Saturday, August 25, 2012

Build Your Own Pension Using Immediate Annuities

If you don't have a pension, or your pension is too small, consider creating your own pension using an immediate annuity (aka single premium income annuity).

Life Expectancies: Mortality Rates for 65 Year Old Males

mortality rates reason for immediate income annuities
Mortality Rates for 65 Year-Old Males

Here's another way to look at the life expectancy problem. The graph above shows the mortality rates for a hypothetical population of males who are exactly 65 years old. The bar at age 65 indicates that 1.7% of this group would be expected to die while still 65 -- i.e., before reaching age 66. The remaining bars show what percent of the original group is expected to die each succeeding year until age 100.

It's worth noting that
about 0.5% live even past 100 -- past the end of this chart. And, the chances of a person alive at age 100 being still alive at age 101 are greater than 50%. It's not until age 107 that you're not expected to finish a year that you start. (Think about the implications of that!)

Implications for Retirement Income

The point is, life is unpredictably long. If you want to cover you retirement expenses for the rest of your life, you need income for the rest of your life -- no matter how long that is. That is the challenge facing retirees.

As we have seen, stock market results are incredibly variable. The market is not well suited to being the primary source of dependable long-term income. By "dependable," I mean income that is as regular and consistent as your expenses are! That's the beauty of Social Security and pensions, especially pensions with cost of living adjustments. However, for many people annual Social Security and pension income falls far short of their annual expenses.

Immediate Annuities: Building Your Own Pension

The case for immediate annuities -- either alone or in conjunction with Social Security and/or a tradition pension -- is simple. It's a case of matching expenses with income that is similar in nature. That is, many planners recommend that you try to cover your permanent, recurring expenses with permanent, recurring income.

If Social Security and pension income is insufficient, then a case can be made for adding enough in annuities to at least cover your permanent, non-discretionary expenses (e.g., basic food & shelter). More volatile sources of income that cannot be guaranteed for life, such as stock market assets, can then be used to cover discretionary expenses such as vacations. That way, if the stock market assets are depleted you can forgo some or all of the discretionary expenses until your finances improve.

Introduction to Immediate Annuities (aka Single Premium Income Annuities)

An immediate (lifetime) annuity is a series of payments guaranteed for the rest of your life. It is an insurance product that you buy for cash. In essence, you trade a lump sum (single premium) now for a stream of payments in the future.

Advantages & Disadvantages of Immediate Annuities

The primary advantage is that it is income that you cannot outlive, and is thus well-suited as a supplement to other guaranteed income (e.g., Social Security), though generally not past the point where your guaranteed income more or less matches your guaranteed expenses.

In addition, this approach will generate more income than a like amount invested in bonds (because you can safely consume your "principal" as income).

The primary disadvantage is that, at least for the basic product, the income is guaranteed only for life -- even if you only live another month or two. (With some companies, for an extra fee you can add riders to guarantee payout for a minimum length of time.)

The price that you pay for a given annuity is primarily determined by your age and current interest rates. Since interest rates are currently near all-time lows, annuity prices are currently near all-time highs (i.e., annuities are currently expensive).

Some Implementation Hints

  • Policies are insured at the state level. Try to keep amounts within maximum insured limit for your state.
  • Choose highly rated insurance carriers, and consider diversifying across multiple carriers as an additional safety measure
  • Consider staggering purchases (similar to laddering bonds) to take advantage of changes in interest rates, and to assure that you do not make all your purchases at the current high prices.
  • Since your basic expenses will increase with inflation, consider paying the extra premium to have your annuity income payments adjusted for inflation as well -- especially if you are still a young retiree.


Single payment income annuities have been somewhat overlooked as a source of guaranteed, stable income. They are now starting to get the attention they deserve.

Note: All calculations based upon 2007 life expectancies for U.S. males.

Related Materials

Is It Time to Buy an Annuity?  from the Wall Street Journal
How to Create Your Own Pension: A Closer Look at Immediate Annuities: Reprint of article from The AAII (American Association of Individual Investors) Journal
How Long Will You Live? Intro to one of the most vexing issues in retirement planning.
Seeking Pension Replacement in Retirement, from Morningstar
Immediate Annuities: A quick overview from CBS MoneyWatch with some more useful links.
ImmediateAnnuities.Com for sample annuity prices/quotes
My SIMPLE Retirement Saving Calculator/Spreadsheet A simple retirement planning tool.
A Retirement Planning Calculator/Spreadsheet  My traditional retirement planner.
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Copyright © 2012        Last modified: 11/13/2012

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  1. This comment has been removed by a blog administrator.

  2. Job well done guys, quality information.

  3. Thanks David.
    Readers note: if you follow David's link, be aware that much of that info appears to be UK-specific.


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