Annuities often get a bad rap as an investment option. Like any other investment options, they serve a purpose. When they meet a need and serve that purpose, they can be the right choice. There are different kinds of annuities – fixed, variable, indexed, or immediate. There are different features – living benefits, death benefits, riders, surrender charges, investment choices, etc. The first step is deciding if an annuity is the right choice for you and then making sure you purchase the right one.
One key feature that often draws individuals to them is tax-deferral. Have you maxed out your 401(k), 403(b), or other employer plans at work? Have you maxed out your $6000 or $7000 IRA contributions? Do you still have funds that you want to put away towards retirement? This can be a good reason to look next at purchasing an annuity.
If you create an individual account with those excess dollars, you will need to pay taxes on the earnings in that account each year. Instead, placing those funds into an annuity, all the earnings are tax-deferred until you start taking funds out of the annuity.
While you do not have to pay taxes each year on the earnings with an annuity, the disadvantage is when you do start paying the taxes, it is at ordinary income tax rates. In an individual account, qualified dividends and long-term investment sales are taxed at capital gains rates, which are capped at 20% for those in the higher tax brackets. Distributions from an annuity are taxed at whatever your typical tax rate is, which could be as high as 35%. This also raises concerns about deferring taxes with the anticipation that tax rates will increase in the future.
Because of the taxation at ordinary income rates and the anticipation of higher taxes in the future, purchasing an annuity for tax deferral may not be the best choice. Other options such as life insurance, growth rather than income-producing stocks, or tax-free bonds may meet that need.
Annuities can create a “pension-like” opportunity. Funds can be placed into an annuity, and with an immediate annuity, you can elect to get a monthly distribution for a specific length of time or your lifetime. When you annuitize an annuity, you lose the option of getting the funds as a lump sum. You are entitled to get the payment for the rest of your life (or a joint life). If you live a long, healthy life and get these payments for your life, the value you receive can be 2,3, 4 times, or more what you put into the annuity. If you have a shorter lifespan, you may not get that leverage out of an annuity. In some cases, you may only get back what was put in with a short life span. That is the risk – are you going to do live a long life?
Setting up this payment stream means you are not concerned about what the stock market is doing. Regardless of the ups and downs, you will always receive this payment. You can set the payment to remain the same for your entire life, or you can use an inflation rider to have the payments increase by a percentage each year. Setting up a lifetime payment means you will always have this payment. Like a pension or even Social Security, it gives you the security of knowing the amount will always be there.
You can elect to receive the payment for a specific number of years called a period certain. Maybe you want to retire at age 60 and want to delay collecting Social Security to age 70. Maybe you want to create a travel budget for 10 years or set funds aside for 5 years of college costs. You could create an annuity with a payment for that 5 or 10 years, knowing that you will not have to be concerned about the stock market declining for those funds.
Annuitizing an annuity or creating an immediate annuity gives you the security of knowing the payment will always be there. The problem is it means you do not have access to that principal. We strongly recommend that you do not annuitize all your available cash. You want a lump sum available for the unexpected or a major cash purchase.
Creating an annuity with some of your cash means that you have a payment coming in for the rest of your life, providing some comfort and security. We often see this as a good option for those concerned about spending retirement dollars too quickly and have a concern about running out of funds. While you are giving up the liquidity of those funds, you also know you will always have those funds to help meet everyday expenses.
The different types of annuities – variable, fixed, and indexed are names for the types of investments they use. A fixed annuity has an interest rate. With current interest rates being low, the interest rates that annuities are paying right now are also low. There is the knowledge that you will not lose money, and these annuities generally are paying at a higher interest rate than most bank accounts.
A fixed annuity can be a safe, secure option giving you more earnings than your bank account. Does removing the interest from your tax return also reduce how much your Social Security is taxable or make you eligible for other aid sources? This can leverage the annuity’s overall return more than leaving the funds sitting in a bank account.
