Annuities at a Glance
First… the “Why.”
Before we get started learning about annuities, let me explain why an annuity can be such an important and valuable tool when planning for retirement. When I started in the retirement planning business, the world was very different. Many folks working to plan for retirement, likely had a better foundation built to provide retirement income that would pay them as long as they lived.
The Old Three-legged stool.
Back then, in what we call “the old days,” it was very common for a person nearing retirement to have multiple sources of regular income they could count on when they stopped working. In addition to Social Security, many companies offered employees a defined benefit (pension) plan that would guarantee a benefit (a paycheck) for as long as the retiree would live. It made financial planning for retirement much easier having 2 solid sources of lifetime income guaranteed. The only thing one had to think about was how they wanted to use the third leg of their retirement stool, their personal savings. This was relatively easy in the interest rate days of 7% or 8%. Retirement planning was easier.
Today, due to regulation changes in how companies must fund these Defined Benefit Plans, we’ve seen a huge shift in the private sector to a “new normal” retirement option. Most companies are no longer willing to take on the responsibility of paying pension income, and instead have shifted that responsibility to the employee in the form of a Defined Contribution Plan such as a 401(k).
Combine this with a historically low interest rate environment, and we are now dealing with retirement planning that is complex and difficult than ever before. When planning for retirement today, You are basically on our own. Most of you have to figure out how to do what a pension did for your parents. Social Security was never meant to be the sole source of income for anyone’s retirement. If you need more income than what your SS benefit will pay, there are few retirement tools that will duplicate the guaranteed lifetime income stream old pension plans used to promise. In-fact… I only know of one. An Annuity.
Take Note…
Defined benefit pensions and Social Security are both examples of guaranteed lifetime annuities that pay in income stream you cannot outlive.
Where did annuities come from?
Although annuities in their current form have only been around for the last few decades, the idea of paying out a lifetime income stream is not a new idea. The Latin word annua meant annual stipend, and was a regular reward for Roman soldiers returning home to retire with their families. The first annuity in the United States dates back to 1720 when the Presbyterian Church wanted to provide a secure retirement for aging ministers and their families. Fast forward more than 200 years when Babe Ruth used annuities to avoid losses in the Stock Market crash that lead to the Great Depression. Even more recently, in 2006, Ben Bernanke who oversaw the Federal Reserve’s response to the 2008 financial crisis disclosed that his major financial assets are two annuities.
What is an annuity?
An annuity is a financial product designed to pay out a steady stream cash. It is an insurance contract, backed by an insurance company. The insurance company makes a promise to the annuity owner to make a fixed stream of payments. That stream of payments can last for a set number of years, or can be guaranteed as long as you live. To purchase an annuity, A person will either make a large lump-sum payment, or a series of payments into the contract.
This is a very simplistic definition of an annuity, and like any other type of vehicle, they come in many different shapes and sizes. Todays annuities offer many other benefits than just regular income and can be a very valuable tool used in retirement planning, however they are not for everyone. As with anything, there are always trade-offs when entering into a contract. Knowing how an annuity works, and why you should own it is incredibly important before you sign on the dotted line.
Annuity Categories - Fixed Annuities vs. Variable Annuities
Annuities typically come in one of two forms. Fixed or Variable. The names are appropriate, because they basically tell you what you can expect. A Fixed Annuity pays the annuitant a regular, fixed payment for a set period. You know what your going to get when you enter into the contract. The parameters are essentially “fixed.” Variable Annuity payments are not fixed, but instead vary based on investment performance. They allow for larger payments when the investments of the annuity do well, and smaller payments when the investments do poorly. Although this can result in a less stable cash flow than a fixed annuity, there are additional riders and benefits you can add (generally for an additional fee) that allow VAs to benefit from upside investment performance and still enjoy a guaranteed lifetime minimum withdrawal benefit if the portfolio value falls.
Riders
This income benefit described is known as a rider. A Rider is basically an additional benefit added to an Annuity Contract. Other Riders available can offer a guaranteed Death Benefit, early liquidity if the annuity holder is diagnosed with a terminal illness, Cost of Living benefit increases to protect against inflation, and many more. As noted before, these additional benefits usually will come at a cost in the form of additional fees to the contract.
Annuity Types
There are endless ways annuities can be structured, so when considering adding one to your plan, ask yourself this. What do you want the annuity to contractually promise, and when do you want that promise to happen? The answer to those 2 questions should help you know if an annuity is right for you, and which type will best fulfill that promise.
SPIA – Single Premium Immediate Annuity
SPIAs are exactly what they sound like. One pays a single Lump Sum premium (Insurance payments are called premium) and in exchange for that premium payment, they receive an income stream (either Fixed or Variable) for a set period of time OR for as long as the annuitant lives. This income stream is initiated immediately, hence the name, Immediate Annuity. The payment one gets from a SPIA will depend on many factors including how long the income is guaranteed, the age of the annuitant, and the current interest rate environment. Every insurance company is structured a little different, so it is always a great idea to consult with an annuity professional to find the best qualified companies paying the highest benefits. Immediate annuities traditionally are irrevocable, so getting it right in the beginning is crucial!
