Annuities have seen a rise in sales in recent years. While some financial advisors endorse them heartily, others are cautious, if not outright hostile toward this entire class of investments. The appeal of annuities is the guaranteed income stream they promise. Many investors are more hesitant to invest in equities in shadow of the market volatility that unsettled and even decimated many Americans’ retirement plans in too-recent history. Guaranteed long-term income, even at modest rates of return, can be incredibly appealing.
You already own an annuity.
Most people don’t think of it this way, but Social Security is an annuity into which you have been paying your entire working life. You can get the best value out of this annuity by delaying payments from it. For every year you wait after full retirement age (67 if you were born in the 1960s or later; somewhere between 65 and 67 if born earlier) until age 70, your benefit will increase up to 8%. That rate of return is inflation-adjusted and guaranteed by the U.S. government. In effect, if you have not yet begun drawing Social Security, waiting to do so until you reach age 70 can increase the monthly benefit you receive for the rest of your life anywhere from 24%-32%. That kind of return is very hard to beat.
Understand the differences among fixed, variable, and indexed annuities.
If you are considering adding a private annuity to your retirement plan, make sure you understand the different types available. Fixed annuities pay guaranteed rates of interest. Because the interest rate is locked in at the time of purchase, fixed annuities are particularly attractive at times when interest rates are high. Other attractive features include low investment minimums (often $1,000 to $10,000) and the fact that tax on earned interest is deferred until withdrawal. Keep in mind, however, that most fixed annuities do not adjust for inflation, so whatever payout you lock in will decrease in real value over time.
Forbes illustrates, “$5,081 in 1970 had the same buying power as $30,000 [in 2012]. Imagine thinking you had your future retirement needs guaranteed in 1970 by buying an… annuity paying $5,081.”
Forbes suggests that a fixed annuity could be a sound alternative to long-term care (LTC) insurance, which has become exorbitantly expensive as well as increasingly difficult to find. “…if you’re in good health at 60, buy a deferred fixed annuity that starts paying you at 80, whether you need long term care or not. Sure, you could easily kick off at 79 and get nothing back. But think of this as combined longevity/LTC insurance—not an ordinary investment.”
A variable annuity, on the other hand, delivers a payout that is dependent upon market performance. As such, they carry a degree of risk. Variable annuities offer a range of investment options, and the income you receive in retirement will be dependent upon the performance of the investments you elect. Be aware that the cost of a variable annuity will include management fees for the investments it contains and may also include mortality expenses (to provide a death benefit), administrative fees, and surrender charges for withdrawing funds early.
An indexed annuity can provide some of the benefits of both fixed and variable annuities. You can buy fixed indexed annuities that guarantee minimum rates of return or return based on an underlying stock index, whichever is higher. This provides both the security of a guaranteed minimum income and the increased potential to outpace inflation. Bear in mind, however, that indexed annuities can also have caps on maximum return, so if the market happens to do exceedingly well, you may miss out on some of the gains.
Understand the difference between an immediate and a deferred annuity.
When you buy an immediate annuity, you hand over a lump sum of money in exchange for an income stream. It is important to recognize that with this type of investment, you give up access to the lump sum when you purchase the annuity. When you receive a payout, it includes the return of your initial investment. For this reason, there is a big difference difference between “annual rate of payout” and “annual rate of return.” Do not let the difference in these terms lure you into thinking you’re getting a better return on investment than you actually are.
Deferred annuities, on the other hand, often allow the purchaser to pay into the fund over time, creating a better opportunity to build the fund before retirement, as well as retain access to some of the money until it is converted into an income stream.
Don’t forget to max out your IRA and/or 401(k) contributions.
Although annuities offer some tax benefit, it is not nearly as great as that provided by IRAs and 401(k)s. If you have not yet contributed the maximum allowable amount to these types retirement accounts, then maxing these out will most likely be a more effective use of your investable money than putting it into annuities.
Boelman Shaw Capital Partners in Des Moines provides a full range of tax and financial planning services, including advice on a range of retirement accounts. For honest, knowledgeable advice about your retirement options, contact us today.
Material discussed herein is meant for general illustration and/or informational purposes only. Because individual situations will vary, the information shared here should be used in conjunction with individual professional advice.