Immediate Annuities: When Guaranteed Income Is a Bad Bet

It's long been a mystery to economists: As Money has often noted, an immediate annuity is a great way to ensure you never run out of money in retirement; for a fixed sum upfront, you collect a monthly check for as long as you live.

So why do few people buy one? This disconnect, dubbed the annuity puzzle, has led regulators to try to add annuities to 401(k)s to encourage savers to buy them.

Turns out, savers had it right all along, even if they didn't know why (a fear of dying young is what deters most). Almost half of retirees are better off keeping their portfolios liquid, not locked up in annuities, according to new research by Felix Reichling of the Congressional Budget Office and Kent Smetters of the Wharton School of Business.

The chief reason: the potentially high cost of health care. "One of the largest risks facing most retirees is running up hefty medical or long-term-care expenses that aren't covered by insurance," says Smetters.

Tying up too much cash in an annuity can produce a double whammy. A health crisis may cut your lifespan, which reduces the future value of your remaining annuity payments. Meanwhile, you need cash to pay for your care.

"The risks of health care costs are something most planners and investors knew intuitively," says Michael Kitces, director of research at Pinnacle Advisory Group.

Still, adds Kitces, as long as you have a savings cushion for health care, the guaranteed income from an annuity can pay off if you end up living beyond your life expectancy. But take these steps first:

Build a health care nest egg. With Medicare covering only about half of medical costs, Fidelity estimates that a 65-year-old couple will spend $220,000 on health care expenses during retirement. And that doesn't include long-term care, which some 70% of Americans will eventually need in some form, according to U.S. Department of Health and Human Services data.

That could be family help -- what's most common -- or nursing care, at an average tab of $91,000 a year, reports MetLife. The average stay is three years.

Create a care plan. Thinking ahead can help reduce your long term-care expenses, says MIT AgeLab director Joseph Coughlin. For example, few baby boomers have made the kind of modifications to their homes -- widening doorways or lowering countertops -- that would allow them to stay put if they become disabled.

Preview your income. With enough set aside for health care, deploy the rest of your assets. Find out how much income your savings will produce with T. Rowe Price's retirement income calculator. To see the benefits of putting a portion in an immediate annuity -- perhaps enough to cover much of your fixed expenses -- get quotes at immediateannuities.com, then head back to T. Rowe's tool, entering the annuity as a pension.

"With a steady income, you'll be better able to hang on to stocks, which can give you higher returns," says Kitces. Given the spiraling cost of health care, every little bit helps.