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Should You Annuitize Your Savings?

When it comes to post-retirement investing, probably no other subject causes as much confusion as annuities. So let's start with the basics. Essentially, an annuity is the mirror image of a life insurance policy. The latter protects your family against the risk of you dying sooner than expected. In contrast, annuities protect you against the risk of you dying later than expected (and thereby outliving your savings). Both of them work the same way: a group of people who want protection against the risk in question pay premiums into an insurance fund. In the case of life insurance, payouts are only made when an insured person dies. Some people pay premiums, but never receive a payout before they let the policy lapse. In the case of a life annuity, payouts are made at regular intervals to provide income to policyholders, and stop only when the policyholder dies. When this happens soon after the annuity is purchased, the "annuitant" receives less than the premium he or she originally paid. However, when the person dies many years after the annuity is purchased, he or she often receives payments well in excess of the premium paid.

Annuities come in many different forms (our most recent indepth comparison "To Annuitize or Not to Annuitize? That is the Question" may be found in our May 2006 issue or signup). Two of the most important differences between them have to do with the length of time over which the payments are made, and whether they are fixed or variable. With respect to the length of time, among the most important annuity types are "lifetime" annuities, which make payments only until the annuitant dies; "joint and last survivor" annuities, which make payments until the second of two people dies; "guaranteed term" annuities, which make payments for a guaranteed period, even if the original annuitant has died (with the remaining payments going to a designated beneficiary).

With respect to fixed and variable payments, some of the most important distinctions are between fixed payment annuities (where the amount remains fixed over time), variable annuities (where the size of the payment is tied to the performance of underlying investment accounts), and inflation indexed annuities (where the payment is increased with the consumer price index, to keep real purchasing power constant over time).

While annuities reduce the risk that you will outlive your savings (and suffer a drop in your standard of living), they do so at a cost. First, they reduce the amount of money you have available for precautionary savings and bequests. Second, they are not liquid -- once you have purchased one, it can be expensive or impossible to change your mind later. For this reason, studies have shown that using a portion of one's savings to purchase an annuity tends to be most attractive when (a) a person or couple expect to live for many more years; (b) they have relatively low income from other annuities (e.g., from national and private employer defined benefit pension plans); and (c) they are relatively more risk averse (see, for example, the paper "Private Pensions, Mortality Risk, and the Decision to Annuitize" by Jeffrey Brown).

The portion of your target income not provided by annuity payments, as well as your precautionary and bequest goals must be generated from your accumulated savings. Asset allocation is the key to achieving these goals.

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