Leveraging the key risk of retirement planning

With this month’s column, we’ve come full circle on the reason annuities are a good bet for income. To quickly recap last month’s column, they work because they leverage the key risk associated with retirement planning: mortality.

The thing that trips up everyone when trying to plan for income is the uncertainty about how long we are going to live. No one knows; it’s all a big guess. And guessing is the worst kind of planning, as it turns out to be wrong so much of the time. In this case, the statistics show us we get it wrong 80 percent of the time.

That’s where an actuarially sound annuity contract comes in. An annuity is simply a contract between an individual and an insurance company. The individual gives the insurance company a lump sum of money, and the insurance company delivers a promise to pay out a stream of cash for a specified period of time.

That can be a certain period (five years, 10 years, etc.), a lifetime (single life, joint life, etc.) or even a combination of the two (life with ten years certain, etc.). It’s all very similar to pension plans, and just as confusing. Like pension plans, it’s crucial to get it right at the outset, as you will be living with your decision for a very long time, and there are so many ways to get it wrong.

The problem with this is, once again, we are left with making the guess as to how long we will live. If I give the insurance company all my money to pay me a life income and then I get run over by a car on the way out of my advisor’s office, bam, there goes all my money.

So maybe I pick a life with 10 years certain (10CC) or a joint life annuity to cover my spouse, should I die prematurely. The problem is that these are expensive options. Take, for example, the 10CC option: At today’s rates, if I elect a life-only annuity, my payout is $6,684 per year. If I take the 10CC option, it’s $6456, or $228 less per year ($6,684-$6,456).

Now, that may not sound like a lot, but think about it: First, the benefit is diminishing coverage. In other words, when the annuity is first issued, the benefit for which I am paying $228 a year is 10 years of payouts of $6,456, or $64,560 ($6,456 x 10). After the first year, it is less: $6,456 x 9, then $6,456 x 8, etc.

Each year, the amount of protection is less, but the amount I pay for it never goes down. After 10 years, my coverage is zero, but I must still pay $228 a year for the rest of my life.

This is in addition to the $35,440 the insurance company gets to keep if I die in the first 10 years. Where does that number come from? If the guarantee is 10 x $6,456, or $64,560, and I paid $100,000 for the annuity, that means I am forfeiting the balance of $35,440 should I die in the first 10 years.

So the cost of guaranteeing $64,560 was really $35,440 + $228 = $35,212 in Year 1, or $35,440 + $2,280 for the entire term. Not bad, if you are the insurance company.

The reason the insurance company can make this deal is that with any of the traditional annuities, you have to trade away and give up control of your money in order to get the payout. A good friend of mine calls this committing “annuicide.” You have to, in effect, kill your nest egg to get the payoff.

That brings up the key dilemma, and objection, that baby boomers have with annuities. We have been conditioned our entire lives to build that nest egg, and now somebody wants me to scramble it. No way am I going to just give away all this money I have been saving for decades – even if you do promise to pay me an income for the rest of my life.

This is one of the reasons annuities leave a bad taste in so many people’s mouths. It seems like all of the benefits go to the insurance company. That, along with having to give up control of all my money, makes me want to avoid them.

However, it’s important to keep this in perspective. If you end up living well into your 80s (a real possibility if you are 65), the benefits of never running out of money, and never having to worry about running out of money, can be enormous. However, the price tag still seems exorbitant to many.

So what’s the alternative? Well, in the above example, how about replacing the 10CC choice with a life-only annuity backed up by an actual life insurance policy? A $100,000 10-year term life policy for a healthy 65-year-old man could be in the neighborhood of $965 a year.

While at first blush it looks much more expensive, think of it this way: The death benefit does not diminish, i.e., if you die, the full $100,000 goes to you regardless of whether you die in Month 1 or Month 120, and once the benefit is gone, you no longer have to pay the premium. It’s a much better way to go.

Another way to do this is using one of the many new deferred-fixed and fixed-index annuities on the market that will offer a lifetime guaranteed payout plus a return of 100 percent of any money left over when you die.

The payout is not as great as with an immediate annuity, and there is typically a small fee – for $100,000 at age 65, you would receive around $5,000 a year, and the fee could be $750-$1,000 a year – but if you do die before exhausting the balance, whatever is left goes to your beneficiaries.

No more “annuicide”! But you still get the benefit of knowing you will never run out of money for as long as you live. Now that’s free money!

“Free Money Guy” Stephen Kelley can be heard, along with his co-host Mark Perkins, on the Free Money Radio Hour at 9 a.m. every Tuesday and Wednesday on 1590 AM WSMN in Nashua, and Sundays at noon on 980 WCAP in Lowell. In addition, Steve is heard weekly on the nationally syndicated “America Tonight” with Kate Delaney and is author of the book “Safe Harbors That Can Reduce Taxes, Remove Risk and Protect Your Retirement.” His financial planning practice, Safety First Financial Planners, is located at 33 Main St. in Nashua. He can be reached at 881-8811.