After years of saving and accumulating, retirees and pre-retirees goal shifts and it’s now necessary to decide on how to source their retirement income. It’s good to assess the tools available and decide which ones you will utilize.
One of these tools are annuities. The challenge of evaluating annuities on your own is they can be confusing, several prominent financial media personalities are strongly against them, and they tend to be costly to reverse once you commit to using them.
Using an advisor can also be challenging. Advisors tend to have their own strong feelings toward annuities. Not to mention, their recommendations can be skewed by the financial incentive they get from selling annuities.
In this blog we discuss annuities, how they work, and how you can determine if they are right for you.
For the sake of brevity, we will focus on two types of annuities: immediate annuities and deferred indexed annuities.
The first thing to know is that an annuity is a contract with a life insurance company. Because the insurance company is providing certain guarantees, this is put into a contract.
A single premium immediate annuity (often referred to by its acronym, SPIA) is a way to convert a sum of money into ongoing income payments. These are the simplest form of annuities available in the marketplace with few bells and whistles to complicate things.
They are called “single premium” because they are purchased with a one-time sum of money. The payments start “immediately” or on a specified date in the near future. Because of these features, immediate annuities are typically used by retirees. They can take a portion of their retirement savings, buy an annuity, and enjoy ongoing monthly payments (usually guaranteed for the rest of their life). Pretty simple!
Why choose an immediate annuity?
- Safety of retirement income: annuities are contractual guarantees of the insurance company. They do not depend on stock market returns or future bond yields.
- High relative income: the safety of annuities is like that of government bonds, but annuities generate much higher income.
- Payments for life: longevity should be a consideration for every retirement plan. Fortunately, annuities can be structured to pay out for your entire life—even if you live much longer than expected.
Let’s look at an example of a 65-year-old male who is retiring and would like to utilize an immediate annuity with a $250,000 premium.
Based on rates at the time of writing, he can get around $1,600 per month from his $250,000 for the rest of his life. If he’s married and wanted the annuity to last for both his life and his wife’s life (who is also 65 years old), the payments would be around $1,365 per month (since the annuity will likely last longer with two lives covered, the resulting payments are smaller).
To put it in perspective, that’s a payout rate of 7.68% and 6.55%, respectively. From an investment consideration, you’ll be hard pressed to find rates that high that also come with contractual guarantees. For safe, conservative sources of income, it’s hard to beat an immediate annuity.
Why does an annuity have such high payout rates?
It’s worth getting in the weeds a little to understand why annuities work so well. No, the insurance company isn’t investing your money into risky assets. On the contrary—they are mainly buying safe government bonds. Since you can buy government bonds on your own (and they don’t yield anywhere near what an annuity pays out), there must be something else at work.
Life insurance companies do one thing really well—analyzing life expectancies for a large group of people. No, they don’t know how long any one person will live. But they do know that in a large group of people, some of them will die early, some at life expectancy, and some will live longer than expected.
Individually, a retiree doesn’t know how long he or she will live. As a result, they must plan for ways to make their money last, or risk running out of money. This “longevity risk” can be solved better by incorporating an annuity and pooling their money with other retirees.
When you purchase an annuity, you are doing this along with thousands of other people like you. The life insurance company is able to give you a high amount of income for your entire life because some people in the cohort will die early. Their payments will cease, so their account balance that’s left over contributes to the survivors.
The life insurance company knows this. That’s why they can give you a high amount of income right off the bat instead of giving you raises as people pass away. With a large enough group in the pool, the odds are overwhelming that some will die early and fund the income of those who live past their life expectancy.
This is the concept behind insurance—pooling risk. How is a life insurance company able to pay out a $1 million death benefit to someone that paid $50/month for an insurance policy? Because there are hundreds of thousands of other people paying premiums that won’t die while their policy is in force. I buy homeowner’s insurance because I’d rather pay a couple hundred bucks each month than come up with half a million dollars if my house burns down. Luckily, millions of others are doing the same thing. A large group of people that pool their risks allow insurance to happen.
