When Are Annuities a Good Idea?
Planning for retirement is too important to leave to chance. Life expectancy is increasing with every decade, which is great news. However, it also means that preparing for retirement needs a fresh perspective.
Many retirees, even those who have consistently saved toward retirement over their lifetime, may realize they don’t have enough money saved to retire comfortably. If 401(k)s, pensions, and social security benefits aren’t quite providing the standard of living that many expect when they transition into retirement, there is a tool worth considering.
Annuities.
What is an annuity and why would you need one?
An annuity is a financial product, primarily for retirees or those nearing retirement, that delivers a fixed stream of payments to an individual. It provides an additional income stream to help fill a gap between necessary living expenses in retirement and guaranteed sources of income, such as social security and pension income.
In short, an annuity is an investment that helps you receive enough money to retire comfortably when traditional retirement incomes fall short. Annuities also provide a buffer for those within ten years of retirement in the event a market crash or recession negatively affects their investments. They can relieve stress and increase quality of life in and before retirement.
Are you wondering if an annuity is right for you? Let’s first get a clear understanding of what they are and what their purpose is before making that determination. It’s important to understand the types of annuities available and the benefits and risks that each one holds.
There are two main types of annuities:
Immediate Annuities
Deferred Annuities
Here’s a closer look at each one:
Immediate Annuities: Here’s when to consider them.
An immediate annuity offers a guaranteed stream of income for life in exchange for a lump sum investment. For instance, you can pay $500,000 into an annuity and, depending on your age, the annuity will provide a monthly paycheck for as long as you live. Payments begin almost immediately after the lump sum payment is made.
An immediate annuity can be a good fit for someone who is within a year of retirement, or who is already retired. Typically, retirement plans involve investing assets, taking withdrawals, and hoping the growth of the assets - minus withdrawals - keeps up long enough to sustain your income for the rest of your life. An annuity, however, provides guaranteed payments that will continue for as long as you live.
What you need to know about immediate annuities:
First, payouts on a lump sum depend on age but can be substantially higher than typical withdrawal rates from a portfolio. This is because the payments actually come from three different sources: principle, interest, and mortality credits. Principle and interest are self-explanatory, but you might be wondering about mortality credits.
Mortality credits are created when annuity holders don't receive as many income payments because they died sooner than expected. Those credits are then pooled together to pay lifetime income to those who live beyond their life expectancy. This strategy allows the insurance company to increase payments to all contract holders in advance of these events. This makes a huge difference. For instance, a 70 year might be coached to not exceed 4% withdrawal rates from a moderately conservative portfolio. In contrast, it’s common for this same person to see annuity payout rates higher than 7% of the initial premium payment. Contractually, that payment can never stop until the annuitant has passed away! So this annuity contract holder cannot outlive his or her money.
Second, annuities should only be used to cover the gap between required retirement cash flow and other guaranteed sources of income. For instance, let’s say a retired couple needs $6,000 per month to sustain their lifestyle in retirement, but social security only provides $4,000 per month. An immediate annuity is a great way to secure the additional $2,000 per month needed. This allows the retired couple to live out their retirement years without having to worry about outliving their assets since their necessary income stream is contractually guaranteed.
A side benefit of contractually securing income throughout life is that a retiree should have more tolerance for investing additional assets more aggressively than they otherwise would if they didn’t own an annuity. The peace of mind that comes from knowing lifetime, necessary income is contractually secure allows a retiree the freedom of knowing he or she can withstand a market correction without fear of sacrificing standard of living in retirement.
Deferred Annuities: When do they make the most sense?
The market is unpredictable, and sudden recessions, as we saw in 2008, can be devastating to your investment portfolio. While you should definitely keep growing your assets, if you are within ten years of retirement and want to safeguard your retirement income, then a deferred annuity is a good fit for you.
There are two primary types of deferred annuities:
Fixed annuities
Variable or Indexed annuities
A fixed annuity earns a fixed rate of interest between now and retirement. It provides a guaranteed return, but it is often lower than that of a well-performing variable annuity.
A variable (or indexed) annuity grows or declines in value based on the performance of your portfolio of mutual funds. Variable annuities are attractive because they offer the potential for higher returns and more income than fixed annuities. However, they are riskier and could possibly lose value depending on how the contract is designed.
When buying a deferred variable annuity, you will likely pay a higher fee that acts as a wrapper, protecting the value of your investments in the event of a market downturn. Your annuity could also be tied to the performance of a specific index, like the S&P 500.
Even though it is a variable annuity, it usually still provides some minimum guaranteed return or protection from market loss. For instance, an insurance contract might give you the annual returns of the S&P 500, but with a “spread” of 3.5%. This means if the S&P 500 goes up 10% in a year, your contract will be credited 6.5%. However, if the S&P 500 goes down 10%, the product might have a floor of 0%, meaning your contract cannot lose money. So you will still continue to have some access to market-like returns, but with the protection of your account value intact.
A caveat to deferred annuities:
If you are a younger investor with a diversified portfolio, a deferred annuity is probably not a great option. I rarely recommend these products to my younger investors. These contracts hold much higher fees or spreads than traditional investing and can drag down performance over time. Your traditional investment portfolio will likely be able to withstand potential downturns of the market and still provide you with better returns over longer periods of time.
Is there a downside to investing in annuities?
As with any investment, annuities have both pros and cons to consider. The most common drawbacks to both types of annuities are cost and liquidity.
Cost:
Obviously, the cost of an annuity is going to be much higher than a typical investment. For instance, the fees on a variable deferred annuity could be 3-4% annually, as opposed to 1% as an average in a normal investment strategy.
This may seem high, but consider what you might pay to insure your house or even your life. An annuity is basically insurance against market decline, and like any insurance, it’s going to cost money. However, for an investor nearing retirement, it could mean the difference between retiring on schedule or delaying retirement because you took an investment risk that didn’t work out.
Liquidity:
Like most retirement plans, annuities carry penalties for early withdrawals. This is called a surrender charge. Once you decide to receive income from your annuity, the decision is usually irreversible. This is why it is so important to clearly define your plan and objectives, as well as carefully decide how much money you will invest. Take stock of how an annuity fits into your retirement plan and what other assets you can access if life demands it. With a deferred annuity, plan for at least 4-10 years of having your money locked up in that vehicle before you can move it freely to another type of strategy.