What's the scariest thing that can happen to a retiree? Running out of money. Only health concerns, which you can't do anything about, carry an equal worry-quotient.
One solution is to buy an annuity that promises a check each month for life. But when you die, the checks stop coming, and the insurance company keeps the balance. You could also accept a smaller monthly check to cover payments over your lifetime and that of your spouse.
But that fixed monthly check creates one more problem: What if today's dollars don't cover tomorrow's basic needs because of inflation?
An alternative is a tax-deferred variable annuity -- an insurance company contract that lets you invest in a choice of mutual-fund-like sub-accounts. Your investment decisions determine the growth of your account, and withdrawals are taxed as ordinary income. But if your choices are bad, you might not have much to withdraw!
It's a tough choice for those reaching retirement age. You must keep your investments growing, but you can't replace stock market losses with new contributions to your retirement plan -- or wait for years for the market to rebound.
Now, some major insurance companies have recognized this retiree dilemma and come up with products that permit the investment equivalent of having your cake and eating it too.
The products are called "living benefits riders," and they offer investment growth as well as withdrawals. There is a small extra cost, but it pays for potential growth, plus the promise that you can never run out of money during your lifetime.
has sold billions of dollars in living benefits riders since the product was introduced less than two years ago. Other companies, such as John Hancock, have similar products with slight differences, so you'll want to compare the offerings.
But as an example, here's how the Prudential "Lifetime Five" works.
The Prudential living benefits rider added to most of its variable annuities constitutes a promise from the insurance company that your "protected withdrawal value" (described below) will grow at 5% annually. If you are willing to take out only 5% a year of that protected value, you will receive that income for the rest of your life, or your spouse's life -- even if the investments in your account decline dramatically as a result of market activities and your withdrawals.
You can decide when to start taking that 5% annual withdrawal. And if your money has grown to be more than your original investment as a result of your investment choices, your "protected withdrawal value" will be the highest of three numbers:
- The 5% compounded rate of return on your original investment until your first withdrawal.
- The highest value your contract attained at any anniversary of your original purchase during the first 10 years.
- The current account value.
Best of all, if you ever need to dig into the principal you've accumulated, you can do so (without penalty, once the surrender period has passed) and still receive 5% annually on the protected value, less the amount you've withdrawn.
You can't speculate wildly in your investment account, knowing that you'll get this guarantee. There are specific and reasonably conservative sub-account choices for this annuity rider.
The Costs of Security
The cost of the "Lifetime Five" rider, attached to any of Prudential's variable annuities, is an extra 60 basis points a year. If you include your spouse, it costs 75 basis points every year.
Of course, tax-deferred variable annuities have other basic costs. There will be surrender charges -- as much as 9%, if you withdraw more than 10% of your investment in the first, second and third years. And there is an annual management charge for the investment fund sub-accounts of about 1% a year, taken out of the fund's investment return.
Then there is a "mortality and expense" charge, which is levied against your account every year. It may range from about 1.25% to as high as 1.65% annually. Then it drops to 0.65% a year. That M&E fee covers the insurance company's expenses for offering the product.
But it also pays for a death benefit, which will give your heirs your original investment or the growth in your account, whichever is greater, less any withdrawals at the time of your death.
In total, you're paying about 3% annually during the first eight years for the peace of mind -- the guarantee of lifetime income and the opportunity for investment growth -- that this product provides. I believe it's worth considering for at least a portion of your investments as you approach retirement. And that's the Savage Truth.
Terry Savage is an expert on personal finance and also appears as a commentator on national television on issues related to investing and the financial markets. Savage's personal finance column by the Chicago Sun-Times is nationally syndicated, and she released her fourth book,
The Savage Number: How Much Money Do You Need?
in June 2005. Savage also was the first woman trader on the Chicago Board Options Exchange and is a registered investment adviser for stocks and futures. A Phi Beta Kappa graduate of the University of Michigan, Savage currently serves as a director of the Chicago Mercantile Exchange Corp. She also has served on the boards of the McDonald's and Pennzoil corporations.