Very few financial products have as much negative press and consumer resistance as annuities. Yet, most all independent research1 tells us that annuities enhance retirement income, that retirement is better by adding an annuity. Why are consumers and the community of financial advisors so opinionated about annuities? Could it be that we all apply the worst horror story they have heard about any annuity to all annuities?
There are at least four different types of annuities: immediate, fixed, fixed index and variable. For simplicity, I will refer to fixed indexed annuities as “indexed annuities.” While each one has its pros and cons, any of them can provide lifetime income. Immediate annuities are all about income. There is no growth period prior to taking income, and no residual value passing to beneficiaries. This may be a cause of alarm to many, while perfect for others.
The remaining three types of annuities offer tax-deferred growth and an option of lifetime income. Fixed, indexed and variable annuities can provide lifetime income with the residual value passing to beneficiaries.
So why do the mathematically analysis of unbiased experts prove the worth of annuities for retirement success? It’s because the conversion of an asset into income—a prime objective for most of us in retirement—is done more efficiently using an annuity than anything else. Is it guaranteed to provide more income than using stocks or bonds? No. Annuities may or may not provide more lifetime income than other options, but the probabilities fall in favor of annuities. Annuities are designed not to fail; to remove the possibility of market and interest-rate risk reducing your income or running dry.
Money placed into annuities should be long-term money, seeking low-risk growth (Fixed annuities and Indexed Annuities) or lifetime income. Short-term money, and money dedicated to covering emergencies should typically not be placed in an annuity. That’s because most all annuities have a surrender period, during which a certain portion (commonly 10 percent a year) is accessible without penalty. Withdrawing large amounts in any one year would incur a penalty for early withdrawal much like a CD or a B-share mutual fund. After the maturity date 100 percent of the account value is accessible. Annuities are appropriate for money that you count on to provide income for life.
Does this mean there is no flexibility? Today’s indexed annuities can offer you full control of numerous options. Many offer tax-deferred growth, full penalty-free withdrawal in case of a long-term care need, a terminal illness or death, a guarantee of a lifetime income, access to your full account balance (less any applicable early surrender penalties) at any time, even a “health-care doubler” that doubles income in case of a long-term care need, and finally the transfer of the account’s value to your beneficiaries.
The core structure of an indexed annuity involves: 1) no stock market exposure, so no risk of loss to market declines, 2) growth calculated as a percentage of the stock market’s growth, and 3) lifetime income calculated by growing the asset at a committed annual growth rate (currently 5-7 percent compounded) and withdrawing a percentage every year based on the ages of the owner and spouse. Currently 5-7 percent are common withdrawal rates.
While stocks, bonds, mutual funds and variable annuities can be much more glamorous (and at times terrifying), indexed annuities offer these advantages: 1) tax-deferred growth, 2) principal protection from market risk, 3) reasonable growth compared to CDs and the post-2000 stock market experience, and 4) lifetime income in excess of variable annuity guarantees and in excess of prudent stock or bond investment withdrawal rates. Variable annuities fall into this category of stocks bonds and mutual funds, because most all Variable annuities hold your money in mutual funds, called sub-accounts. Consequently, a variable annuity offers greater growth potential in up markets than Indexed Annuities, but also substantial risk of loss and weaker lifetime income guarantees.
The limiting factor for stocks, bonds, mutual funds and Variable Annuities is market volatility. The unfortunate reality is that once you begin withdrawing from your nest egg, market volatility overcomes the power of growth. In other words, you might average 10 percent a year but find that a 4 percent withdrawal rate depletes your account in less than 30 or even 20 years.
A good retirement plan will split money into buckets, each designed to accomplish a certain goal.
1) Adequate money should be kept for emergencies or opportunities. Usually the bank is the most appropriate custodian.
2) Next, sufficient money should be allocated to annuities to provide predictable, dependable lifetime income to pay the bills.
3) A third bucket is used to grow money for future needs in a liquid manner.
4) A fourth bucket may be desired to grow money for special purchases, future charitable gifts, gifts to children and grandchildren for college or weddings, etc. and perhaps for life insurance to provide income-tax free growth to your loved ones.
I find that more and more families planning for retirement are turning to annuities. Once they realize the pros and cons of each type, they’re able to decide and choose the one that best fits their desire. Some need the glamour of the stock market; more conservative investors are learning to appreciate the predictability of annuities.