Annuities have had a bad reputation for many years due to its complexity and fees. However, due to the economic climate changes, these types of retirement products are becoming more valuable to your retirement income planning than ever before! I am going to give you the good, the bad, and the ugly of annuities in order for you to make a better educated decision on which type of annuity to purchase for your retirement (income) portfolio.
1) General Annuity Features including their pros/cons
2) Types of Annuities including their pros/cons
3) Contract features within a annuity
4) Personal opinion on which annuity is right for you and when to purchase them
Part 1. General Annuity Features including their pros/cons
Annuities are offered by an insurance company rather than a brokerage firm. These types of products can be compared to a pension plan with the exception that annuities tend to go with inflation thereby giving you the upper hand. General annuities have many features that you should be familiar with. One of the most important benefits is it will pay you an income for life. In other words, your account will not be depleted and you will always receive an income off the amount you have put into the annuity and the percentage/dollar you will receive. This is guaranteed. So if you live to be 110, you will still be collecting from that annuity.
The next benefit that all annuities include is that all interest earned are tax deferred. Because the IRS sees this as a retirement account it will be treated as such. Many people argue that they can get the same interest from a CD however CD’s are FDIC insured which makes this product HEAVLY TAXED.
For example: You invest $100,000 into a 30 year CD earning 3% with a tax bracket of 39%. In year 10 you have earned $119,882; year 20 = $143,719; year 30 = $172,294 after taxes. However in an annuity earning the same interest you would have earned the following respectfully $120,978; $149,173; $187,063.
Now remember, you have earned more money and you have an income for life whereas your CD is paid to you in lump sum and you either reinvest or simply deposit the cash into a savings account in which the interest you earn in the savings will, again, have tax implications. Let’s also remember that annuities tend to move with the rate of inflation (minimum) therefore not only do you have to pay taxes, you will be losing money if you are not earning the same or more than the CPI (Consumer Price Index= The measurement of inflation).
All annuities have a death benefit just like an insurance policy. If you have invested in an annuity and the annuitant (those that will/are receiving the annuity pay) has an untimely death, the assets will be transferred to the beneficiary that was listed on the annuity. This is ideal for estate planning since the proceeds with pass directly to the beneficiary without delay, expense, and probate!
Unlike a 401k and IRA (Individual Retirement Accounts) that can be depleted and has a contribution limits, there are also no contribution limits for annuities. You can easily deposit large sums of money to an annuity without any concerns. Some insurers have high contribution limits in which you just open another annuity and continue adding to your retirement portfolio. Either way, there is no limit.
Annuities have a variety of payment options to you including the following:
– Annuitization (the most popular one and personal favorite: payment for the remainder of your life)
– Lump sum distribution (one- time payment)
– Periodic distributions (per month, quarterly, yearly, etc.)
– Systematic Distributions (a fixed or variable amount sent to you on regular intervals)
The IRS views this as a retirement vehicle and as such you cannot withdrawal until the age of 59 ½. If you do, penalties will occur. The same goes for other retirement plans so this should NOT be a surprise.
Some other miscellaneous features include easy maintenance and no 1099 for income earned on the annuity contract as well as the ability to exchange older non- performing annuities into a newer fixed annuity without any tax implications (IRS section 1035). However, be warned that if it’s an exchange within a certain time frame (depending on the insurance company) into another insurance company product, fees may be charged. This is called the surrender charges and it varies by each company.
Surrender charges should be one of the main cons you should keep an eye out for when choosing which annuity for your retirement account. These fees range so far out that it can’t truly be listed but I believe it is safe to say it can range as high as the sales charge themselves! Surrender charges are implications in which the insurance company forces you to keep your money in the annuity for a specific time which is usually 7 years. This really should not be a concern since this is retirement money so you really should not be investing in annuity anyway if you’re unsure you will need these funds within 10 years. There are annuities that do not have these charges and will be explained in part 2.
