How to Build Your Retirement Paycheck—and Make It Last: Here's how to know if an annuity is right for you.

When it comes to retirement, many Americans are on their own. They've saved diligently for years and have to figure out how much they can spend each month to make their money last as long as they expect to live.

Yet our do-it-yourself retirement system is cracking: Aside from Social Security, few of today's workers will have a guaranteed source of income like a pension. And millions now in retirement may be spending too much or too little for their age and other factors.

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Wall Street, of course, has answers. New annuity-like products from companies like BlackRock are cropping up in 401(k) plans, aiming to siphon off a portion of savings and put them into income vehicles that will guarantee paychecks for life.

It isn't a bad idea. Despite their negative connotations, there are good reasons to consider some types of annuities as part of a retirement paycheck that may include other sources like Social Security, portfolio income, and capital gains. The big jump in interest rates has made some income annuities more attractive.

For many retirees, that guaranteed part is crucial. Financial advisors often recommend that retirees cover their necessary expenses with guaranteed income, whether in the form of Social Security, a pension, annuity, or some combination thereof. That way, you don't have to rely on the vagaries of the financial markets—or your ability to manage money into old age—to make sure you have enough to cover food, housing, healthcare, and transportation.

Annuities Aren't All Bad, Really

If you're queasy about annuities, you're not alone. They have a reputation—in some cases, well deserved—for being complicated, expensive, and pushed aggressively by salespeople. Yet a simple income annuity—as distinct from investment-focused products like index-linked or variable annuities—is essentially just a contract that shifts some of the risk of outliving your assets to an insurance company that provides guaranteed payments for life regardless of how the market performs.

The logic is the same as buying other insurance: Just as you insure your home, it may also make sense to insure the income that will help keep you in your home when you're too old to work or look for a job.

"Annuities by themselves aren't good or bad," says Tony Kure, a senior portfolio manager at Johnson Investment Counsel in Cleveland.

Income annuities are the kind favored by economists who worry that people will outlive their assets. They come in two main varieties: Immediate income annuities start paying out right away, while deferred income annuities start at some point in the future.

There's now a more compelling case to buy one as higher interest rates have pushed up payouts that can be guaranteed for life at today's rates. Payouts average 7.5% for immediate-income annuities, for instance, up from 5.7% in May 2020, according to the Cannex Payout Annuity Yield Index. If you put $100,000 into an annuity, you can expect roughly $620 in monthly income right away, guaranteed for life, based on averages among men, women, and joint-life annuities for couples.

Wall Street is making a renewed pitch for annuities. A recent example is BlackRock's LifePath Paycheck, which offers a guaranteed-income sleeve within the company's target-date funds. Launched in April, the product has attracted 14 employers with 401(k) plans totaling $27 billion in target-date assets. To date, two insurance companies vetted by BlackRock—Equitable and Brighthouse Financial—handle the annuity portion. Companies such as Nuveen and State Street offer similar products for 401(k) plans.

Many people don't want to hear the word "annuity." And the financial industry has gotten the message: You won't find the word featured prominently in the new 401(k) products. Instead, they use terms like "product guaranteed income," "structured income," or "retirement paycheck."

"We realized we were going to have to re-plumb the 401(k) industry," said Mark McCombe, vice chairman of BlackRock, at a launch event for LifePath in New York.

Annuities in 401(k)s can solve a longstanding problem: Workplace retirement accounts were never set up to simplify withdrawals, or what the industry calls "decumulation." A guaranteed-income option can help address the transition from accumulating savings to the withdrawal phase and provide peace of mind that some money will be there for life—even if an account runs dry.

Another plus: Annuities in 401(k)s are simpler and less costly than many on the retail market, providing some assurances that you won't be saddled with high fees and other bad practices. Since 401(k) sponsors are fiduciaries—required to act in the best interest of investors—they have an obligation to make sure that annuities or similar products have upheld basic standards on fees, portfolio composition, and other requirements. Employers also fear lawsuits from plan participants charging that they have failed in this duty.

Washington, D.C., has eased a path for annuities, too. The Secure 1.0 law of 2019 limits the liability of employers overseeing 401(k) plans if they partner with an insurer that subsequently goes bust. That has granted plan sponsors a legal shield and financial firms more license to re-engineer 401(k) plans, the accounts that hold most of Americans' investible wealth.

For now, uptake has been slow. And it's too early to tell whether the new products will wither away, another example of "the annuity puzzle." The term was coined by economists to explain the phenomenon that retirees tend to avoid annuities, even though there's lots of actuarial math backing up their benefits for people at risk of running out of money.

To determine how much you should put in an annuity, work backward: Add up your monthly essential expenses and then subtract the income you expect from Social Security and a pension, if you have one. The difference is the monthly income you'll need from an annuity.

Some people won't need an annuity at all. If you have saved more than 36 times your annual income needs—defined as your expected expenses minus Social Security benefits and pension, if you have one—you're probably "self insured" against running out money, according to research by Morningstar. Lower-income workers may be poor candidates, as well. Not only will Social Security replace a higher portion of their income, but also they probably can't afford the trade-off: sacrificing the liquidity of modest savings to buy an annuity.

You can search for annuities that will generate the amount of income you need on the retail market. IncomeSolutions.com, for example, allows consumers to compare offerings from different companies. The fee for income annuities is baked into their payout, so comparing payouts will show how far your lump sum will go with each insurer. Income Solutions' flat, one-time fee of 2% to retail buyers is reflected in the quotes it displays and disclosed to consumers during the transaction.

