A key concern of many retirees is ensuring that they don’t outlive their wealth. One way to accomplish this is to consider making immediate annuities part of a well-diversified retirement portfolio. Annuities are the only financial instruments available today that, like Social Security and pensions, can provide income for life and thus offer some peace of mind.
An immediate annuity is a financial contract that makes fixed, regular payments starting within one year of purchase. These payments can be for either a set period of time or over the lifetime of one or two individuals. In the latter case, the contract is known as a lifetime immediate annuity.
Most retirees need to secure a guaranteed income for life. Social Security and pensions both provide lifetime income, but their outlook is uncertain. Meanwhile, defined benefit (DB) plans, which guarantee workers an income for life, are disappearing. According to the triennial Federal Reserve Survey of Consumer Finances, the proportion of workers covered by DB plans has slid from 88% in 1983 to just 32% in 2010.
Consequently, people are increasingly left to their own devices to fund retirement. By purchasing an annuity, one can effectively create a personal pension that provides the same income stream that DB plans have traditionally provided.
A key threat to retirement security is longevity risk, the risk of living longer than planned and exhausting one’s assets. Workers are living substantially longer than in generations past. Their growing reliance on personal savings and defined contribution plans like 401(k)s and IRAs to fund retirement means they must increasingly bear longevity risk. The risk of outliving one’s wealth is particularly acute when financial markets fare poorly.
Annuities that provide lifetime income are insurance products uniquely suited to helping investors hedge this longevity risk. In exchange for a lump sum, the buyer receives a stream of income for life. Lifetime immediate annuities can be contrasted with life insurance. Life insurance hedges the risk of dying prematurely and leaving others in financial distress. A lifetime immediate annuity hedges the risk of exhausting one’s assets prematurely.
Immediate annuities can help people address longevity risk by providing an income for life that may be higher than they can earn elsewhere. The reason is simple: Retirees who purchase a lifetime immediate annuity are exchanging the use of their capital after they die for a higher rate of return during their lifetime, earning what are known as “mortality credits.” This trade-off may be worthwhile for retirees who need to generate higher income than is available from other low-risk
Age and health should figure into the decision to buy a lifetime immediate annuity. Because these annuities offer higher payouts for older buyers, they tend to make most sense for people in their 60s — and even more sense for those 70 or over. For people under 60, other investments may be preferable. Moreover, since the cumulative payout of lifetime immediate annuities generally depends on how long the annuitant lives, they are best suited for people in reasonably good health for their age.
Immediate annuities have some shortcomings worth considering. First, the funds used to purchase an immediate annuity usually cannot be accessed afterward except through its periodic payments. Therefore, those funds are unavailable to address unforeseen needs. Second, buying an immediate annuity means being unable to leave a bequest from the funds used to make the purchase. Third, inflation erodes the spending power of an annuity’s payouts.
These drawbacks are not as stark as they sound, however, because the decision to purchase an annuity is not all-or-none. A retiree might, for example, allocate some of his or her wealth to an annuity while investing the rest elsewhere. By so doing, one can gain the longevity protection that annuities provide while allocating capital for other purposes such as bequests.
Timing too is important. There are compelling reasons to purchase immediate annuities gradually rather than all at once. Because the level of annuity payments increases with age, waiting a year or two before purchasing can mean higher payments. Moreover, because interest rates are now low by historical standards, annuity payments today are relatively low. It might therefore make sense to wait before buying, in the hope of higher interest rates.
Each of these points has a counterargument, though. First, if owning an annuity provides attractive income, someone who delays a purchase forgoes this income in the interim and may, due to inertia, never buy one. Second, although interest rates are low, they could stay low for some time or even decline, reducing annuity payments still further. Finally, while low interest rates mean lower payouts for annuities, this does not necessarily make them less attractive than alternatives. For many clients, immediate annuities can be a valuable part of a sensible, well-diversified portfolio that provides income for life.
Diversification does not assure a profit or protect against a loss in declining markets. All annuity guarantees and payout rates are backed by the claims-paying ability of the issuing insurance company. They are not backed by Merrill Lynch or its affiliates, nor do Merrill Lynch or its affiliates make any representations or guarantees regarding the claims-paying ability of the issuing insurance company. Annuities are long-term investments designed to help meet retirement needs. An annuity is a contractual agreement where a client makes payments to an insurance company, which, in turn, agrees to pay out an income stream or a lump sum amount at a later date. Early withdrawals may be subject to surrender charges, and taxed as ordinary income, and in addition, if taken prior to age 59 1/2 an additional 10% federal income tax may apply. This communication was prepared to support the promotion and marketing of annuity products. Merrill Lynch and its representatives do not provide tax, accounting or legal advice. Any tax statements contained herein were not intended or written to be used, and cannot be used for the purpose of avoiding U.S. federal, state or local tax penalties. Please consult your own independent advisor as to any tax, accounting or legal statements made herein. This communication does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue. Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S”), a registered broker-dealer and member SIPC, and other subsidiaries of Bank of America Corporation (“BAC”). Investment products offered through MLPF&S and insurance and annuity products offered through Merrill Lynch Life Agency Inc.:
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