high fees that can diminish potential income. If you have sufficient funds, you can consider investing part of your savings in an immediate annuity and the remaining portion in traditional investments controlled by you. The guaranteed income can provide peace of mind, and the balance can offer you money for extraordinary expenses, emergencies, and as a legacy for your heirs. Keep in mind that when you die, most annuities do not return any of your principal. Insurance companies often offer a generous monthly payout because of this fact; they make a ton of profits on those who die below the mean and can still make a profit when they are paying those that live beyond the mean a high return for a lengthy period.
You will need to receive payments for about 30 years to make these sorts of contracts a good investment. If you are willing to take the loss for the sense of security that they provide, then there is nothing preventing you from doing so. Note that your payout amount will reflect how much the insurance company thinks they can make investing your money.
During times of high interest rates, you will want to consider putting off buying an annuity until rates improve. Of course, there are some risks to this strategy, namely the chance of loss in the markets. Also, note that your monthly payments will be based on your age versus the average life expectancy. The older you are when you start, the higher your monthly fee will be.
Perhaps the most significant drawback to buying an annuity is that the decision is irrevocable. You are stuck with it for as long as you live, regardless of how many other opportunities may arise in the future.
Economists wondered for a long time why everyone didn’t run out and buy these things. The problem with these mathematical analyses was that they were only looking at essentially one variable: Mortality. If you died, you didn’t need the money anyway. If you didn’t die, then you had an excellent hedge against longevity risk. According to research by Felix Reichling of the Congressional Budget Office and Kent Smetters of the Wharton School of Business, nearly half of retirees are better off keeping their portfolios liquid, not locked up in annuities, because, thankfully, life and death are not binary. We all know that, as we get older, our health declines. With advances in modern medicine, we are living longer lives. We, unfortunately, are not necessarily living healthier lives in our declining years.
Most people understand that “social safety nets” in the United States are full of holes, and no one in Washington seems willing to do the hard thing and really fix them. Politically expedient band-aids have been the trend for decades, and I do not want to see you planning your financial future based on the false hope that things will get better, or even that they will remain the same. This gives rise to two unpleasant potentialities that we must consider: In your retirement years, it is possible that you will run up some hefty medical bills that aren’t covered by your insurance and benefits. The other related concern is that you will need long-term care such as that offered by assisted living facilities and nursing homes.
Recall that with an annuity, you are turning over a substantial sum of money to be doled out at a specified rate. This rate is not likely to cover mounting medical expenses and nursing home costs that are nothing short of exorbitant. When you enter into an annuity, you no longer “own” your money. You own the annuity. That annuity is illiquid, and you cannot “raid” it for cash when the need arises.