June is National Annuity Awareness Month. To honor that I’m kicking off the month with a video and article discussing the basics of annuities.
If you are retired, or approaching retirement, it is essential that you understand annuities.
Why, you may ask?
Because as you approach that date when you will quit your full time job, you will realize that your paycheck will go away. If you are lucky you may have a pension.
It likely will not be enough to cover your monthly expenses.
You will then look at your Social Security income. It, too, will probably not be enough to cover your monthly expenses.
To fill in the remaining gap between your monthly income and monthly expenses, you will have to withdraw money from your retirement nest egg.
This is the tricky part.
There are so many different strategies for withdrawing money from your nest egg. Some advisors advocate an approach that leans heavily on guarantees and safety. In other words, mostly annuities.
One risk with this strategy is there may not be enough of a growth component to your portfolio to help you offset the effects of inflation throughout your retirement. FYI, retirement can be a long time and inflation can do a lot of damage in that time period.
Other advisors advocate withdrawing money from your portfolio that is invested in the market. They point to studies done in the past showing that if you withdraw just 4% of your portfolio each year you will have a high likelihood of not running out of money in retirement.
One risk with this strategy is you may have a couple years at the beginning of your retirement where your portfolio does not perform well. If your portfolio gets hit hard with losses at the beginning of your retirement (while you are withdrawing funds from it) you can seriously be set back. Potentially you could even run out of money in retirement.
A more balanced approach includes some of the guarantees of annuities with a portion of the portfolio invested in the market to also benefit from potential growth. This helps the retiree walk the line between the need for guaranteed income as well as the need for growth to offset inflation.
Whichever method is used, one thing is certain: most retirees have a gap to fill between the amount of income they will draw in retirement vs. the amount of monthly expenses.
Your goal should be to fill this gap in as low risk and low cost a way as possible that will give you the best likelihood of success over the length of your retirement.
Annuities will likely serve a role with filling this gap.
So you need to make sure you understand how they work, the different types of annuities, and the pros and cons of annuities.
The 2 main types of annuities are:
- Variable Annuities
- Fixed Annuities
Since this article is all about the “basics of annuities” I’m going to give you a “birds-eye-view” of them. This will help you understand the big picture when you are trying to make a decision.
It will help you understand the right questions to ask your advisor as well. It may even show your advisor that you are an informed “high information” consumer. So he or she better shoot straight with you because you’ve done your research.
Let’s talk about Variable Annuity Basics
Variable annuities take your money and invest them in sub-accounts (these are like mutual funds). The sub-accounts can go up and down in value.
If the sub-accounts perform well, your variable annuity value will go up.
If the sub-accounts perform poorly, your variable annuity value will go down.
There are no guarantees when it comes to how your sub-accounts perform. This is important to remember.
When you put together a retirement income plan for your future, you have no way of knowing what kind of performance variable annuities will give you. You may get growth from them and you may not. But you won’t get much on the contractual guarantee side.
“But wait!” you say. “They have the potential for growth. Couldn’t variable annuities be used for the component of your retirement income plan that is devoted to growth potential to offset the effects of inflation?”
Good point. You could use them for this. But you have to ask yourself if that is the best way (in other words the most low risk and low cost way) to achieve your portfolio’s growth needs in retirement?
Speaking of “cost” let’s take a look at some variable annuity fees.
Annuity Basics – Variable Annuity Fees
Variable annuities are notorious for having high fees. The 4 main fees of variable annuities and the approximate costs that you may pay with these fees are:
- Mortality and expense – 1.5%
- Management fees – 1.5%
- Income rider (optional) – 1.0%
- Administrative fee – 0.15%
These fees can add up to over 4%, depending on if you attach an optional rider to the contract.
Now, there are some variable annuities in the marketplace that have lower fees. These are called “no load” variable annuities. The main fee associated with them is the management fee of the sub-accounts. These types of variable annuities can have fees under 2% since they are no load.
No-load variable annuities are typically used as a vehicle to put your non-qualified money into a tax deferred financial product. Earnings within any annuity are tax deferred until you withdraw them.
