Is It Time to Buy Your Own Pension?

Nov. 11, 2008 — -- Now might be the right time to buy yourself a pension.

In a difficult investing environment, one of the best protections you can have against market uncertainty is a guaranteed stream of income from something like a traditional pension plan.

The problem is, of course, fewer U.S. employers today offer a defined-benefit pension plan that provides a guaranteed monthly payment to retirees. Instead, many of us are responsible for securing our own retirement income through a 401(k) plan or similar retirement savings vehicle.

A 401(k) plan offers the potential for greater rewards, but it also carries a much higher degree of risk, as has been quite evident this year.

One way to mitigate that risk is to buy your own pension through the purchase of an immediate annuity. With an immediate annuity -– also referred to as an income annuity -- you turn over a lump sum of money to an insurance company, which in return, provides you with a guaranteed monthly payment, regardless of how long you (or a spouse) live.

That's exactly how a traditional pension plan works: guaranteed monthly payments for life. But instead of your employer arranging the monthly payment, you're doing it on your own with savings accumulated during your working life.

This advice is intended mainly for folks at or near retirement age, not those with a number of years left in their working lives.

Also, I'm talking strictly about immediate annuities, not their more complicated and often quite expensive cousins, variable annuities. Variable annuities are a topic for a whole other column, but let's just say I have less enthusiasm for them than I do for immediate annuities.

The immediate annuity protects retirees in two ways. First, it provides a guaranteed payment regardless of market conditions. Even when the stock and bond markets tank, the immediate annuity provides a fixed payment that you need not worry about.

This is important for retirees in the current market environment, according to Julia Lennox, a vice president of retirement strategies for MetLife, which offers a variety of annuity products.

"With the market volatility, they're unnerved that they won't know how much income can be generated if they leave their money in the stock market," Lennox said.

An immediate annuity, she said, "gives them peace of mind in terms of how much money they have."

And often an immediate annuity can provide a higher level of income than a safe withdrawal rate from an investment portfolio. An immediate annuity might generate annual income equal to 6 percent to 8 percent of a lump sum amount, Lennox said, while many financial advisers suggest withdrawing about 4 percent a year from a portfolio in the early stages of retirement.

A second protection provided by an immediate annuity is that it protects you against the possibility that you will outlive your money. This is called longevity risk, and it's something many of us underestimate. Six in 10 pre-retirees believe their chances of living beyond age 85 are 25 percent or less, according to a recent study by the MetLife Mature Market Institute. The truth, however, is that an individual who reaches age 65 has at least a 50 percent of living past age 85.

And with a married couple each at age 65, there's more than a 50 percent chance one of the two will live into their 90s. That's why you need to protect yourself against the risk of longevity.

The chief objection against immediate annuities by many consumers is the loss of capital if you die early. Many retirees do not want to turn over say $100,000 to an insurance company and then only collect back $50,000 before dying.

Lennox, the MetLife retirement strategist, said retirees can mitigate this by first not investing an entire nest egg into an annuity and second by staggering your annuity purchases into a series of steps. This is similar to a laddering strategy employed by investors buying CDs or individual bonds.

The risk of dying shortly after an annuity purchase is certainly something to consider, but let's look at an example to determine whether it's a reasonable risk to take.

Assume for a moment you are age 65 and retiring this year with $500,000. What if you took $200,000 of that sum and bought an immediate annuity? What kind of income would that provide?

According to an online calculator at ImmediateAnnuity.com, a $200,000 lump-sum purchase for someone living in Massachusetts as I do would produce a monthly income of $1,350 on the life of a single person and $1,167 on the lives of a couple, assuming the monthly benefit remains the same after the first spouse dies.

That works out to $16,200 for the single-life annuity and $14,004 for the joint-life annuity. Under these scenarios, it would take about 12 and 14 years respectively for the annuity purchasers to recover their initial investments.

In this case, ask yourself, at age 65, how likely is that you or spouse will live until at least your late 70s. Quite likely for many folks, I'd say.

I know $14,000 a year in annuity income for a couple might not sound impressive, but look at it in context of your overall income situation.

The average married couple collecting Social Security will receive $22,512 next year. That would bring my imaginary couple's guaranteed annual income to $36,000. Add to that a 4 percent annual withdrawal from the remaining $300,000 investment portfolio, and this couple might be looking at more than $48,000 with three quarters of it guaranteed.

One important thing to keep in mind about annuities is that there are many add-ons you can purchase, just like when buy a new car from a dealership. These include inflation protection, guaranteed payment periods in case you die early and reduced payments for a surviving spouse or partner.

Each option you add or subtract will change the monthly payment you receive. To test scenarios that might fit your situation best check ImmediateAnnuity.com or another online calculator for the Vanguard Lifetime Income Program under the annuities section of Vanguard.com.

Running the numbers yourself can help you decide whether it's the right time to buy your own pension and add a new level of security to your retirement.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.