When we retire, most of us will lose what has become a comforting fact of life: a steady paycheck deposited directly into our bank accounts, whether every week, every two weeks, or every month. However, we will still need to pay most of the same bills we’ve always paid, not to mention going shopping for food, clothing, and entertainment. How can we replace that paycheck?
If we are fortunate, we may have a pension through our employer, via a defined benefit retirement plan. In these kinds of plans, throughout the course of our working life, we contribute a certain percentage of our earnings on a regular basis into our company’s general pension fund, and when we retire, we are guaranteed a monthly payment for life, with the amount of that payment calculated based on various factors such as our age at retirement, our preretirement salary, and other factors.
However, employers these days are more likely to offer a defined contribution retirement plan, the most popular of which is the 401(k) plan. Employees can elect to contribute a percentage of their paychecks into their own individual retirement funds — with their contribution often matched by employer contributions — and invest the funds as they please, based on the investment options on offer (usually, a selection of mutual funds). On retirement, each retiree will receive his or her 401(k) in a lump sum, and the total amount will depend on how well the markets have done, and how well the retiree’s selected funds have done over the years. In most cases, however, if an employee has contributed the maximum amount permitted and taken full advantage of matching funds from the employer, the lump sum can be substantial.
Deciding what to do with this money may be perplexing — it seems there are a limitless number of options. But at least some of it will need to generate income, providing you with a monthly “paycheck” so that you can pay your routine bills. And one of the easiest ways to do this is to purchase an immediate annuity.
Many responsible financial advisors and financial journalists steer their clients and readers away from most kinds of annuities, citing hidden costs, high sales commissions, and hard-sell sales techniques. Often, retirement “seminars” targeting seniors are thinly veiled sales pitches delivered by commission agents hawking hard-to-understand variable annuities. There are cheaper and more reliable ways to generate income than these often misleading products.
However, “immediate annuities” are an exception, and are often recommended by financial advisors. When you purchase an immediate annuity, you hand a sum of money over to an insurance company, bank, or other financial institution, and you immediately begin getting monthly checks, which you will continue to receive until you die. Commonly, payments can continue for the life of you and your spouse, ending when the surviving spouse passes away.
The advantages are obvious: you will have a guaranteed stream of income for the rest of your life (or for a specific number of years, if you choose to set it up that way). The interest rate that you are earning on your annuity might not beat current market rates, and you might not earn what you would in the equities markets, but then again security has its price. You won’t lose anything, as you might in the stock market, and you won’t need to worry about falling interest rates eroding your monthly checks.
However, if you purchase an immediate annuity that lasts for the duration of your lifetime — or for a long, fixed period of time, such as 20 years — your monthly checks will inevitably lose purchasing power to inflation. A thousand dollars today will pay a lot of monthly bills, but it may seem a pittance in 25 years. (Granted, our expenses will likely go down as we enter the later years of our retirement.) You may have the option of purchasing a variable annuity, which follows the markets according to a defined formula. Variable annuities have the ability to keep pace with inflation. However, fees for variable annuities are usually high and fee structures complex; plus, if the markets plummet, so will your monthly checks. For a chance at higher returns, your are losing security.
You will need to take a careful look at all your assets and determine the right course for you. Usually, it doesn’t make sense to put all of your nest egg into an immediate annuity; you might take a portion of your funds to purchase an annuity and provide guaranteed income, and invest the remainder in other financial products that give you a chance at higher returns, minimizing your overall inflation risk. If you have a sizeable nest egg, it would make sense to consult with a certified financial planner, to determine the best way to proceed.
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