Let’s say you won’t have a defined benefit pension in retirement, or that you have a pension that won’t pay much. One option is a do-it-yourself pension–better known as an income annuity.

An income annuity is something like the mirror opposite of life insurance. A life insurance policy protects you and your family from the possibility you’ll die prematurely; an income annuity insures you against the risk that you might outlive your assets. Last week, we focused on the issues surrounding longevity risk for women; this week, let’s talk about the role annuities can plan in mitigating that risk–for women and men alike.

The insurance industry markets two basic annuity types–income and deferred. But deferred annuities are just another type of retirement investment product, not all that different from a mutual fund or other vehicle; you’re investing money with the aim of future return. With an income annuity, the goal is retirement income.

The plain vanilla product is called a single premium income annuity (SPIA), and the proposition is fairly simple. At some point after you retire, you make a payment to an insurance company, which in turn promises to send you a regular check from a date certain. In most cases, the payments continue as long as you live.

The SPIA hasn’t been a very popular financial tool for retirement. One reason is the overwhelming urge people seem to have to choose lump sum payments over an income annuity stream; even in cases where employer-sponsored retirement plans offer the choice of a lifetime annuity or a lump sum payment, most choose the lump sum. Very often, people just aren’t comfortable giving up control over a fairly large sum of money to an insurance company.

“When you look at all the studies on this, the main reason people don’t buy an annuity is the ‘wealth illusion,’” says Dallas Salisbury, president and CEO of the Employee Benefits Retirement Institute.

“A typical individual who is retiring with an accumulation of funds in a retirement plan is looking at a lump sum payment that is more money than they have ever had in their life. If that person is told he can have this much at once, or get a $300 monthly payment for life, for life, that person almost always takes the lump sum–even though he would typically receive much more over the course of his life taking the $300 monthly payment.”

Estate and inheritance concerns are another reason income annuities haven’t gained a lot of traction, since payments end when you die. Another problem holding back the annuity market is a lack of transparency. There’s no widely accepted third-party source of information and ratings for consumers like the ones that exist for mutual funds–Morningstar, for example.

Most commission-based financial advisors aren’t crazy about annuities either, because their compensation is often geared to the total assets they manage–stocks, mutual funds, bonds and the like. If a client spends $100,000 with an insurance company on an annuity, those dollars disappear from the adviser’s ledger.

While income annuities shouldn’t be used to provide the total answer to your retirement income needs, they can play an important role in addressing several key retirement security issues. And most are sold with flexible options that give you a degree of control or a death benefit.

Here’s an easy way to think about how an annuity can fit into your plans:

First, estimate your annual income needs in retirement. Start with your total monthly expenses and then subtract your expected Social Security and any other guaranteed income source, such as a defined benefit pension. The gap amount is what you could consider filling with an income annuity.

Two websites offer free quotes on annuity products: Immediate Annuities and Annuity.com.

One important caveat: An income annuity is a promise from an insurance company to make payments to you over a long period of time, so the company’s financial health is a major factor to consider when you shop. Be sure to buy from companies carrying top ratings from agencies such as A.M. Best or the S&P Insurance Ratings Service.

Some experts also advise splitting your annuity income need among two or three policies from different carriers in order to spread the risk.

Resources: Shopping for an annuity

Related posts:

1. Do-it-yourself pensions gaining ground in workplace retirement plans
2. Reader mailbag: Do IRA Withdrawals Affect Social Security Benefits?
3. We’re flunking our IQ test on retirement security
4. Women face high risk of outliving their money
5. Paying off your mortgage can boost cash flow in retirement

Tags | annuities, planning, women