You might be retired for 20, 30 or 40 years, or maybe even longer. How can you protect yourself against the possibility that you’ll deplete your savings and run short of money?

One possibility is to put some of your investment dollars into immediate annuities. These annuities can provide you (and perhaps your spouse) with regular income (usually monthly) no matter how long you live.

Before you decide whether to buy an immediate annuity — and, if so, how much of your portfolio to allocate to such an investment — it’s important to understand how these contracts work…

START THE CASH FLOWING

An immediate annuity might be called a “payout annuity” or an “income annuity,” depending on the company offering it. By any name, you pay a lump sum to an insurance company.

What you get: In return for your investment, the insurer promises to send you a stream of payments. As the name indicates, these payments will start right away.

Immediate annuities may be divided into two main types…

  • Fixed annuities. You can lock in fixed payments, so that you will receive the same amount in 2010, 2011, 2012, etc. This provides you with reliable cash flow.
  • Variable annuities. You can opt for variable payments — ones that grow over time. Such a choice may be appealing because inflation will cause a fixed amount you receive in 2010 to lose value over time.
  • Among variable payout annuities, you might choose to have your payments indexed to inflation. You’ll start with payments lower than you could have received with a fixed annuity, but those payments may eventually grow to exceed the offered fixed payment.

    Another option is to choose an immediate variable annuity in which you choose among multiple investment accounts. If those accounts produce certain results, as specified in the annuity contract, the payments to you can increase over time.

    OPTIONS For Annuities

    In addition to choosing between fixed and variable immediate annuities, you’ll also have to select the duration of payments. The following selections are common for retirees who want to avoid outliving their savings…

  • Single-life annuity. Example: John Smith retires at age 65. He can buy an annuity that will pay him for as long as he lives. That might be 40 days or 40 years.</li

  • Joint and survivor annuity. Instead, John might want an annuity that will pay out for as long as either he or his wife, Mary, is alive. In some cases, this type of annuity will pay less money after the death of one spouse. And because two lives will be covered instead of one, from the beginning, your monthly payments will be less than you would receive from a single-life annuity.
  • Period-certain annuities. Suppose, as above, John wants an annuity on his life only. However, he is reluctant to take the risk that he’ll invest, say, $100,000 but die after receiving only a few thousand dollars.
  • He could specify an annuity with a 10-year “period certain.” That is, payments will continue until John’s death or until the 10th anniversary of the investment, whichever comes later.

    If John dies within 10 years, payments that the insurer still owes will go to a beneficiary named by John. Period-certain annuities are available for various time periods.

    TAX TREATMENT of immediate annuities

    Immediate annuities offer some tax-free cash flow.

    Reason: With immediate annuity payments, you are getting a return of your investment as well as interest. Only the interest is taxable. So, you get a stream of cash flow, part of which isn’t taxed.

    This will continue until you have received a complete return of your principal, when you reach the life expectancy you had at the time you invested. From that point on, all annuity payments will be fully taxable.

    DEALING WITH THE DOWNSIDE

    If you purchase a single-life annuity, there won’t be any of it left for beneficiaries no matter when you die. If you want a survivor benefit, you’ll have to name a beneficiary and accept less in the way of cash flow for yourself.

    You also bear the risk that the insurer will not deliver the promised cash flow if the company goes under. To reduce this risk, choose a company rated A+ by A.M. Best, AA or AAA by Standard & Poor’s, or Aa or Aaa by Moody’s. To check an insurance company’s rating, go to Insure.com (www.insure.com) and use their “Insurance Company Ratings Lookup.”

    Costs: Naturally, the insurance company receives a fee for providing the annuity, which is reflected in the annuity payments you receive. The lower the charges, the higher the payout. If you buy your annuity through a financial adviser, you may pay an additional fee.

    Strategy: Get quotes from several top-rated insurers, and select the one that has the highest payout. If you have an insurance agent that you trust, ask him/her to help you search.

    SPREADING THE WEALTH

    Now that you know how immediate annuities work, should you invest? And if so, how much? If you are concerned about running short of money as you grow older, our research shows that, based on what the average person is likely to receive from Social Security and assuming no other investment income, up to 50% of your retirement portfolio is a good amount to invest in immediate annuities to cover your basic needs.

    Investment strategy: Diversify your holdings. Put some of your retirement funds into immediate fixed annuities and bond mutual funds for steady income… and some into immediate variable annuities and stocks for growth potential.

    Be wary of investing the entire amount at once. That’s especially true now, when interest rates — and annuity payout rates — are on the low side.

    Instead, plan to buy smaller immediate annuities every year or two. The older you are when you purchase them, the more cash flow you’ll receive. And if interest rates rise, you may get even higher payouts.

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