Create Your Own Pension Using an Economist-Recommended Method

A lifetime annuity, which allows you to create a custom pension, protects you as you enjoy your golden years.

There is a time-tested way to create your own supplemental pension: Economists agree that annuitizing a significant portion of your retirement savings is the way to go, according to a study from Wharton Financial Institutions Center.

By buying a lifetime income annuity, you can create your own custom pension. Also referred to as single-premium immediate annuities, you can convert your savings into a monthly income that is guaranteed for life.

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Life insurance protects against the risk of a breadwinner dying prematurely. A lifetime annuity does the opposite, insuring against the risk of living longer than expected.

While most retirement plans anticipate an average lifespan, many people live far longer. A healthy 65-year-old man has a 50 percent chance of living beyond age 85 and a 25 percent chance of living beyond 92. A healthy 65-year-old woman has a 50 percent chance of living beyond 88 and a 25 percent chance of living past 94.

With lifetime annuities, the 50 percent of people who die earlier than average subsidize the half who live longer than average. That risk pooling is what makes life annuities so valuable.

You can self-insure against longevity risk by investing in stocks, bonds and savings, but there is a cost. You will need to save 25 to 40 percent more than with an annuity because you won’t have the advantage of risk pooling, the Wharton Financial Institutions Center study concluded.

How much will you need to annuitize?

First, try to determine how much monthly income you will need at a minimum in retirement. Then, subtract out Social Security and other pension benefits, if any. You can cover that shortfall by purchasing an immediate annuity. Because a portion of the income is taxable, you will usually want to wait until you are about to enter retirement or semi-retirement.

How far will your money go?

Here is one typical scenario: a 65-year-old man can create a $1,093.54 monthly lifetime income guaranteed for life by depositing $200,000 in an immediate annuity from a highly-rated insurance company. If the buyer lives an average lifespan, to age 85, he will collect $262,449 in benefits — not a bad return. But the longevity insurance aspect really starts to kick in after 85. A man who lives to 90 will get $328,062 in total. A 95-year-old will have collected $393,674.

Since you are counting on an insurance company to keep its promise of providing lifetime income, be sure to choose a financially strong insurer. State guaranty associations provide an additional level of protection for annuity buyers, but if you choose a strong company, it is very unlikely you will ever need to rely on the guaranty fund.

Inflation Protection Available at a Cost

Inflation reduces the value of future monthly payments. Insurers have responded by offering lifetime annuities with inflation protection that provide a stream of increasing payments.

Inflation-protected annuities guarantee a growing income based on an annual cost-of-living adjustment (such as 3 or 2.50 percent) chosen when you buy the annuity. If you choose a COLA that is near the historical average, annual income increases will outpace inflation some years, and in other years they will fall short. Thus, you will probably keep up with inflation in the long term.

You do pay a significant price to get automatic pay raises annually. Using the same example above, but choosing an annuity with a 3 percent COLA, your monthly income would be $792.47 to start. It would not exceed the monthly payment from the plain annuity until you reach 76. Even at 85, you would have collected slightly less in total than you would have with the plain annuity. You will, however, be collecting $1,431.29 monthly at that point. If you choose a lower increase, such as a 2.5 percent COLA, the differential will be lower at the start.

For the most part, I prefer standard level-pay immediate annuities. But a COLA-adjusted annuity can be a wise purchase if you are fairly sure of a long life expectancy. And you can put some money in an inflation-protected annuity and some in a standard immediate annuity.

Annuity expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities. More information is available from the Medford, Oregon, based company here.

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