In last weeks article, we introduced the life annuity as a potential income option for conservative investors. Before you buy an annuity, there are some key decisions that have to be made. Before we get into these decisions, it is important to clarify the term annuitant. The annuitant is the person for which the life of the annuity is based on.
Single life or joint life
Step one is to consider the differences between a joint life annuity and a single life annuity. The single life annuity is based on one life. If that person passes away, the life annuity ends. A joint life annuity is different in that the longevity of the annuity is based on two lives instead of one. If one of the annuitants passes away, then the annuity will continue to the surviving annuitant. The annuity only ends on the death of the last annuitant.
For a joint annuity, there is an added decision of whether to have the income reduced on the death of the first annuitant. The best way to illustrate this is to give you a sense of numbers to apply to the theory. Let's look at Jennifer and Bob.
Jennifer has $100,000 and is age 65. A single life annuity would pay her $649.17per month. Her husband Bob is also 65. If she elected a joint life annuity, they would only get $581.15 per month. Why? When you add the second life to the contract the likelihood of paying income for a longer period of time increases. If you put a 60% continuation (the income will drop to 60% after the first death), the income will go up to $661.73
For joint annuities, you can determine a primary and secondary annuitant so the income will drop only if the primary annuitant passes away. As you can see, there are many variations and combinations and each combination will come with a different income.
Another big decision that must be made is to decide if you want to add a guarantee period to the annuity. A basic annuity is sometimes called a Life Annuity Guaranteed zero years. This means that when the annuitant passes away, the annuity ends no matter when death occurs. In the example above, what if Jennifer buys a $100,000 single life annuity and she dies one year after purchasing the annuity? Jennifer will have received $649.17 per month for 12 months (or $7790.04). In this example, the annuity would stop and the remaining money would go to the annuity company.
One of the ways to alleviate this risk is to attach a guarantee period to the annuity. For example, let's say Jennifer decides to add a 15-year guarantee. What she is doing is adding an option to the base annuity that will ensure the annuity will pay out at least 15 years of income no matter what. Sounds great but the catch is that adding a guarantee will cost money. In fact, for Jennifer, adding the 15-year guarantee will drop her income from $649.17 per month to $608.95 per month. If you do the math, $608.95 for 15 years is $109,611 of total income on a $100,000 of capital. If Jennifer dies after one year, her beneficiary will get the remaining income for the balance of the guaranteed 15 years. If Jennifer lives longer than 15 years, the income will continue. The annuity is still for life no matter if she lives longer than the guarantee period.
You can choose any guarantee period. They are usually done in increments of 5 years.
For all life annuities, you can apply an indexing factor where the income will increase every year by a certain factor. This is typically done to account for increases in cost of living. Indexing can appear to be a very costly option to add to a plan. If we consider Jennifer again, her income would drop 17% to $538.56 if she added a 2% indexing option. This means that her income would increase by 2% per year every year.
Life annuities can get pretty confusing. Once you start considering guarantee periods, multiple annuitants, reduction factors, and indexing options, it gets increasingly difficult to make the right decision. If you are baffled about the annuity options, get help. Most financial advisors and life insurance agents can help you make decisions about life annuities. However, make sure you shop around. It's a competitive world out there and different companies will offer different incomes for your business. In any case, annuity income can vary by as much as 10%.