Premiums (fees) to participate in an annuity are a big concern and the ranges vary depending on age brackets and company. It covers MOST of the fees in which includes the following (VERY IMPORTANT NOTE: These are average amounts and NOT all products have these fees!):
– The Morality and Expense risk charge (M&E) is charged against the value of the sub accounts and is usually 1.25% of the portfolio value.
– Administrative fees are charged for record keeping and other misc. expenses and is paid yearly at an average of around $30 pr 2%, whichever is LESS.
– Management fees are charged 1.5% a year on average and just like it sounds, it pays for managing the portfolio.
The safest bet is you will be paying a range, on average, from 3%- 8% upfront and approximately (again, not all annuities have these fees).5- 2% a year. These fees are higher depending on how young you are. This is due to the accumulation period (earning more there by having your value increased higher in which you will be receiving higher pay). In my honest opinion, with benefits like annuitization and tax deferred, it is worth the cost! No other retirement product offers guaranteed income for life.
Part 2. Types of annuities
This is where most people get a bad experience with annuities. They choose an annuity that they do not qualify for or do not understand and things turn soar. There are 4 major types of annuities: Fixed, Indexed, Variable, and Immediate.
– Fixed/Traditional Annuity: This type of annuity is almost identical to CD’s in which you are guaranteed to earn X amount of percentage for a certain amount of time. After the time expires, the annuity rate is reset annually by the insurance company. In most cases it is by the rate of inflation (Consumer Price index). Major difference compared to CD is the guaranteed income for life and it is tax deferred.
– Indexed Annuity: This product is unique in which you are correlated with a particular stock market (in most cases the S&P) and have a guaranteed minimum. For example, you have a guaranteed minimum of 1.5%. If the market crashed (such as what happened in 2008 and most people lost half of their retirement), you will still earn a minimum of 1.5%. Indexed annuities also have a maximum cap. So if you have a cap of 10% and the market earns 15% or even 30%, you will only earn 10%. This is what is called an opportunity risk. These rate of returns are based on your chosen options on how it will be measured which can be month- to- month, yearly, point- to- point (depends on the insurance company and/or you), or quarterly. The longer the time usually means the higher the rate. As long as you have a guaranteed minimum and able to participate in some upside in the markets, the opportunity risk is worth taking for most investors.
– Variable Annuity: Unlike fixed and indexed annuities that have a fixed earning potential. A variable annuity correlates with the markets or particular investments within the annuity. Remember, it does have all the tax and income benefits BUT like a mutual fund, the value itself will rise and fall depending on the investments within the vehicle. In other words, your principle is NOT protected. With premiums and surrender charges higher than fixed, indexed, and immediate annuities, my personal opinion is if you qualify for investing in a variable annuity, just invest in ETFs (Exchange Traded Funds) in an IRA. You are taking the same amount of risk so it is not worth the extra fees (all fees mentioned in part 1 apply to this type of annuity indefinitely). Some will disagree with me but those that do tend to sell this type of product for its very high commission which makes their credibility almost irrelevant.
– Immediate Annuity: Also called a “Single- Premium immediate annuities”, this is a safe vehicle that pays an income for life after you pay 1 lump sum. The problem is the lump sum should be enough that it is worth the income (usually anything over $150,000 is fine but also depends on your life style). This product is great for those that plan on retiring in less than 6 years.
These types of annuities are broken down to 2 categories, qualified and non- qualified. The simplest way to understand these categories are simply distinguished by the way it is funded with before taxes (qualified) or after taxes (non- qualified). Qualified annuities are usually built within retirement accounts (such as 403b/457). The major difference for a qualified annuity is:
- Contribute with pre- tax dollars
- Contribute based on “work” earnings
- Yearly contribution limits
- Direct rollover accepted to another qualified plan
- Withdrawal requirements at age 70 ½
Non- qualified plans have none of these. In most cases, if you purchase an annuity, it will be nonqualified.
Part 3. Contract features within a annuity
Most annuities have certain features within the contract. I will explain some of these common features:
– Indexing Method: The indexing method means the approach used to measure the amount of change, if any, in the index. Some of the most common indexing methods, which are explained more fully later on, include annual reset (ratcheting), high- water mark and point- to- point.
