There’s a lot of controversy surrounding the use of annuities.
I think that annuities are like any other tool. They have the ability to accomplish a purpose but they also have the ability to be misused. Saws are great for cutting boards in half, but really lousy for pounding nails into walls!
What is the purpose of an annuity if used correctly in the retirement income toolkit?
An annuity is a contract with an insurance company to guarantee a lifetime income. It is a way to take a certain amount of retirement assets and create a predictable income stream. It’s not the only way to create predictable income, but it is one of the only ways to create guaranteed income for life.
Annuities come in three varieties:
FIXED ANNUITIES – A Fixed Annuity is used for the purpose of safely accumulating money. It provides the owner a known return on investment over a predefined amount of time. The principal is safe and cannot lose money. If the contract is surrendered before the end of the predefined period, the owner of the contract will incur premature withdrawal costs.
Fixed Annuities do not generally offer lifetime income benefits.
FIXED-INDEXED ANNUITIES – A Fixed-Indexed Annuity has two time periods… the accumulation period and the distribution period.
During the accumulation period, the contract owner is able to participate in a portion of market index gains but the gain is generally capped or limited. If the participating market index loses money, the contract owner simply does not earn any interest for the year. They do not participate in market losses.
In the distribution period, the contract owner activates an income for life based upon the growth of the annuity, the annuitant’s age(s), and a withdrawal factor that the insurance company publishes. The lifetime income can be based upon a single life or a joint life.
VARIABLE ANNUITIES – A Variable Annuity has some overlapping characteristics to the Fixed-Indexed Annuity, but also some differences.
It also has two time periods… the accumulation period and the distribution period. During the accumulation period the contract owner’s account value can increase or decrease in value based on the performance of the underlying investments in the contract (called subaccounts). If the investments lose money, the contract holder does participate in those losses (but usually still has some underlying future income guarantees).
In the distribution period, the contract owner receives an income for life based upon the growth of the annuity, the annuitant’s age, and a withdrawal factor. The lifetime income can be based upon a single life or a joint life.
What are the tradeoffs of using an annuity over other vehicles to generate income in retirement?
First, annuities have limited liquidity in the early years of the contract. Generally a contract owner can access up to 10% of the annuity value each year without penalty until the surrender period is complete.
Second, fixed-indexed and variable annuities generally have annual costs.
For both fixed-indexed and variable contracts, the income benefits are generally paid through an income rider that is deducted from the contract value each year. An income rider can vary from no cost to 1% or more each year.
Variable Annuities also charge an annual mortality and expense (M&E) charge to guarantee that the contract beneficiary receives at least all the premiums placed into the contract. These M&E charges will vary by company.
The investments inside of variable annuities will also have internal management costs similar to those of mutual funds.
The total annual costs for a fixed-indexed annuity are generally around 1% per year (although there are some companies that do not have annual costs).
The total annual costs for a variable annuity will vary, but can be in the 2.5% – 3.5% range or more depending on the total number of riders elected.
I personally believe as an advisor that those looking for guaranteed income in retirement should first evaluate the use of a fixed-indexed annuity because of the lower fee structure. In my experience, those who own variable annuities don’t substantially gain from the additional benefits they are paying for each year.
If you have any questions about the use of annuities in retirement, please contact me.