Turning Your 401(k) or Other Savings into Guaranteed Lifetime Income

By Chuck Yanikoski

There are two traditional ways to make sure you never run out of income in retirement: (1) never spend your principal, and just live off the income from your savings; and (2) buy an annuity. If outliving your savings is a concern of yours, it often makes sense to follow the first strategy (or something close to it, perhaps spending small amounts of your principal, if you need to) in the earlier years of your retirement, and then switching to an an-nuity when you get older - perhaps in your early 70s.

What's an annuity? It is simply a guaranteed income, usually for life. Old-fashioned employer pensions that pay retirees for the rest of their lives are a form of annuity; so is Social Security. But you can also purchase annuities for yourself, or convert certain kinds of existing assets into annuities.

Purchasing an annuity means turning some of your savings over to an insurance company, and they in turn will pay you a monthly amount for as long as you live, even if you break the all-time record (currently age 126). The benefit to you is not just the lifetime guarantee, but the fact that in general you can get a higher monthly income - usually a lot higher - than you can get by investing conservatively and living off the interest. There are two reasons for this.

First, the insurance company is not going to try to preserve your principal. They are going to spread it out over your expected lifespan, so that every month you get part of your principal back, as well as earnings on the principal.

Second, the insurance company doesn't have to invest as conservatively as you would, so they can generally earn more on your behalf.

So why wait until you're seventy or so?

In fact, there is nothing magical about that age. But for traditional annuities, the older you are when you purchase them, the higher the monthly amount you get. That's because your life expectancy is shorter, so more of the principal can be paid back to you each month.

The absolute best age to buy an annuity, however, can be determined only after the fact. If you knew exactly how long you would live, you could pick the perfect age to buy. But since you don't, what I usually recommend is that people purchase annuities in smaller amounts, and spread those purchases over a period of years - maybe three or four purchases, each two or three years apart, starting at about age 70.

But if you are male or a smoker, your life expectancy is lower, so you might start a bit sooner. If you are female or a non-smoker, you might start later. Or if you are a couple and you want one annuity to last as long as either of you is still alive, then your combined life expectancy is extra long, and you should wait later still.

If you have a short life expectancy (because of poor health, usually), then maybe you shouldn't buy an annuity at all. Or if you do, have your insurance agent find you an insurance company that will give you credit for your shorter expected lifespan.

What's the catch in all this? The main catch is that you are turning over your money to an insurance company, and so you can't use it for other things. Nowadays you can get riders on annuities that do give you access to some of your money if you need it, but your monthly payments will be a lot less if you have that option, and I myself would rarely recommend that you go for it. The best thing is simply not to turn every penny you have into an annuity - or to make sure you have a reserve (perhaps from a home equity line of credit), just in case.

The other catch that bothers a lot of people is that if you die shortly after purchasing an annuity, you have lost quite a bit of money. Of course, that won't matter to you, because you'll be dead. It will matter to your heirs, but that is not necessarily a good reason to avoid making a choice that could be highly beneficial to you. And if you are really very concerned about this, you can get annuities that pay you less, but guarantee that a minimum number of payments will be made (usually for five, ten, fifteen, or twenty years), even if you die the next day.

The kind of annuity I have been describing here is called a "fixed single-premium immediate annuity" - because the monthly payment to you is fixed for life, you pay for it all at once, and it starts paying you back immediately. There are lots of other variations, too. If you are still working and saving, you can get annuities that you pay into over time and that defer the payments you get back until you ask to start receiving them, while you get a tax shelter in the meantime. You can buy annuities with increasing benefits to help you cover inflation. You can get others (called "variable annuities") that will tie your money and therefore your income directly to the financial markets, so that your benefits will fluctuate. You can get "equity indexed annuities" that give you limited participation in market performance, but guarantee a basic level of benefit.

An insurance agent can explain all your options to you, and quote you prices. But nothing worth having is free - and the more bells and whistles and special benefits or protections you add, the more you pay for it. So I recommend that you get some quotes for a basic fixed-payment single-premium annuity, and then compare everything else to that.

Two other important things: First, the amount that insurance companies will pay you varies from company to company, so get quotes from several companies with long-standing good reputations. Second, the benefits they quote will depend on what they themselves expect to earn in the financial markets, and since what you get may be locked in for life, it is not a good idea to buy a traditional annuity when interest rates are low, as they tend to be in bad economic times. Annuity prices are best in boom times, and you can lock them in permanently. But if you want to buy a variable or equity indexed annuity, the opposite is true: buy during bad times when the markets are depressed and are likely to go up over the long run.