– Cap Rate or Cap: Some annuities may put an upper limit, or cap, on the index- linked interest rate. This is the maximum rate of interest the annuity will earn. In the example given above, if the contract has a 6% cap rate, 6%, and not 6.3%, would be credited. Not all annuities have a cap rate.
– Participation Rate: The participation rate decides how much of the increase in the index will be used to calculate index- linked interest. For example, if the calculated change in the index is 9% and the participation rate is 70%, the index- linked interest rate for your annuity will be 6.3% (9% x 70% = 6.3%). A company may set a different participation rate for newly issued annuities as often as each day. Therefore, the initial participation rate in your annuity will depend on when it is issued by the company. The company usually guarantees the participation rate for a specific period (from one year to the entire term). When that period is over, the company sets a new participation rate for the next period. Some annuities guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified maximum.
– Floor on Equity Index- Linked Interest: The floor is the minimum index- linked interest rate you will earn. The most common floor is 0%. A 0% floor assures that even if the index decreases in value, the index- linked interest that you earn will be zero and not negative.
– Averaging: In some annuities, the average of an index’s value is used rather than the actual value of the index on a specified date. The index averaging may occur at the beginning, the end, or throughout the entire term of the annuity.
Part 4. Personal opinion on which annuity is right for you and when to purchase them
An annuity is not just a retirement account but it’s a long- term commitment between you and the insurance company. Many advisors are quick to sell 1 type of annuity but 1 type is NOT built for everyone. I am going to say it again, 1 type is NOT build for everyone. You must be sure which product to choose and that you do not require these assets for at least 7- 10 years. The best age to invest in these products is in your 50’s. This will give you ample time to accumulate sufficient funds for your annuity as well as build your IRA and qualified retirement account ( 401k’s, 403b’s, 457’s, and keogh plans). I recommend you should max contribution to your employer’s retirement account and your IRA before you invest in an annuity. Once you are in your early to mid- 50’s, you should start thinking of an annuity that is right for you based on your risk tolerance and lifestyle.
In most cases, Indexed annuities are great for those under the age of 65. You can tolerate some volatility. If you are over the age of 65, you should consider a fixed annuity to avoid volatility. You can start to plan your retirement knowing what your income will be based on the percentages/dollar amount you will be receiving. Immediate annuities are great for those that will retire in less than 6 years. There is no point in investing something risky or waiting to receive payment without surrender charges therefore it is best to just invest an a immediate annuity to avoid these issues.
Variable annuities are only good if you max all your retirement accounts (employers and IRA) and wish to contribute more in a retirement account. I personally do not recommend variable annuities unless it is used for those that are too busy to manage their bond/ETF portfolios AND max all retirement contributions. I would rather advice you to invest in a municipal bond ladder portfolio or ETFs (Exchange Traded Funds) and reinvest in the dividends to build a tax- free/deferred portfolio THEN later in your mid- 50’s move the assets over to an indexed/fixed annuity that is guaranteed lifetime income. This will also avoid the massive amount of fees that come with a variable annuity and take part on the volatility that can in many cases be beneficial for you.
Your retirement is more important than just trying to gain as much in the stock market. You need to protect your “nest egg” and annuities should be a big part of your retirement. If your under the age of 40 than you should be in more equity/stocks and take the risk since you have many years of work and making money ahead of you. Please take note that I am speaking in the general sense and am not taking current income, lifestyle, goals, needs, and net worth into consideration. This is vital information in analyzing the percentage of your retirement portfolio that needs to be invested in annuities because it is not a question of “if” but how much needs to be in an annuity. Retirement income planning is vital to your future and annuities must be part of it.
As the economic environment changes, so should your retirement account. Investing only in 1 retirement account and relying on social security is nothing more but setting yourself up for failure. You will lose assets and soon enough you’re back on the work force till the day you die. I am sure involuntary part- time work is not part of your retirement plan…or is it? The decision will always be yours.
Feel free to contact me if you have any questions regarding retirement income planning or annuities.