Let's say you have just retired and want to invest your savings to produce steady income. You could buy immediate annuities, which provide a nice payout since a lot of the money you get in the monthly checks is a return of principal. Absent special provisions, however, annuities die when you do. But while you are alive they pay well. Thus, they protect you from the risk of outliving your savings.
If you are a 70-year-old male, for example, you can get $630 a month for life from insurer New York Life by plunking down $100,000. That's a 7.6% annual payout, a lot more than you could get from other relatively safe investments, like bank CDs and U.S. Treasury bonds.
But annuities come with two hazards. One is that an insurer might go bust. You can protect yourself against the worst by buying only from insurers with high financial ratings and by spreading your capital around. Instead of buying one annuity for $300,000, you could buy three $100,000 annuities from different companies. It's unlikely that all three will go the way of AIG
The other risk is inflation, and this is not so easy to combat. Here are six ways to cope with a rising cost of living. All have drawbacks.
1. Buy an annuity with an inflation rider.
By accepting a lower initial payout, you can get a promise from the insurer to raise your check to keep up with the Consumer Price Index.
Advantage: You don't have to guess how high inflation will be.
Disadvantage: The rider may be hard to find--and is going to cost you a pretty penny. That's because the insurer doesn't know how high inflation will be, either, and has no cheap way to cover its bets. Note that the inflation-adjusted versions of U.S. Treasury bonds (called TIPs) carry a tiny 1% real yield.
2. Get a fixed annual bump-up.
With an automatic 2% annual increment (irrespective of what happens to the CPI), New York Life's payout for the 70-year-old male investing $100,000 drops from $630 to $533.
Advantage: Because the insurer knows in advance what its payouts will be, it can fund them by investing in conventional (not inflation-adjusted) bonds. Those bonds have much better yields than TIPs, so the insurer doesn't have to be so chintzy with its payouts.
Disadvantage: You might experience worse inflation than the 2% (or whatever you choose) that is built into your annuity policy.
3. Buy in stages.
Instead of putting $300,000 into annuities at age 65, you could do $150,000 now, then buy more at age 70, says Martha Kendler, who oversees annuity sales at Northwestern Mutual. If inflation has resurfaced by then, interest rates will be higher and you will get a better monthly return as a result. (Remember, the insurance company is covering its obligations by investing your cash in fixed-income assets like corporate bonds.) Even without any rise in interest rates, the monthly payout is going to be better for longevity reasons. That's because 70-year-olds, on average, don't have as many years left to collect as 65-year-olds do.
Advantages: You can invest the $150,000 for five years, and presumably will have more than that sum in 2015 to use on annuity purchases; you get a higher monthly payout per dollar invested, because you're older; and you get a peek at the Grim Reaper's plans for you. If your health is very poor at age 70 you just don't buy the second annuity.
Disadvantage: You've missed five years of monthly payouts.
4. Buy stocks instead.
The S&P 500 stock index yields about 2%. Stocks have a history of enjoying dividend hikes that, over a long period, more than keep up with inflation. Indeed, without being considered a spendthrift you could both cash the dividend checks and also sell off 1% or 2% of your portfolio every year to help pay the rent. It's likely that you could continue that spending behavior indefinitely without depleting your capital.
Advantage: If you can get by on just the dividends plus a 2% withdrawal of capital, you are likely to leave a nice pot for your heirs.
Disadvantages: There are two disadvantages. One is risk. Dividends get cut in a recession. And what if we get a 25-year bear market in stocks? What if you own a disproportionate amount of the next Enron or AIG? The other problem is that you cannot match the 6% to 8% payout that retirees can get on annuities. Take 7% a year out of a stock portfolio and there is a significant chance that, by time you turn 80, you will be sleeping on the sidewalk.
5. Buy a government annuity.
Here's the deal. You start collecting Social Security at age 62 (we're assuming you are out of the workforce). If you're still healthy at 70, you repay all your Social Security checks to that point and reapply. That entitles you to a much higher lifetime benefit, and this benefit is adjusted for inflation. "In effect you are buying an inflation-protected annuity from the government," explains Matthew McGrath, a managing partner at Evensky & Katz, financial planners in Coral Gables, Fla.
Advantage: The terms are very good. Each dollar spent at age 70 buys a much bigger increment in monthly benefits than you could get from a commercial insurer.
Disadvantage: The terms are too good. The Social Security Administration is moving to limit this option.
6. Live with it.
Plan on a fixed monthly income during retirement. Your purchasing power will gradually decline (assuming we don't get deflation). Maybe that's something you can stand. It would mean more traveling at age 65 than at age 75.
Advantage: You go to Europe when you are still young enough to enjoy it.
Disadvantage: Other costs, like medical costs, may go up a lot as you age.
Read more from William Baldwin at blogs.forbes.com/baldwin.