The ABCs of Annuities
December 4, 2014 by Joanne Cleaver
Annuities are the basic financial tool your financial advisor doesn’t want to talk about.
That’s because annuities provide a bedrock income for retirement by shifting money out of the “I want this money to grow” part of your portfolio into the “I don’t want to outlive my money” part of your portfolio. An annuity is the flip side of life insurance, explains Kim O’Brien, president and CEO of the National Association for Fixed Annuities, an industry group based in the District of Columbia. “Life insurance protects your loved ones if you die too soon. Annuities protect you if you live too long,” O’Brien says.
You set up an annuity with a large lump sum. The financial institution – typically an insurance company – guarantees you will receive a monthly income from the lump sum. You will have to decide if you want an annuity that delivers the same amount of income each month or income that varies with market returns. Another key decision is whether you get your lump sum back at some point. With traditional annuities, you don’t. With some newfangled annuities, you do.
When you move a big chunk of money from a mutual fund or exchange-traded fund into an annuity, that’s less for your fee-based financial planner to manage. It trims the fees he or she earns, and that’s why your financial advisor may steer you away from a financial tool that guarantees you a lifelong income.
Here’s an overview of the basic types of annuities, and why you may or may not want one.
With a classic annuity, you are essentially buying a pension for yourself, says Dan Keady, senior director of financial planning for TIAA-CREF. You pay an upfront lump sum and start getting payments.
With an immediate annuity, you pay the lump sum and start getting monthly payments right away. With a deferred annuity, you pay the lump sum but don’t start taking the monthly payments until a predetermined date. Typically, the date is tied to a particular age, Keady says. People often have an annuity kick in at age 75 or 80 to ensure additional income to cover rising living and medical expenses.
If you buy the annuity decades in advance, you can get it at a discount. For example, you may buy a $100,000 annuity for $85,000, because the insurance company has time to win investment gains before it starts making payments to you.
“One way to think about how much to put into an annuity is to estimate your basic monthly living expenses in retirement. How much of that is covered by Social Security? How much do you still need to cover? Can you convert or buy annuities to cover what isn’t covered by Social Security?” Keady says.
If you want the annuity to provide lifelong income for both yourself and your partner, be sure to buy a joint-survivor annuity. When one partner dies, the other partner continues to receive the monthly income. Fixed annuities deliver the same amount of income per month. Variable annuities guarantee a minimum amount per month, plus a potential additional amount, depending on how the market performs. Variable annuities are usually tied to commonly used market indexes, such as the Standard & Poor’s 500 index, financial advisors say.
Once you hand over that lump sum for a traditional annuity, however, you can’t get it back, says Michael Guillemette, assistant professor in the University of Missouri’s department of Personal Financial Planning. “It’s locked in. You get the monthly payments, but you can’t get that lump sum back,” he says. “That means there’s less for an inheritance.”
Some variations on annuities allow policyholders to reclaim the lump sum, O’Brien says, but that flexibility comes with stiff fees. Guillemette explains that you could buy an annuity including a life insurance component, thus providing a death benefit. Another twist is a term-certain annuity, which guarantees income for a certain number of years, paying out to you or your heirs, he adds. These variations add fees and make it more complicated to see how annuities fit into your retirement plan.
Don’t assume you should put as much money as possible into annuities. Financial advisors unanimously stress that retirees also need accounts they can tap right away. You may be able to convert part of your 401(k) account to an annuity, all within the framework of the plan. This mode of setting up the annuity can minimize fees and keeps the accounts under the 401(k) umbrella, Keady says.
If you decide to buy an annuity, be sure to work with a financial representative or advisor who has a fiduciary responsibility to you for that transaction, Guillemette says. “You want someone who’s looking out for your best interest as a fiduciary, even if they make a commission in the process,” he says. “If you go to ‘Joe the Insurance Guy,’ who is under the suitability standard, he’ll sell you whatever he can. Go with a fee-based advisor. In this case, a commission isn’t a bad thing.”
Don’t think of annuities as a type of investment. They are a way to convert savings to guaranteed income, Guillemette says. Investments involve calculated risk. Annuities involve minimal risk. The whole point is that you know how much monthly income you can count on. Do consider buying an inflation-protected annuity, which increases the payments each year to keep up with the cost of living.
Regulations regarding annuities might change as Congress seeks ways to ease pressure on the Social Security system, Guillemette says. For example, last summer the U.S. Treasury issued final rules on longevity annuities. Guillemette recommends keeping an eye on policy changes that tweak the rules about how much money you can put into and take out of annuities, in case politicians decide to add some tax incentives to make this traditional financial tool a bit more appealing.
