By Ryan O’Leary
As more Americans near or enter retirement, generating income from investments becomes a top priority. While there are a number of different ways to create a stream of retirement income, annuities are a particularly compelling option since they can promise what no other investment can—tax-deferred growth and guaranteed lifetime income.
Annuities are complex investments, so it pays to learn more about them before making any decision to invest in an annuity.
The first thing to understand is that there are four basic types of annuities: Fixed, Immediate, Variable, and Fixed Index. Let’s take a closer look at each type.
Fixed annuities are the simplest and easiest to understand. You give the insurance company an investment (typically one lump sum) and in return they pay you a stated guaranteed interest rate for a stated term, e.g., a $100,000 at 4% per year for 5 years. Some carriers will let you withdraw the interest payments or a certain percentage of the contract each year, while others do not allow any withdrawals during the term of the contract.
A fixed annuity is comparable to a bank Certificate of Deposit (CD) or bond investment, though it does not offer the FDIC insurance protection of a CD; nor is it subject to daily price fluctuations of a bond investment.
Unlike CD’s or bonds, fixed annuities grow tax deferred. This can be an attractive feature for someone interested in minimizing his or her current taxes. Taxes will eventually come due upon withdrawal of those earnings, but because it may happen during retirement, the income may be taxed at a lower rate.
Fixed annuities can be an attractive alternative to CD’s or bonds since the rates they offer are typically better than you would get for a CD of a similar term. Unlike bonds, whose value may move up or down, a fixed annuity’s value is not subject to market changes.
At the end of a fixed annuity’s term, you can choose to reinvest for another term or liquidate the annuity and have your principal investment and interest earnings returned to you.
While fixed annuities are most often used for accumulation purposes, immediate annuities are used for distribution purposes. In an immediate annuity contract, you agree to give the insurance company a principal investment in exchange for an income stream that you and your spouse, in the case of joint contract, cannot outlive. It is very similar to electing a pension payout versus a lump sum payment. There is a risk that, in the event of a premature death, you (and your spouse) may have surrendered a substantial chunk of savings for a short period of income benefits. That said, the biggest risk in retirement is outliving your money, so an immediate annuity does offer the benefit of knowing that, for as long as you are alive, you will receive an income stream to supplement your Social Security and your other investment income.
Variable annuities are much more complicated and therefore much more susceptible to misunderstanding and potential misrepresentation. Unlike the fixed annuity, you do not know what the earnings will be on your principal investment. That’s because your principal is invested into market investments (like a 401k) called sub-accounts. You typically can make changes to those investments to be more aggressive or less aggressive and there is no guarantee against principal losses.
The biggest drawbacks with variable annuities are their cost and lack of principal protection. Many will offer guarantees in the form of either an income rider or death benefit rider, which can be costly to add to the policy, but do nothing to protect your investment principal. Ultimately, it’s up to you to determine if the additional fees are worth the tax-deferred and lifetime income benefits.
A type of annuity that is gaining popularity is the Fixed Index Annuity (“FIA”). Unlike variable annuities, FIA’s are generally principal protected, which means that you cannot lose money in an FIA due to a market decline (you can lose principal due to fees and charges). It is the only market-based investment that is guarantees your principal investment. (This guarantee is only as good as the insurance company behind it.)
If your main priority for a particular investment is to earn market-based returns without the risk of losing principal, with no need for full access to your funds, then an FIA can be a good choice.
I find the principal protection to be a compelling reason to consider an FIA for a portion of your portfolio. Interest rates have been on a steady decline since the 1980’s and it is hard to find safe investments that outpace inflation. And for some, stock market volatility is just not something they are comfortable with, even though they know that stocks are one of the few ways to outpace inflation over the long run. FIA’s can fill that gap between stocks and bonds. Moreover, FIA’s are increasingly becoming more diversified in terms of the underlying index that determines the rate of return. In other words, you can choose between US and International Stocks, or an index that contains both, as well as bonds and commodities – all the things that you would want to own in a diversified portfolio.
The key with annuities is that they are PART of an overall plan and are not meant to be the only investment for your liquid net worth. The devil is always in the details of the individual contracts. Make sure you understand how you can access your funds and what penalties you will have to pay and for how long. If you elect any riders, make sure you understand them and they fit into your overall financial plan.
Ryan O’Leary, CFP ® is a Senior Vice President, Investments with Rockport Global Advisors and a subscriber to MyPerfectFinancialAdvisor