Will you have enough income to fund a retirement of 20 years, 30 years... or more?
Building a steady stream of retirement income is a top priority for many Americans, especially those nearing their anticipated retirement date. With lifespans extending into the 80s, 90s and even 100s, there is even more reason for investors to ensure they’ll have a source of income that lasts a long time.
One way to help meet that need may be an annuity. An annuity is a contract between you and an insurance company designed to help meet retirement and other long-range goals, under which you make a lump-sum payment or series of payments. In return, the insurer agrees to make periodic payments to you beginning right away (an immediate annuity) or at some future date (a deferred annuity).
While there are many different types of annuities, there are a number of commonalities:
- There are no annual contribution limits to an annuity as there are in IRAs or 401(k)s unless the annuity is held in a qualified account. The issuing insurance company may, however, impose contribution limits.
- All contributions—and any earnings—grow tax-deferred until withdrawal. Note, however, that annuities do not provide additional tax deferral on qualified contracts.
- Annuities offer a wide range of underlying investment options, from very conservative to very aggressive.
Whether an annuity is right for you may depend on how much you anticipate receiving from traditional sources of retirement income, such as Social Security, a 401(k) or an employer pension. You have a choice of annuities:
- A fixed annuity, which provides a fixed rate of return for a specified time period.
- A variable annuity, which provides a variable rate of return based on the underlying investments.
- An equity-indexed annuity, which offers a guaranteed rate of return that may increase depending on the index to which it is tied.
As its name suggests, fixed annuities typically present a guaranteed interest rate that is locked in for an initial period (typically one to 15 years) and may be adjusted thereafter, often annually. With a fixed annuity, you have no control over the investments—the issuing insurance company decides how to invest your assets, primarily in government securities and high-grade corporate bonds. There are two basic types of fixed annuities:
- The Guaranteed Return Annuity (GRA) offers a guarantee that you can never receive less than 100 percent of your investment—no penalties or fluctuations in the interest rate market can impact your principal should you surrender.
- The Market Value Adjustment Annuity (MVA) works much like the GRA, but there is no guarantee of your principal if rates rise and you surrender your contract. MVAs often pay more than a GRA due to the increased short-term risk of rising interest rates.
Earnings accumulate tax-deferred and are not taxable until they are withdrawn, when they are taxed as ordinary income. Withdrawal options may include a lump sum or a lifetime stream of income.
This type of annuity, in contrast, generates investment returns that fluctuate depending on how the underlying subaccounts are invested. Generally, you can make an investment selection that may include stocks, bonds, cash subaccounts or some combination of these. Available choices range from conservative—such as money market, guaranteed fixed accounts and government bond funds—to more aggressive—such as small cap, mid cap, large cap, capital appreciation, aggressive growth and emerging market investments. As with many investments, the value—and payout—of a variable annuity will change depending on the performance of the subaccounts you choose. Withdrawals are taxed as ordinary income.
In addition to offering a stream of income that cannot be outlived, many variable annuity products have “living benefits,” optional features available for an added fee that can help protect your principal investment from market declines and/or provide a minimum future income. There are three basic types:
- The Guaranteed Minimum Income Benefit (GMIB) guarantees a minimum future income level regardless of how the market performs. This benefit typically requires the owner to meet certain criteria, such as owning the contract for a specified number of years before exercising the benefit, and the owner must annuitize the contract to take advantage of this benefit.
- The Guaranteed Minimum Accumulation Benefit (GMAB) ensures that you retain the value of your purchase payments regardless of investment performance. At the end of a waiting period—typically 10 years—if your contract value is worth less than your purchase payments, the insurance company will increase your contract value to equal the guaranteed amount (adjusted by any withdrawals),
- The Guaranteed Lifetime Withdrawal Benefit (GLWB) guarantees a return of your purchase payments through fixed annual withdrawals, which are guaranteed until your principal is returned, even if the contract value declines to zero. Some benefits also guarantee the owner five-percent annual withdrawals for life in addition to guaranteeing the principal. Withdrawals in excess of the benefit withdrawal limit may negatively impact the guarantee.
Living benefits are increasingly evolving into new hybrid benefit options, as insurance companies seek ways to differentiate their offerings in the marketplace. This environment of expanding flexibility and functionality is helping to redefine variable and fixed annuities for a new generation of retirement investors.
EIAs have characteristics of both fixed and variable annuities. They frequently offer a guaranteed minimum interest rate combined with an interest rate linked to the performance of a market index. At a minimum, the guaranteed minimum is 87.5 percent of the premium paid at a one- to three-percent annual interest rate, but rates can fluctuate based on the issuing insurance company. The index-based return is tied to an index, such as the S&P 500.
The index-linked interest rate may be computed in a variety of ways. Some annuities present a participation rate (for example, 80 percent) that determines how much of the index's gain is credited to the annuity. There may also be an interest-rate cap on how much an EIA can earn. For example, if an index linked to an annuity gained eight percent and the cap rate was six percent, then the gain would be six percent. There are also a variety of indexing methods used to calculate the index-based return.
The Pros and Cons of Annuities
One reason annuities are attractive is they can help build more value over time. Money is accumulated in an annuity through contributions and investment earnings. By providing potential growth that is tax-deferred, an annuity's investment earnings can accumulate and compound untouched by federal, state or local income taxes until you begin making withdrawals, which is usually after retirement.
In addition to tax advantages, annuities offer a choice of investment options, including fixed accounts, which may help protect principal from market risk, and variable investment accounts in stock and bond portfolios, which offer the potential for higher returns. Together, these features may make annuities attractive to those who seek investments that can help supplement future retirement benefits, and to retirees who want greater control over their income and the flexibility to continue deferring taxes on investment earnings.
While annuities certainly have some advantages, there are also a number of concerns, including:
- Surrender charges. While most annuities allow you to withdraw 10 to 15 percent of your account value without penalties, the surrender charges for pulling money out of an annuity within the first several years after you buy it can be prohibitive. Surrender charges typically run for five to ten years after first purchase and can eat up 10 percent or more of your account value. Most contracts will begin a new surrender period for each subsequent purchase payment.
- Taxes. Withdrawals made from an annuity are taxed as ordinary income. Withdrawals made prior to age 59½ may be subject to an additional 10-percent federal penalty tax.
- High annual fees. The expenses for annuities, particularly variable annuities, can be high—often two to four percent a year. Fees include administrative expenses, which can average 0.1 to 0.3 percent or more; investment management expenses, which range anywhere from 0.25 to more than two percent; and mortality expense, which provides a death benefit for your beneficiaries, which can range from 0.5 to 1.5 percent.
- Estate planning considerations. If you die with money remaining in your annuity, your beneficiary will inherit all the taxes you have deferred. Annuities do not receive a “step up” in tax basis.
Balance Costs and Benefits
An annuity can be an excellent retirement investment vehicle if you are able to forgo use of the money for several years. Annuities also offer unlimited contributions (subject to insurance company limitations), protection of principal in fixed accounts and/or with living benefit riders, and the potential to earn higher rates of return on your investments in variable accounts. But annuities may also entail higher fees and expenses than some other investment vehicles, in part due to the insurance feature annuities provide. Consult your financial advisor to determine if an annuity is right for you. iBi
Cathy S. Butler, CFP, CRPC is a financial advisor with the Butler/Luthy Group of Morgan Stanley. For more information, visit morganstanleyfa.com/thebutlerluthygroup.