Does Your Client Need an Annuity? Here's a Formula to Help Decide

What You Need to Know

Annuities provide income payments that are not only higher than investors could generate on their own but also guaranteed for life.
Advisors can use a formula to help the client determine if an annuity would fit their needs.

As demand for guaranteed income is on the rise these days, advisors might need to be prepared when clients ask about annuities. These products allow clients to invest a lump sum to guarantee a future income stream, insuring against running out of money in retirement.

Perhaps the first question from a client is, why bother?

As Amy Arnott, a portfolio strategist for Morningstar, writes in a recent column on these insurance products, “because the insurance company spreads risk across a broader pool, it’s able to manage longevity risk and provide income payments that are not only higher than investors could generate on their own but also guaranteed for life (assuming the insurance company is financially sound).”

In addition to this, a client needs to understand they would be moving funds into an annuity from their portfolio or savings, and the decision to do this, once the contract is signed, is “irrevocable” in most cases, Arnott says.

Another question: What kind of annuity should they get, and how much will it cost?

There are Internal Revenue Service limits with certain annuities. For example, Arnott notes, for a qualified longevity annuity contract, which is a deferred annuity funded with retirement assets, a client can convert up to $135,000, or 25% of the account, whichever is less.

Also, the kind of annuity a client should get depends on several factors, and there is a wide variety to choose from. Features, benefits and costs differ.

Other than making sure the insurance company a client uses is solid, there is a formula to determine how much a client will need for an annuity to ensure a certain level of guaranteed income.

Arnott runs down six steps to determine how much a client would need to invest in an annuity. The math is based on purchasing an immediate fixed annuity:

1. Determine monthly spending needs.

Conservatively, determine essentials such as housing, utilities, food, medical costs and insurance. Let’s say spending needs will be $6,166 per month, or $73,992 a year.