A Lifetime Contract.

As defined-contribution pension plans grow and defined-benefit plans fade, future retirees will need to create their own reliable incomes. Insurers believe payout annuities should and will be part of retirement planning.

Two powerful demographic trends are about to provide insurers with an unprecedented opportunity to use payout annuities to further their ties to the largest demographic group in the United States, the baby boomers.

Some 76 million strong, the boomers have been plowing trillions of dollars over their working lives into tax-qualified plans like 401(k)s, 403(b)s, individual retirement accounts, 457s and Keoghs. The oldest boomers have reached 54 years of age, and the retirement boom in America is about to begin.

For most, retirement will be a time of tough decisions about how to position their investment portfolios for both growth and a stream of income. And that is exactly where payout annuities can fill the void.

Few boomers today even know what a payout annuity is, and producers still concentrate on building assets. But the payout annuity can provide prospects with exactly what very few have, short of Social Security: an income stream guaranteed for life.

"Before the market dived, the amount of money in the 401(k) plans of people retiring this year was $300 billion," said John O'Sullivan, vice president and consulting actuary with Aon Consulting, Closter, N.J. "If the insurance industry taps just 10% of that, that's still an enormous amount of fresh money coming every year. It's a win for the customer, the mutual fund industry--which still gets to manage the assets--and the insurance industry."

Trillions Sacked Away

At the end of last year, $1.766 trillion resided in 401(k) accounts and $498 billion was in 403(b) plans, according to Boston-based research firm Cerulli Associates. Another $2.471 trillion were in individual retirement accounts, making them the largest depository of U.S. private retirement assets. A sizable amount in IRAs flowed there through rollovers from 401(k) plans, and Cerulli estimated that by 2010, nearly $500 billion annually will flow out of 401(r)s into rollover IRAs.

That may seem like a lot of financial security, but studies show that individuals worry that their own assets won t last their entire lives. That's where pay out annuities come in.

Insurers view the product as a diversification tool. "We're not saying individuals have to use all of their money to buy the product," said Elaine Stevenson, vice president of retirement and savings at MetLife Inc., New York. "It's just the piece of money they'll need for an income guarantee. They can allocate the rest in liquid accounts."

Jeff Botti, a spokesman for Nationwide Financial, Columbus, Ohio, predicted that the pay-out-annuity market will grow rapidly. "The majority of folks are in the accumulation phase, but we're reaching the point where more attention will be paid to how the money will be managed in retirement," he said.

Individuals can become owners of a payout annuity in two ways. If they already own an annuity in the tax-deferred accumulation phase, they can exercise their option to "annuitize" it, meaning that they cede all or part of the assets to the insurer in return for guaranteed periodic payments, usually monthly, that last for life or some agreed-upon length of time. For money that is not yet invested in an annuity, a prospect may buy an immediate annuity, which begins the payouts soon after purchase. Like annuities in the accumulation phase, payout annuities offer owners investments in either fixed general accounts or fixed and variable subaccounts.

Longer Life Spans

Outliving assets is a relatively new concern as scientific advances of the 20th century have extended life expectancies. "Unfortunately, these longer life expectancies are often viewed as a problem," said Linda George, a gerontologist at Duke University in Durham, N.C. "At the individual level, the questions are about retaining independence in the areas of finance and health," she said. "At the public level, the questions are about how we can support all these people." It is now common for people to live 20 or 30 years or even longer after retirement, not only because of longer lives, but because of earlier retirements, added George, who has interviewed more than 6,000 elderly people over 25 years.

In her research of people 65 and older, George said she has come across an interesting paradox. Some 85% of them told her that their finances are fine, though not great, a much higher percentage than among younger adults. "But if you ask the additional question about whether they have enough money to last through their lives, 80% say they're afraid they will run out," she said. "Interestingly, it doesn't matter how much money they have. A financial planner told me a client lived his last 10 or 12 years convinced his money wouldn't last, and he denied himself things that would have made him comfortable. He died with an estate of $5 million."

MetLife's Stevenson made a similar point. 'The biggest problem with the fear of outliving your money is spending too little," she said. "People actually lower their standard of living significantly." With an immediate variable annuity, those people can invest some of their money "to go up a notch" in income and maintain the standard of living to which they are accustomed, she said.