You are comfortable buying insurance on your other assets, why not incorporate the same concepts into your retirement income plan?
Deferred Indexed Annuities
An immediate annuity is a great tool for retirees. What about someone still several years away from retirement?
A deferred annuity is an annuity that you can purchase today which defers your income payments to a future date.
This type of annuity is a catch-all for several types (fixed annuity, variable annuity, indexed annuity, QLAC), so I will focus on one popular type here—an indexed annuity with an income rider.
What is an Indexed Annuity with an Income Rider?
An indexed annuity is a way to accumulate money with downside protection. Your performance is linked to the performance of an underlying market index, like the S&P 500. If the underlying index increases, you get positive interest credited to your account value. If the underlying index decreases, you typically see no downside in your account value for that year. Because of this downside protection, your upside is limited, usually by a cap (e.g., a 6% cap) or by a participation rate (e.g., a 60% participation).
For example, if your indexed annuity was linked to the performance of the S&P 500 index, and the index increased by 12% in the first year, here’s how your return would be calculated:
- With a 6% cap: your return would be 6% (12% capped out at 6%)
- With a 60% participation rate: 7.2% (12% x 0.60 = 7.2%)
In year two, if the S&P 500 index declined by 12%, your return would be 0% in both instances.
The indexed annuity can be used as an accumulation vehicle like mutual funds or bonds. You don’t have to use it to provide a stream of income. A popular option is to add a rider (an additional benefit) onto the annuity that guarantees a future income stream.
Let’s use the example of a 55-year-old worker who wants to plan for retirement at age 65. She wants a conservative way to invest a portion of her nest egg over the next 10 years. Since this money will be used to generate retirement income, she is looking at an indexed annuity with an income rider.
This particular annuity is linked to the performance of the S&P 500 index. As explained earlier, each year she will get interest credited to her account value if the index is positive. She won’t lose any money due to poor market performance. But this is secondary. Her main concern is the income rider.
This particular rider has a completely separate value, called an income benefit value that is guaranteed to increase by 7% each year until she decides to start taking income. For example, an investment of $250,000 will mean her income benefit value will increase by 7% ($17,500) each year. After 10 years, the income benefit value is guaranteed to be $425,000.
Furthermore, if she decides to take income at age 65, she is guaranteed an income equal to 5.5% per year of the value of the income benefit value. In her case, 5.5% of $425,000 = $23,375. She knows in advance that she will be guaranteed $23,375 each year for as long as she lives, regardless of the future performance of stocks and bonds.
The reasons for using this type of annuity are simple:
- Guaranteed future retirement income
- No stock or bond market risk
- High amount of future annual income
Can she do better in a different type of investment? Possibly. But someone who chooses to do an indexed annuity like this isn’t concerned about maximizing their return by investing in the market. She prefers a retirement income solution that provides conservative growth and contractual guarantees.
How to evaluate if an annuity is right for you
An annuity can be a good solution for you if the benefits justify the costs. But there are other solutions available to generate income, namely stocks and bonds. So, which strategy is better?
I believe the first step to determining if an annuity is right for you is to discover your preferences for sourcing your retirement income. The different strategies of generating retirement income are all viable. Advisors and researchers can make compelling cases for any option. But if your own personal preferences don’t line up with the strategy, retirement won’t be a fun journey.
That’s why we are offering the Retirement Income Style Awareness® (RISA®). The RISA® is a simple questionnaire that helps you choose what retirement plan feels right for you. The solution is to lead with yourself—discovering your preferences and creating a retirement income plan around your style.
The RISA® is best for someone who is retired or who is less than 10 years away from retirement. The questionnaire is taken online, and your results can be reviewed and explained by one of our financial advisors.
There is no cost to take the RISA® questionnaire. After taking the RISA®, you will:
- Learn about the four types of retirement income strategies
- Discover your own personal style for sourcing retirement income
- Receive recommended tools to utilize in your retirement income plan