Therefore, it may make sense to use no-load variable annuities for your non-IRA money (i.e. non-qualified) money. The earnings grow tax deferred until you withdraw them.
The downside to that is you pay income taxes on the earnings when you withdraw them out of the variable annuity. Income taxes can be higher in many cases than capital gains taxes. So it may not always make sense to go for the tax deferral if it means you paying a higher tax rate upon withdrawal. Each individual’s situation may be different on what is best.
But remember, it’s what you keep that counts.
So there may be a place for no-load variable annuities. But your typical variable annuity will have the fees that I mentioned above. And the fees can be rather high.
Pros to Variable Annuities
Some of the pros to variable annuities include tax deferral. Tax deferral helps you accumulate more money by deferring the day you pay Uncle Sam.
But keep in mind, all annuities defer taxes until earnings are withdrawn. This is not unique to variable annuities.
Another pro to variable annuities is that they do offer some contractual guarantees through their income riders. But often times the insurance company will restrict the types of investments you can have in your sub-accounts if you attach an income rider.
They don’t want you taking a lot of risk in your sub-accounts if they have to be on the hook to guarantee you a certain payout from an income rider. If you lost too much money from risky sub-account investments, the insurance company will still have to find the resources to meet the contractual guarantees they made under the income rider.
Their solution is usually to limit your investment options to more conservative choices when you have an income rider. If that’s the case you could have just gone with a fixed annuity that is very conservative anyway. (And typically will have lower fees.)
Another pro to variable annuities is the death benefit. Many variable annuities will put a death benefit in place that will return your original investment (less any withdrawals) to your beneficiary.
The typical sales pitch you will hear for this goes something like this:
“You have the potential for your investment to grow with the market. And your original deposit is guaranteed to be paid out to your beneficiary, even if the value of your variable annuity goes down. It’s the best of both worlds: Principal Protection and Market Growth Potential. ”
The death benefit can be helpful if the value of your annuity went down due to poor sub-account performance. At least you’d know that your beneficiaries would get the original amount you put in (less withdrawals).
But keep in mind… you have to die for it work. It is a death benefit, you know.
Downsides to Variable Annuities
Some of the downsides of variable annuities include the fees obviously. These can put a big drag on your performance.
Also, they don’t have as many contractual guarantees as fixed annuities. You can lose money with these contracts. The performance of your sub-accounts is outside of your control.
So if you are looking for contractual guarantees, variable annuities may not be the best place to look.
Also, while the death benefit is a perk, you have to die. So there is always that.
Annuity Basics – Fixed Annuities
The other main type of annuity is the fixed annuity. These work differently from variable annuities.
With a fixed annuity your money is not invested in the market, so you have no market risk. If the market goes down, you do not lose money with a fixed annuity.
Most fixed annuities have no fees, such as the Single Premium Immediate Annuity (SPIA) and the Multi-Year Guarantee Annuity (MYGA). Even fixed index annuities can have no fees if you choose to not attach an income rider to them.
This is important to remember. When you hear articles in the financial media bashing annuities for their high fees, they are typically talking about variable annuities.
Fixed annuities also have more contractual guarantees. Since your money is not in the market it can’t go down with the markets. This can be very important to retirees that don’t want to have much risk in their portfolios.
Here are some of the common types of fixed annuities:
- Single Premium Immediate Annuities (SPIA)
- Multi-Year Guarantee Annuities (MYGA)
- Fixed Index Annuity
- Hybrid Annuity
Before we go any further, let’s go ahead and mark off Hybrid Annuity. It’s simply a marketing phrase. It usually means a fixed index annuity with an income rider attached to it. A Hybrid Annuity is really not even a real thing. And I hate the term. But you’ll see it out there all the time so I wanted to mention it for you.
SPIA’s are a type of fixed annuity that begins to immediately (or within 12 months of purchase) paying you an income. You can specify how long this income should last, even going so far as the rest of your life (or your spouse’s life).