Today's older women are particularly ill-prepared to handle their finances in retirement, George said. They are less likely to have played an active role in financial decision-making. They are less likely to have earned pensions, and those that have tend to receive lower payments due to shorter work histories and lower-paying jobs. All of those problems are compounded because they live longer on average than their male counterparts, George said.

Better products are part of what is needed to respond to the current and emerging needs of the elderly, George said, and many insurers are working to develop them in the form of immediate variable annuities. "The shift from accumulation to asset management is a real one for these people, and that shift has to address risk," she said. "From a risk perspective, managing $10,000 is different when you're older and don't have time to recoup from losses, so you need products attentive to those concern."

Wealth Protection

"People don't buy annuities to get wealthy," wrote researchers Jeffrey R. Brown of Harvard University Olivia S. Mitchell of The Wharton School and James M. Poterba of Massachusetts Institute of Technology, in a paper last year on payout annuities. "They buy them to protect their existing wealth, accumulated by years of bard work, against the possibility that they might exhaust those funds before they die."

In the paper, "Mortality Risk, Inflation Risk and Annuity products," the researchers said that few elderly households in the United States convert their assets into a life annuity. But they found that the risk protection provided by nominal payout annuities (those that do not offer any inflation protection) is substantial: The present value of annuity payouts relative to their purchase price in the United States during the late 1990s was from 80 to 90 cents per premium dollar for randomly selected individuals, but 90 to 100 cents for the average annuitant.

Still, few people buy payout annuities, The American Council of Life Insurers reported last year that in 1999, only 2.7 million people were covered by individual immediate annuities. They received less than $7 billion in payouts. What's more, there was almost no interest in immediate variable annuities; about 99% of the payouts were on fixed (nominal) annuities. By contrast, 41.5 million people were invested in deferred annuities.

Mitchell and her colleagues said there was even less utilization than statistics like those would indicate. They said that in 1998, about half of all newly purchased individual immediate annuities were the funding vehicles for structured-settlement cases, which result from awards in legal cases and, therefore, do not represent income to retirees. Of the remaining annuities, only half were life annuities. The rest were period-certain policies, which the writers characterized as "effectively, bonds issued by insurance companies."

Prospects typically object to payout annuities in any of several ways, all of which insurers have been working to address in recent years. The main problem stems from the fact that buyers must buy a payout annuity with a lump sum. That money is then no longer available to them during emergencies or other urgent needs, and they cannot bequeath it. And once prospects make the decision to buy, they can't change their minds later.

Nor are payout annuities popular among independent financial planners, who earn fees and commissions based on how much money they manage for clients. But O'Sullivan said other kinds of distributors--banks, mutual funds and low-cost annuity providers such as Fidelity Investments Life Insurance Co. and TIAA-CREF--have the incentive to keep assets on their books through payout annuities. "So if financial planners don't go ahead and make it work, other channels will," he said.

Nationwide Financial is among the insurers to address investor concerns with a variable product it introduced in April 2000. America's Income Annuity, part of Nationwide's Best of America series, offers nine payment options. All but the life option offer death benefits in the form of continuing payouts or a lump sum to beneficiaries. Mortality and expense fees are 1.25% annually. For another 20 basis points, the policyholder may purchase an enhanced death benefit in which the beneficiary receives a lump sum or ongoing benefits equal to all remaining payments computed using the highest payment the owner received before death or the 80th birthday, whichever occurred first.

Nationwide also allows full and partial withdrawals on term-certain income options for any reason subject to surrender charges during the first eight years.

But the real value of the immediate variable annuity is that the underlying investments offer a chance for payments to rise through the years, America's Income Annuity offers more than 40 investment options, and Holly R. Snyder, associate vice president for income products, said policyholders can make transfers every day.

Nationwide hired George to teach its marketing partners how the market is changing. "We want our wholesalers to know how to approach these people differently and to understand where they're coming from," Snyder said, "Linda's been very helpful in these strategic issues, and she validates how we're trying to move the organization."

Part of the appeal of immediate variable annuities is that they help people manage their assets. Not only do policyholders have guidance from the people who sold them the product, but their investment choices are part of the package. "Best of America very aggressively monitors those subaccounts and watches for those that may underperform," Snyder said.

The financial professionals also help clients on their asset allocation. A common mix is 75% variable and 25% fixed, Snyder said.