DIA - Deferred Income Annuity (Longevity Annuity)
DIAs are very similar to SPIAs except one thing. When the benefit is paid. Just like the SPIA, one pays a lump-sum premium payment to the insurance company in exchange for a benefit. Also like a SPIA, this generally is an irrevocable contract where the parameters are set in stone, and the owner gives up control of the lump sum of money. The rise and fall of the stock market has no affect on the income you receive. The major difference between deferred and immediate is just that. payments in a DIA don’t start now. They start later. In some cases, much later. Because of the extended time the Insurance Company holds the funds, this allows the income payments to be much higher than that of an Immediate annuity.
MYGA – Multi Year Guarantee Annuity
A MYGA is a type of deferred fixed annuity that is very similar to a Bank CD in that it guarantees a specific rate of growth for a specific amount of time. Typically, the longer you agree to leave that money with the company, the higher amount of annual interest they are willing to pay. MYGAs today run in the 3-year to 10-year durations for the most part, and again, offer different rates of return depending on the company. The rates offered for new contracts will vary from month to month, depending on current market conditions, so having access to an annuity professional will dramatically enhance your chances to find the best company and rate for you. Unlike CDs, these products are NOT backed by FDIC, but instead by the insurance company issuing the contract. Also unlike CDs, these solutions grow tax-deferred.
For anyone looking for predictable growth for a set period of time, these products can offer a great alternative, and often higher rates than what banks offer in CDs.
FIAs – Fixed Index Annuities
Fixed Index Annuities (once called Equity Index Annuities) are another type of Fixed Annuity. They are similar to a MYGA, in that they offer principle protection and a choice of duration, but instead of having a declared rate of return, they offer an interest rate dependent on the performance of a market index (like the S&P 500). This does not mean FIAs will reap the full benefit of any rise in the index. FIAs often set limits to the potential gain at a certain percentage of what the actual index does. This is commonly referred to as a Participation Rate. The participation rate could be 100% meaning you get 100% of the index, or it could be 25%. Let’s check out an example.
If the S&P gained 10%, an 80% participation rate would translate to an 8% return. Many FIAs offer high participation rates in the first few years, typically reducing them in later years.
Another adjustment that could be made in performance is the use of a Cap. A cap is a limit the index will return for that year. In the same example before, if the S&P gained 10%, a 7% cap would translate to a 7% return.
Most of these annuities offer a floor of 0% and in some cases, even offer a minimum rate of interest. Not only do they offer principle protection, but most also offer protection of credited interest. The can offer a very effective, safe money solution in volatile market and low interest rate environments.
VA – Variable Annuity
VAs are likely to be the most complex products in the annuity family. The are unique in that they offer a pre-selected group of Mutual Fund sub-accounts. Instead of a “Fixed” or guaranteed rate of return, your premium is allocated to an account subject to the performance of those chosen sub-accounts. This can provide superior returns over the long haul, but can also diminish your value. Although your cash value can be at risk in a VA, most products will contain both Living and Death Benefits that can guarantee a minimum account value or stream of income.
VAs offer many things including market-like growth combined with insurance, but this all comes at a cost. It would take many different financial products to do what a VA can do, and that directly contributes to the higher fees that can be associated with such products. VAs do not offer principle protection, and therefore, should be carefully considered when thinking about purchasing. As with any annuity, speaking to an expert you can trust in the field is incredibly important.
Hybrid Annuities
Hybrid Annuities are a new phenomenon happening just recently. Consumers love the safety an FIA provides with principle protection, but want the performance associated with a VA. This desire to have our cake and eat it too as resulted in a new family of products that offer SOME downside protection, and just SOME of the upside potential.
To limit the downside, most Hybrids offer a “buffer.” This is basically a limit on how much downside your annuity experiences in a poor performing market. An example would be a 15% buffer. If the market goes down significantly in any one year, your loss in that Hybrid would be limited to just 15% instead of the entire downturn. In order to have this kind of protection, you will also have some sort of limit on the upside in the form of a cap or participation rate. This upside potential would generally be higher than an FIA, but lower than a VA. Hybrid are fairly new to the annuity space, and the evolution of these solutions continues to change rapidly.
Surrender Charges
I know it’s funny to say, but I’m personally a fan of reasonable surrender charges. A surrender charge is a fee you pay when you end an annuity contract early. Surrender charges typically start high and decrease each year until they reach 0%, at which time your commitment to the annuity has been met. This is why I love surrender charges so much. If you stick to the plan, you don’t pay them! There are circumstances where Surrender Charges will be waived by the insurance companies like entering a nursing home or premature death. It is always very important to understand your liquidity options and commitment to the contract. Also, beware of unreasonably high surrender charges for long durations. Maintaining liquidity and access to your retirement will need to be carefully considered when selecting the right solution.
Suitability
There is a lot more information you need to know before you choose an annuity. Hopefully you have an annuity professional to help guide you. Annuities are not for everyone. Determining whether an annuity is right for anyone depends on many personal factors. Age, time horizon, investment experience, risk tolerance, health, dependents, long term care options, liquidity needs…. All of these need to be taken into consideration when choosing the right annuity. Working with the right advisor who is committed to acting in your best interest is essential to getting this choice right. Many annuity purchases are long term commitments, so it is also important that your annuity professional is one who will be there now, and down the road. Being with an insurance company that can back their contractual commitments is even more important.
Annuities can be confusing, complex, and even dangerous when used incorrectly. If you identify a certain type of annuity you think is best for you, make sure to take a deep dive. Educate yourself and consult with an independent annuity expert and professional who can help guide you.