Annuities

If you’re 70 and living off your income from a Certificate of Deposit (CD) you may find it more advantageous to switch to a laddered annuities for more income. Let’s consider how.

A $100,000 5yr-CD paying  5% gives you an annual taxable income of $5,000. At a 25% income tax rate, you’re left with $3,500. Of course you’re also left with your $100,000 too.

But if you need more income, and you don’t want to get locked into any current income rate, you may consider investing your $100,000 into a set of annuities. Laddering these (i.e. stagger when begins its income stream) allows you to follow income rates if they go up (or down).

Laddered Annuities Option
We’ll assume you’re 70; and with your $100,000, you buy 5 annuities each for a single premium of $20,000. The first will be a Single Premium Immediate Annuity (SPIA) for a 5 year payout term. The four others will be Single Premium Deferred Annuities (SPDA) geared to produce a payout after 5, 10, 15, and 20 years respectively. Let’s consider what sort of income you’d generate in this case. Refer to the table. These are hypothetical examples and all fees have been ignored (immediate annuities usually don’t have fees as they are already included in the income stream).

You can see under the SPIA 5 year certain payout  that you’d receive $4248 income giving you an after tax (25% income tax rate) of $4,186. This beats out your CD net income, although all the money in this SPIA is gone after 5 years. But, you’re still accumulating savings in all the other SPDAs.

I’ve assigned a hypothetical accumulation interest rate of just 4.5% - safely under the CD’s rate. And I’ve kept the rate constant over time as a neutral scenario. Increasing (decreasing) rates would affect both the annuities and the CDs together.

You can see what the (neutral) projected values of the 5, 10, 15, and 20 year SPDAs would be when they become due as you turn 75, 80, 85, and 90 respectively. Along with these values are the projected income they’d produce  (based on current payouts) for both a 5 year term payout and for your remaining lifetime – if you chose the latter.

As you approach age 85, you may decide to choose a lifetime income from the next SPDA, and leave the remaining SPDA as a legacy for your beneficiary.

By annuitizing your assets, you have more income to live on.  You can use the fixed annuity calculators to see the figures for yourself.

Note: With tax deferred investments, income taxes may be due upon withdrawal of funds, withdrawals prior to age 59½ are subject to a 10% penalty, the rate of return above is hypothetical and does not reflect the return of a particular investment and the values shown should not be used to project future income. This table refers to hypothetical investments only and is not indicative of a guarantee of any particular investment results. There are no fees or expenses in the annuity illustrated, but if they were present, they would reduce performance.  Earnings withdrawn from an annuity are taxed as ordinary income.  Note that many differences exist between CDs and fixed annuities such as the FDIC insurance which applies to CDs but not to annuities or bonds, the fact that annuities may have surrender charges or expenses associated with them, while CDs may have early withdrawal penalties and the fact that the term of annuities often exceeds the terms of CDs. While CDs are FDIC-insured, annuities are guaranteed by the claims paying ability of the insurance company. Additionally, the purchase of annuities may incur commission and annuities may not be as liquid as CDs. Annuities, once annuitized, cannot be surrendered for value.

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One major advantage of an immediate fixed annuity is the security of a guaranteed income. You can count on those regular monthly payments. If returns on other investments diminish–because of a fall in interest rates or a stock market slump–your annuity payments remain steady.

Offsetting this advantage is if interest rates are down when you purchase your annuity, your monthly payments will be less and may not keep up as easily with inflation. Is there a way to offset this situation?

First, realize that once your immediate annuity begins, it is irrevocable. You cannot change your mind; there’s no lump-sum repayment provision (there are a few companies that offer commutation–the ability to get your principal back at a discount). So, shop for the best deal when you buy.

The amount of your monthly annuity check is based on the size of your investment, your age, and what the insurance company estimates it will earn on their contract with you. But realize, too, that the monthly payment on the same size investment can vary significantly from company to company. Get several different proposals to ensure you are getting a good deal.  Do not let anyone rush you into making a purchase. The consequences are permanent. Check out a company’s rating from Standard & Poor or A.M. Best & Company. You will be counting on those monthly payments for quite a while.

Now, if you are ready to buy an annuity but interest rates seem historically low, you might consider laddering your annuity investment to take advantage of hopefully higher interest rates in the future.  To do this, simply take the total amount of money you have set aside for purchasing an annuity and divide it evenly into several amounts.  Purchase an annuity with the first amount now according to prevailing interest rates and the best deal you can find. Then do the same with the remaining amounts spread out over the next five or six years.  This is referred to as “laddering annuities” or an “annuity ladder.” Hopefully interest rates will ratchet up for your later purchases. 

You can in fact purchase all of the annuities today to create your annuity ladder.  The first one, which will start the payments immediately and the other will be deferred annuities.  After the first year, you will convert deferred annuity “A” into an immediate annuity (i.e. you will annuitize the contract).  After 2 years, you will do the same with annuity “B” and so on.  Or, maybe you do this at 5 year intervals pictured like this

You could be better off with a higher average rate among them than if you had purchased one annuity when interest rates were low.  Of course, if interest rates seem historically high today, you’re best of by getting all of your funds into an immediate annuity and locking in a high lifetime payment.

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