Tax Advantage

Payout annuities also offer a tax advantage for nonqualified products, or those funded with money that has already been taxed. In taxable investment accounts, owners pay income tax on their realized gains every year. In payout annuities, part of every payment is already taxed principal and part realized gain, and only the realized gain is taxable. "More of income remains in the product, and it is tax-deferred for a longer time." Snyder said. "That can result in a greater payout over longer periods."

Stevenson said MetLife is very much aware of the opportunities for converting clients' qualified plans into payout annuities. She said the average 401(k) balance of a person retiring is currently about $150,000. MetLife offers financial advice to qualified-plan customers while they are employed through relationships with Standard & Poor's and the Web site Financial Engines, but Stevenson said there isn't much advice available from the industry in general on what individuals should do with that money when they retire. "It's an area we are very interested in examining," she said. "That's where we see the need."

MetLife offers both fixed and variable immediate annuities. The immediate variable annuity is called the Preference Plus Income Annuity.

As of early April, Congress was considering a proposed change in the tax law that could make payout annuities more attractive. The Lifetime Annuity Payout proposal would lower the tax on annuity payments from the ordinary income-tax rate to the capital-gains rate. This would make tax on annuity payments equal to those on long-term capital-gains distributions paid by mutual funds and on long-term gains from mutual-fund redemptions. O'Sullivan, however, said the capital-gains treatment would be afforded only to payout annuities funded with nonqualified money. Still, he said it would be a "fantastic thing" for customers and the industry and would focus more attention on annuitization in general.

Nationwide supports the proposal, but Stevenson said it would not make much of a difference. "I don't know if it's enough to help someone make the decision to buy or not," she said. She added that the fear of outliving one's money is the primary motivation for buyers.

Nor will the recent changes in mandatory minimum withdrawals from IRAs and qualified plans beginning at age 70 1/2 have much effect on the payout-annuity business, she said. The Internal Revenue Service early this year issued a clarification on the law that provides for significantly lower minimums. In effect, the combination of lower minimums and wise management of assets could stretch out the life of the plans over generations. But O'Sullivan said that managing distributions from qualified plans cannot match the security through bear markets afforded by payout annuities, and possibly not the size of the payouts. That's because in payout annuities, mortality risk is pooled so that those who live longer are subsidized by those who die sooner, he said.

Stevenson predicted that the new minimum-distribution rides won't have any bearing on sales of payout annuities. "They're not as related as they might appear," she said. "We think of age 70 1/2 as a triggering event, a good time to talk to someone about an immediate variable annuity."

O'Sullivan predicted the change will be "slightly positive." He said some financial advisers interpreted the old rules to mean that once minimum withdrawals from qualified plans had begun, the plan owners could not annuitize any of the money, "because you'd be lengthening the distribution period." That is no longer a concern.

"It's still pretty complicated, but an advantage of using an annuitization is that once you annuitize, you don't have to worry about minimum-distribution rules," he added.

Stevenson said a bear stock market could help payout-annuity sales, even though it would undercut the value of underlying investments. "As people realize the market can actually go down, and they may need some professional guidance, the idea of a guaranteed lifetime income might be more attractive," she said. "It's important to realize the immediate variable annuities offer a guaranteed component. Some of the products out there allow movement from variable to fixed accounts, so you can continue to do asset allocation."

                         Qualified-Plan Assets
                  Annuities can provide insurers a way
                   to tap into the increasing pool of
                  assets in qualified retirement plans
                              ($ Billions)
                      Defined         Defined
Year     401(k)  Contribution    IRA  Benefit
1993       $616        $1,068   $950   $1,170
1994        675         1,088  1,014    1,193
1995        864         1,322  1,223    1,444
1996      1,061         1,551  1,389    1,542
1997      1,376         1,835  1,627    1,783
1998      1,624         2,080  1,845    1,988
1999      1,838         2,331  2,214    2,206
2000      1,766         2,219  2,471    2,150
2001[*]   1,924         2,457  2,751    2,301
2002[*]   2,202         2,716  3,053    2,450
2003[*]   2,452         2,996  3,379    2,597
2004[*]   2,726         3,300  3,728    2,740
2005[*]   3,025         3,629  4,098    2,877
2006[*]   3,352         3,986  4,488    3,006
(*.)estimated
Source:Ceruill Associates