For example, a single 65-year-old woman in Florida who put $100,000 in an annuity would receive $538 to $591 in monthly income for life, according to quotes from Income Solutions, assuming the buyer selects a "cash refund" option for a beneficiary to receive the remainder if she dies before her entire lump sum is paid out.

When to buy an annuity—early in retirement or later—is another subject of debate.

Some advisors like to wait for clients to be well into retirement before putting some savings in an annuity. Carolyn McClanahan, founder of Life Planning Partners in Jacksonville, Fla., typically buys income annuities for clients in their 70s or beyond. By then, they tend to have a better sense of their own longevity and that of their portfolio. Annuities bought at that age offer fatter payouts than those bought at younger ages, so they're a good option for healthy clients who might be in danger of outliving their assets.

But there may be benefits to buying earlier in retirement or before retiring. One is that it could help you invest more for growth in your portfolio, building more wealth. According to anillustration from BlackRock and the Bipartisan Policy Center, retirees can generate 29% more annual spending from their retirement savings (excluding Social Security) if they buy a series of deferred annuities from ages 55 to 65 and increase their stock allocation from 40% to 50% at retirement.

That's essentially the approach taken by BlackRock's LifePath Paycheck. The funds start shifting investors' assets into the insurance product once they reach age 55. It starts with 10% of their account balance and then dollar-cost-averages up to 30% by the time they reach 65. The shift happens behind the scenes, similar to the glide paths in target-date funds that gradually get more conservative.

"Just as we don't ask people when to start allocating to international equities, we don't ask them when they want to start allocating to an annuity," said Nick Nefouse, head of LifePath at BlackRock, at the launch event.

Participants in the BlackRock plan can then choose to begin receiving income between ages 59½ and 72. They can also choose not to annuitize—meaning they don't start taking payouts. In that case, the money would then roll back into the target-date fund before required minimum distributions start, which is currently age 73.

Payout rates depend on interest rates and other factors when you annuitize. LifePath Paycheck's rate for a 67-year-old as of May 15 was 7.6%, according to an illustration provided by the company; so, if you annuitized at age 67, you would get that rate of income on your annuitized savings for life. (Note that this isn't the same as an individual bond yield, since annuity payouts deplete your principal over time.)

Annuities still aren't for everyone. The median 401(k) balance of someone in their 60s is about $209,000, according to Empower, a retirement plan provider. If you put 30% of that in an annuity, it would be about $63,000, which might translate into a few hundred dollars a month of lifetime income, even at today's relatively high interest rates.

At those levels, "I don't think it makes a lot of sense," says David Boniface, an LPL Financial–affiliated wealth advisor and president of Legacy Capital Wealth Management in Forest Lake, Minn. One drawback is that your money is tied up—if you need it for an emergency, it may not be available. Liquidity is going to be a concern for most people at those asset levels, he says.

Make the Most of Social Security

While it isn't called an annuity, Social Security is the most generous one around. In part, that's because the federal government has no profit motive; it doesn't collect fees or try to maximize profits like an insurance company. According to Morningstar, one of the best ways to guarantee income for life is to wait until age 70 to claim Social Security—no outside annuity needed.

Waiting to claim until 70 may not be easy, psychologically or financially. But it confers benefits: You would have an 86.7% chance of having enough lifetime income if you wait that long, a slightly higher probability than buying either a series of annuities from 55 to 65 or one upon retirement at 65, according to Morningstar.

Furthermore, if you claim at 70, your benefit will be about 76% more than it would be at your earliest eligibility of 62. Put another way, if you claim early, you lock in benefits that are about three-quarters less than they would be at age 70. (Some people think you can claim early and then get a benefit bump at full retirement age, but it doesn't work that way.)

Tap Your Portfolio, but Be Smart About it

Waiting until 70 looks great on paper, but you'll still have to pay the bills until then. Those with a healthy 401(k) balance shouldn't be scared of tapping it to bridge the gap. Not only will this help you delay claiming Social Security, but it will also lower your future taxes by reducing the amount in your tax-deferred accounts, says Charles Czajka, a certified Social Security claiming strategist and founder of Macro Money Concepts in Stuart, Fla.

Consider how you might use the 4% withdrawal rule and adjust it for Social Security. This general rule holds that you can withdraw 4% of your portfolio in the first year, adjust the amount annually for inflation, and have enough money for a projected 30-year retirement. While the rule has merit, many advisors recommend adjusting it based on factors like your projected longevity and other sources of income.

Waiting to claim Social Security can also allow you spend more from your portfolio. If you wait until 70, you might be able to withdraw 6% to 7% of your portfolio a year to tide you over, says Spencer Look, associate director of retirement studies for the Morningstar Center for Retirement & Policy Studies.

It isn't easy to parcel out your life savings, especially since the financial-services industry hasn't trained people to think in terms of lifetime income, says Allison Schrager, a senior fellow at the Manhattan Institute. Fixed-income annuities assume the complexities and the risk of that task, and can be a good option, combined with other sources of income.

"Everyone is looking for a simple solution to a complicated problem," Schrager says. "Sometimes you need a complicated solution to a complicated problem."

Write to Elizabeth O'Brien at elizabeth.obrien@barrons.com