Most SPIA’s do not have a provision to increase your income stream over the years to overcome inflation. So that is a downside. But in a properly built income plan, you should have a growth component that has the potential to outpace inflation.
MYGA’s are like CD’s. They guarantee an interest rate for a certain period. You can choose from 3 years of a rate guarantee, to over 10 years if you’d like. And since they are an annuity, the interest earnings grow tax deferred inside the MYGA until you pull the money out. A non-qualified bank CD does not have this benefit.
The fixed index annuity credits interest to your account based on how an index (such as the S&P 500) performs. If the index goes up the fixed index annuity will participate in some of the gain. If the index goes down, the value of your fixed index annuity will not go down with it.
You won’t get the full participation in the market due to “cap rates.” But the trade off is that you won’t lose money if the index goes down.
Pros to Fixed Annuities
The pros to a fixed annuity include low (even no) fees. Unless you attach an optional rider to a fixed annuity, there is a good likelihood it will have no fees.
SPIA’s and MYGA’s do not have fees. Even fixed index annuities can have no fees if you don’t attach an income rider.
Fixed annuities also provide contractual guarantees. This is very important when you are planning for your retirement income. With the contractual guarantees you can know what level of income you will have guaranteed to you in the future. This gives you predictability when making a plan.
The fixed index annuity can be a good vehicle for income riders. These help you with your retirement income planning as well. Expect to pay a fee for an optional income rider. The fee could be around 0.70% to 1.0%.
And the Multi-Year Guarantee Annuities (MYGA) provide a contractually guaranteed interest rate for a specific time period. And like all annuities, the interest credited grows tax deferred until you pull the earnings out of the annuity.
Downsides to Fixed Annuities
The downsides to fixed annuities include surrender charges. Even variable annuities will often have these surrender charges. So make sure before you purchase an annuity that you understand the purpose and can commit to it for the duration of the surrender charge.
MYGA’s can have interest rate risk. If you lock in a rate for say 5 years, then if rates in the economy rise you may miss out on the higher rates because your money is inside the 5 year annuity.
A way to minimize this risk is through “laddering,” by spreading your purchase among annuities with different maturities. When one annuity matures you can take that money and invest it at the higher rate prevailing in the market.
And lastly, fixed annuities are conservative financial products. This means they should not be expected to grow as much as more aggressive financial products (like an index fund that tracks the S&P 500).
Ultimately, with less of a growth component, fixed annuities may not keep up with inflation as well as more aggressive growth financial products.
But the flip side to this argument is that they are conservative products. And you can’t lose your money in them due to market down turns.
I believe that fixed index annuities get a bad reputation a lot of the time because they may be over hyped by a few insurance agents. The typical sales pitch for a fixed index annuity will go something like this:
“You get to participate in the market upside but you have no risk of losing money. It’s the safe way to invest and make a lot of money without ever risking your money in the market.”
While it’s true that you can’t lose money when the market goes down, you also won’t participate in all the market growth when it goes up. Fixed index annuities will put “caps” on how much of the market upside you get credited to your account.
It’s a trade off between risk and return. If you don’t have your money invested in the market (with the risk that accompanies that type of investment) then don’t expect a market-like return.
Fixed index annuities were originally made to compete against bank CD’s. And they can often outperform them. They should be explained for what they were designed to do.
And any comparisons between a fixed index annuity and the S&P 500 index should be looked at with one raised eyebrow. They are apples and oranges. Not a fair comparison.
If you are researching annuities before making a purchase, then do your research carefully. You don’t want to make a mistake with your hard earned retirement nest egg by purchasing a product that is not right for you.
To learn even more about annuities and how to avoid mistakes when purchasing one, you can download my free ebook “How To Avoid Annuity Traps.” Just CLICK HERE.
It goes into even greater detail than this article did.
And if you know someone that is considering purchasing an annuity, forward this article to them. Who knows, by you doing that if could potentially save your friend from making a bad decision.
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Thanks for reading. And best of luck with your retirement planning!