When purchasing a fixed annuity, you need to be concerned about the annual costs. With interest rates being historically low right now, will that interest rate outpace the annuity cost? Some fixed annuities have a guaranteed interest rate for a certain length of time, making them a more attractive option. The low-interest rates right now also mean that your funds are not growing at the rate of inflation, which means a loss of purchasing power over time.
A variable annuity uses investment-like mutual funds called subaccounts. These are market-invested, and the value will go up and down as the stock market goes up and down. The advantage is over time, you generally outpace inflation. As the investments are bought and sold, you are not creating a current tax burden.
An indexed annuity allows you to participate in the stock market’s growth while providing the downside protection of not experiencing a loss. The index says you get to take part in the growth in the stock market. The advantage of the indexed annuity is that while you can earn zero, you will not lose money. You give up some of the benefits of the market’s upside to get the protection in the down market.
Distributions can be taken out in two forms. You can annuitize the payments. When you guarantee the payments for life or a period certain – you know the payments will always be there, and you lose the ability to access a lump sum.
You can also elect to take withdrawals out of the account on an occasional basis or even on a systematic basis. Taking funds out in this manner does not guarantee how long the funds will last. The account’s value goes up and down with the investment options, and you could run out of money.
Annuities can have a living and/or death benefit rider, which provides partial protection against a stock market loss. This rider allows for a value to be locked in at predetermined times, generally on the anniversary of policy issuance.
For example, a policy was issued on May 29, 2015. On May 29th each year, the rider locks in the value at that time if it is higher than the prior lock-in value. It does provide some limited protection against declines in the market since you know you can get the living benefit value. However, if you need to withdraw money while the market is down, you will not get the higher value, and generally, your locked-in value declines proportionally.
Some policies provide a living benefit while others provide a death benefit lock-in. It works the same way as the living benefits, getting locked-into the higher value generally once a year. If you have not fully liquidated the annuity by the time of death, it is possible to get the higher locked-in value rather than a current lower current market value.
Living and death benefits can be a feature of the annuity or a rider to the annuity. A rider is an optional feature that generally will have an additional cost to it. Many different riders can be part of an annuity, and you want to make sure that you have an annuity with the ones that are important to you. One example is the inflation rider, where payments increase annually by a certain percentage. There may be a long-term care rider allowing for funds to be accessed for long term care purposes without incurring a surrender charge.
The surrender charges are essential to look at if you are considering the purchase of an annuity. Using an example of an annuity with an 8-year surrender period says that if you take money out of the annuity anytime within the first eight years, you will pay a penalty for doing so. In most cases, it is a declining charge. Put it in today, take it out tomorrow, and you would be subject it an 8% penalty. Take it out in 3 years, and that penalty may only be 5%, or if you take it out in year 7, it might be a 1% penalty.
There are annuities with no surrender charges. I have seen annuities with surrender periods that are 20 years. It is common to see a surrender period in the 5–8-year range. A surrender charge does not make an annuity bad if other features make it an attractive option. The key is – do you think you will need those funds within the surrender period?
If I have $500,000 and I am putting $100,000 into an annuity, do I think I would have to take funds out of the annuity before my surrender period is up? I have the other $400,000 to spend, so I would anticipate the answer probably would be no. If I have $500,000 and I am putting all $500,000 into an annuity, I would be concerned. You want to put into an annuity with a surrender period only the dollar amount you believe you would not need to access before that time was up.
This is the basics of annuities. Insurance companies provide annuities. Each insurance company has added its own twists in the form of bonuses, riders, and benefits. Each has added its own twists in the forms of annual fees, expenses, and surrender periods. Variable annuities have different investment choices from one annuity to another. Indexed annuities have different indexes and participation rates from one annuity to another.
Do your research and homework to determine if an annuity is right for you and, if it is right, which one is right for you. Like any other investment – there are pros and cons. We at Planning with Purpose do see a purpose and find them valuable for some. For others, it is not the right choice. If you think you would like to explore if an annuity is a good option for you, we are willing to assist in that.