Ask Money

Dad and an annuity

Chris Farrell Nov 22, 2010

Question: I am fortunate that my retired parents are financially independent. My father will be required to start taking minimum distributions from his IRA starting in January. His broker has recommended that he instead take a lump sum of money from his IRA and purchase an annuity that will pay out a certain amount each year. The annuity premiums can be taken from this amount thus reducing the taxable amount of the payout. The annuity would also have a fixed death benefit payable when both of my parents die. Crunching the numbers, I see a small tax savings this way, but the whole thing seems too good to be true. Can you see a downside? Thanks for the advice. Robertta, Prattville, AL

Answer: The world of annuities is almost infinitely complex. There are countless variations and shades of annuities. It’s also a product that is often sold, rather than bought.

My response depends on what kind of annuity the financial advisor is recommending. The advisor may be suggesting an “immediate” annuity? if that’s the case it can be a good strategy. The downsides include low interest rates, losing flexibility with the money that is annuitized, and the time it takes to properly analyze the product.

Your father can buy a measure of financial safety and financial comfort with an immediate annuity. He’ll want to do business with a blue chip high quality company. He’ll invest a sum of money and get a predictable monthly income (or quarterly or annual depending on the chosen payout option) on the investment for the rest of his life. He can’t outlive the investment or the income.

I favor inflation-protected immediate annuities. Right now, inflation is tame and I am a long term optimist on the price level. But what if inflation does take off? It erodes the value of savings over time. Inflation is the big risk all retirees face (all long term savers for that matter), especially since so many people are living longer these days. Your father will get a lower payout if he takes the inflation rider, but it’s a worthwhile hedge.

Henry Hebeler of also suggests these annuities should be laddered to hedge interest rate risk and so that your father will receive larger payments as you age.

Indeed, a major drawbacks of immediate annuities right now is interest rates are so low. You don’t want to put much into immediate annuities at today’s rates. Another traditional downside to immediate annuities is that its an inflexible product: The money is locked in. You can’t get at it if you want a bigger payout this month because the car engine went or a big medical bill arrived in the mail.

That’s why financial advisors say annuitize only a portion of savings. You want the rest of your savings to remain flexible in case you need it.

The other two major annuity categories are deferred annuities and equity-linked annuities. I am wary of deferred annuities. This is a product typically sold to people who have accumulated some assets. The investment of after-tax money grows tax-deferred in the annuity until it’s tapped. Deferred annuities do come with a death benefit, but fees tend to high and the death benefit worth a lot less than touted.

As for equity-linked annuities my main thought is run–don’t walk, run. These are opaque securities that promise to limit the downside risk of owning stocks while allowing investors to share in some of the upside in the stock market. Simply put, the devil is in the fine print with this annuity product which, as far as I can see, is a classic case of the house always wins.

I’m only touching the surface of immediate annuities and I don’t have enough detail to give you much more detail. But if you, your father, and mother want to learn more I would go to the calculators created by Hebeler at to evaluate your options. Hebeler lays out the major issues to consider, and there are a number of critical decisions to make, from inflation-adjustment to survivorship issues.

For instance, if your father dies would he want the payouts to continue at the same level to your mother? While I like inflation-protection and spousal survivorship, checking those two boxes will lower the regular payout. On the other hand, I don’t think its worth it to lower the payout for some variation of a death benefit. But your parents and you may disagree with that judgment. These are the kinds of issues to think through.

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