Kiplinger's
Personal Finance Magazine June 28, 2019
When you think
about retirement, what's your biggest fear?
If you're worried
about running out of money, you're not alone. Survey after survey has found
that building enough income to last through a long retirement is one of the top
concerns for baby boomers and the generations behind them.
Of course, there's
a good reason for their anxiety. Prior generations typically could rely on
employer-sponsored pension plans, as well as Social Security, to provide them
with guaranteed paychecks in retirement. But those pension plans are quickly
disappearing. And the future of Social Security seems to be constantly in
question. (As it is, if you have average earnings, the Social Security
Administration says those benefits will replace only about 40% of your income.)
Clearly, there's a
growing need out there for another source of guaranteed income.
According to
the 2018 Retirement Confidence Survey from
the Employee Benefit Research Institute, four in five workers expressed an
interest in the possibility of adding a guaranteed lifetime income product to
their portfolio, regardless of whether it was an in-plan investment option or a
separate product purchased at the time of retirement.
And yet, I wonder
what the response would have been if that same study had used the word
"annuity."
Actually, I don't
have to wonder. According to the 2018 Guaranteed Lifetime Income
Study by Cannex, though 73% of respondents reported high
interest in guaranteed lifetime income products, when the word
"annuity" was used, a third expressed a lower interest in the same
product.
I get it. All
annuities are not created equal -- and neither are the financial professionals
who sell them. The contracts can be complicated. Fees and commissions used to
be higher than they are now. And you still need a good guide to help you
understand exactly what to expect -- and what to avoid.
But annuities have
seen a tremendous evolution over the past 30 years -- and especially recently.
To broad-brush them all as unworthy is a mistake, particularly if you need
additional guaranteed income in your retirement plan.
I like to break up
the annuity "world" into several segments, each of which has its own
uses and may be implemented for people at different stages in life.
A
Matter of Timing
First, annuities
can be broken down based on when your payments begin:
I think of these as
the old-school annuities our parents would have had. They are, for the most
part, simple in concept: You give the insurance company a lump sum, and it
promises to pay you income for the rest of your life and your spouse's life, or
for a designated period. Just as you'd expect from the name, an immediate
annuity begins paying income checks immediately upon being funded.
There are many
nuances beyond those basics, but the bottom line is that you lose control of
the money you put into the annuity and shift all the risk to the insurance
company that guarantees it.
Who might be
interested in this type of annuity? Although this was once the only option for
anyone seeking a steady income stream in retirement, and is still often what
comes to mind when people hear "annuity," it's fallen somewhat out of
fashion because of the loss of control. Yet, for those whose No. 1 concern is
an income stream they can't outlive--trumping concerns about inflation, growth
or legacy planning -- this may be something they discuss adding to their
financial toolbox.
Most annuities sold
these days fall under the banner of the deferred annuity. Like immediate
annuities, they are intended for income and have an insurance component, but
they differ in that their incomes streams won't begin until a later date in the
future. Deferred annuities allow their contract owners the opportunity to grow
the value of the underlying contract using various crediting methods.
Who might be
interested in this type of annuity? Those who anticipate wanting a steady and
reliable income in retirement but who may not need that income stream right now
will likely consider a deferred annuity. Which one will largely depend on what
crediting method is most in line with their goals and expectations.
A
Matter of Math
Next, deferred
annuities can be broken down based on how your payments are calculated:
The growth rate for
the contract value in a fixed rate annuity is guaranteed by the insurance
company. The contract owner pays either a lump sum or a series of payments into
the contract, and that sum is credited growth by the insurance company at a
minimum fixed rate, usually pretty modest but hopefully enough to keep up with
inflation.
Who might be
interested in this type of annuity? Because of the fixed, regular credits of
interest, these tend to be suitable for folks who like to invest in similar
instruments, such as CDs.
These annuities
have market exposure through sub-accounts that look and act like mutual funds
and ETFs -- except the sub-accounts grow tax-deferred. The annuity works in two
phases. During the accumulation phase, you contribute money and allocate it to
the investment funds of your choice. Many times there are no investment
restrictions, and your adviser can help you build a diversified portfolio to
match your objectives and risk tolerance.
Of course, market
exposure comes with market risk, meaning that you could lose your contract's
credits and principal if there's a significant market correction. During the
payout phase, you receive income from your annuity most commonly as a series of
monthly payments that last your entire lifetime and your spouse's lifetime. It
is possible to take it as lump sum, but be aware of potential tax liabilities
and potential surrender costs if you make a large withdrawal too early.
Variable annuities
can carry higher expenses and fees than other types. And they may become even
more expensive if you add certain benefits (or riders), such as a living
benefit that provides income even if you outlive your investment, and a death
benefit that guarantees your beneficiaries will receive a certain minimum
amount of money as a legacy. The insurance benefits you purchase are added expenses,
which if used correctly, can create excellent value and are sometimes hard to
beat.
Who might be
interested in this type of annuity? For people who want the gains that can come
with market exposure and are OK with some volatility, variable annuities can be
a great solution. Many times these annuities make the most sense for those who
are further out from retirement.
These hybrid
products combine features of both variable and fixed rate annuities. Your
principal is guaranteed, as with a fixed rate annuity, but you also may get to
participate in some market-related growth. There are many variations, but the
most common types are cap-rate or participation-rate annuities. With a cap rate
of 6%, for example, the annuitant will enjoy market increases up to 6% but no
higher. With a participation rate, the insurance company allocates only a
portion of the growth of the index to the annuitant -- typically 35% or higher.
Both types usually
come with the promise that you won't lose anything to the market -- it's just
that your upside is limited. As with variable annuities, you can add living and
death benefit features to fixed index annuities -- at a cost. Many fixed index
annuities have no portfolio fees until you add benefits, which makes them
appealing to investors who are looking for an alternative to bonds.
Who might be
interested in this type of annuity? For those who have some time before needing
an income stream, and who would like the opportunity for higher gains but
without the risk to principal that comes from being exposed to market risk,
this absolutely makes sense. Especially as people approach retirement, it's
imperative that they search for guarantees for a portion of their portfolio,
but there are limited options, and often fixed index annuities can serve in
this role.
Some
Final Thoughts
These are just the
annuity basics; there are many factors to consider when choosing the right
product for you -- including liquidity, risk, fees, tax consequences and your
time horizon. Annuities are not backed by the federal government -- they are
the obligation of the issuing company, so it's important to shop around and
carefully research any potential investment.
Despite many
improvements to today's annuities, it's still a good idea to consult with a tax
professional and a financial adviser with a deep understanding of these
products.
Kim Franke-Folstad
contributed to this article.
Important
Disclosures:
Annuities are
long-term investments designed for retirement purposes. Withdrawals of taxable
amounts are subject to income tax and, if taken prior to age 59½, a 10% federal
tax penalty may apply. Early withdrawals may be subject to withdrawal charges.
Optional riders have limitations and are available for an additional cost
through the purchase of a variable annuity contract. Guarantees are based on
the claims-paying ability of the issuing company.
Variable annuities
are sold by prospectus only. Investors should carefully consider objectives,
risks, charges and expenses carefully before investing. The contract prospectus
and the underlying fund prospectus contain this and other important
information. Investors should read the prospectus carefully before investing.
For a copy of the prospectus contact your financial adviser.
Securities offered
through Securities America, Inc. A Registered Broker/Dealer. Member FINRA/SIPC.
Advisory services offered through Cooper McManus, a Registered Investment
Advisory Firm. Link Financial Advisory, Cooper McManus and Securities America
are not affiliated.
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This article was
written by and presents the views of our contributing adviser, not the
Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
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