It’s been 10 years since the 2008 financial crisis, and discussions between advisers and investors are more likely to focus on when—not if—the next market downturn will happen. As you sit down with your adviser to explore how you can better prepare for and live in retirement in the face of this challenge, annuities might be part of the conversation.
Whether you are between the ages of 45 and 55 and looking to maximize the benefits of tax-deferred accumulation, or in your 60s and ready to begin generating an immediate stream of protected retirement income, there are annuities that may fit your investing needs.
Retirement: 5-year countdown
You may be hearing more about annuities lately. And that could include some warnings — that annuities are expensive and complicated. But there are many types of annuities, and they can be an essential part of a comprehensive retirement plan.
If you’ve been thinking about an annuity, or your adviser suggests investing in one, there are five questions you should ask—and important answers that you need—to determine if it is the right solution to help you reach your financial goals.
How does an annuity help me in retirement?
Many investors say that running out of income in retirement is their No. 1 fear. Tax-deferred qualified retirement accounts such as a 401(k) or IRA allow investors to accumulate assets that they will then draw down in retirement. But those assets—and that income stream—can be subject to market risk. An annuity, on the other hand, is like an insurance policy for your retirement, that can convert your investment into a guaranteed stream of protected income for specific period of time, or even income for life.
There are so many options. How do I determine what is right for me? For starters, you can control when you will receive income from your annuity by choosing between deferred or immediate annuities. Deferred annuities allow investors to grow assets tax-deferred, over years or decades, before choosing how to generate an income stream. Immediate annuities, such as a single premium immediate annuity (SPIA), will begin income payments soon after making an initial lump sum investment, and typically are a better fit for individuals when they are ready to begin their retirement.
You can also choose from annuities based on the growth potential of the assets that you’ll be investing. There are variable annuities, where returns are tied to market performance for greater growth potential—but with more risk as the contract value fluctuates based on the market’s ups and downs. Indexed annuities can provide some upside potential when markets rise, but also offer protection from market downturns. There are fixed annuities, which provide a guaranteed interest rate, regardless of what may happen in the market. In recent years, many advisers have been recommending fixed index annuities (FIA) as a better bond alternative.
What are some fees I may be charged?
Just like other retirement accounts, such as a 401(k) or IRA, there are also expenses associated with annuities. Fees for variable annuities can easily total 3% a year or more. The industry average for five typical fees include:
1) mortality and expense fees (M&E): 1.35%
2) administrative fees: 0.10% - 0.30%
3) investment management fees charged for the underlying funds inside the annuity: 1.00%
4) fees for optional riders or insurance guarantees: 1.00%
5) surrender fees which may be charged for withdrawing funds from an annuity too soon: as much as 8.00%.
There may also be commissions that an insurance company pays to the broker or agent who sells the annuity, typically ranging from 5% to 9% of the amount you invest. This may lead directly to the size of the surrender fee, as well as impacting the overall cost. Your adviser can explain all of the fees associated with an annuity, and help you evaluate them.
If fees are a concern, consider low cost and no-load annuities when determining which annuity will fit best into your overall financial plan. These low cost, no-load annuities often charge an M&E that is one-half to one-fourth of the industry average, or even a flat subscription fee, eliminating commissions and other insurance fees. The tradeoff may be limited access to insurance guarantees and limited downside protection.
Is the income truly guaranteed?
Annuities can offer many choices for guaranteed income, from the simplicity of an immediate annuity, to a range of different optional living benefit riders that are designed to protect portfolio assets or income payments when markets decline. Some of these living benefits provide guaranteed income even if the underlying investments lose value. As another solution to protect against market risk, investors may be able to purchase an optional Return of Premium rider (ROP) to guarantee their initial investment.
Because the annuity is a contract with an insurance company, the guarantee of future payments is based on the financial strength of the insurer. Insurance companies are highly regulated, with strict requirements related to their investments and capital reserves. Their financial strength is regularly reviewed and rated by five independent firms: A.M. Best, Fitch, Kroll Bond Rating Agency (KBRA), Moody’s and Standard & Poor’s, each with their own rating scale and rating standards.
In addition, each state has a Guaranty Association to protect policyholders in the unlikely event that the insurance company is unable to meet their financial obligations. A study by the U.S. Government Accountability Office determined that even following the profound effects of the 2008 financial crisis, the impact on the majority of insurance companies and their policyholders was limited, with a few exceptions.
Are there other ways I can use my annuity?
Advisers can recommend many ways that annuities can be an effective financial planning tool to meet a range of investing needs at all different stages of the financial lifecycle. For example, investment-only variable annuities (IOVAs) are built specifically to maximize the power of tax-deferred accumulation—with lower costs, more fund choices and sophisticated portfolio management platforms.
IOVAs can be beneficial for high earners and those with high net worth, who can easily max out qualified plans, such as 401(k)s and IRAs, and are looking for another tax-advantaged investment vehicle. With virtually unlimited contributions, IOVAs can also be used to shelter a large cash infusion, such as the proceeds from selling a business. And tax-inefficient asset classes, such as fixed income, commodities, dividend-yielding stock and liquid alternatives, can be “located” in IOVAs to increase returns—without increasing risk.
Annuities can also be used for tax-efficient legacy planning. Many offer a range of optional death benefits, from a lump-sum payment to a guaranteed income stream for heirs. These proceeds typically receive favorable tax treatment, and can be transferred to heirs without the hassle of probate and legal fees. Some annuities offer a restricted stretch provision, to minimize the tax burden of a large inheritance by spreading taxes over a beneficiary’s lifetime, while controlling distributions to heirs with less complexity and expense. Advisers can also help clients with a tax-efficient strategy to fund trusts in a low-cost IOVA, allowing the assets to accumulate and grow tax-free.
Remember that annuities are long-term investments and should be considered carefully. They might not make sense for investors who want immediate and unrestricted access to their capital, because the tax-deferred structure means certain kinds of withdrawals may incur tax consequences. But for other investors who don’t have immediate liquidity needs, especially high earners and the high net worth, annuities might fit within their financial plan.
Before investing in an annuity, work with your advisers to determine your retirement income needs, evaluate liquidity needs and create a holistic picture of your existing retirement income sources, including qualified retirement plans. Then ask your adviser the right questions, including if they operate under a fiduciary standard, and get the answers you need, to determine if an annuity might fit within your holistic financial plan.
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