From high fees associated with increasingly complex products to questionable sales practices, annuities have gotten a bad rap over the years for many reasons. But they’re not all bad.
Because certain annuities can offer a guarantee of income in the future, they may be attractive to investors looking to ensure a steady stream of income in retirement. With today’s low returns, market volatility and economic uncertainty, it could be a good time to brush up on your annuity knowledge, especially if you’re thinking about retiring in the near future.
How do they work?
An annuity is a contractual financial product typically sold by an insurance company. In the most basic form, an individual purchases an annuity with a lump-sum payment and receives income in the future, either in the form of periodic payments or in a lump sum. Annuities often have an accumulation phase, when the lump sum is held and invested by the insurance company, and a distribution phase, when the owner receives the money back, with interest.
From fixed to indexed to variable annuities, these products can be designed to invest the funds in a variety of ways. Because there are so many types of annuities, there are also many riders and features that are available as add-ons to various annuity products.
But many advisors agree that consumers considering annuities should only purchase them based on the guarantees they offer. These agreements can include the income payment amount, the duration, and the rate of return promised during the accumulation phase. These guarantees are backed by the financial strength of the provider, so it’s important that investors purchase an annuity from a stable company.
For people seeking income during retirement, income annuities could be a good option. These products are structured to provide regular income payments to the owner at some point after the initial investment. For simplicity’s sake, let’s take a look at two types: single-premium immediate annuities and deferred-income annuities.
Immediate annuities work exactly how they sound. A lump-sum premium is paid, and the annuity income stream begins immediately. With deferred annuities, a lump-sum purchase is made, and annuity income payments are deferred to some point in the future.
The income can also be structured in different ways, including lifetime income, joint-life income or income for a certain period of time.
Deferred annuity strategy for retirement income
With retirement planning, one of the main challenges is determining whether your savings will last as long as you need them. You simply don’t know how long you will live, so it’s impossible to know how long your money will need to last. With the promise of guaranteed income, income annuities can help solve this problem.
In retirement planning, the rate at which retirees begin to draw down money from their retirement portfolios is known as a “withdrawal ratio.” For decades, many advisors used 4% as a “safe” withdrawal percentage, meaning that investors could safely withdraw 4% of their nest egg each year during retirement and feel confident that the portfolio would last at least 30 years. Today, due to low interest rates, many advisors think 3% is a better safe withdrawal rate. Of course, there is no guarantee that the portfolio will last that long.
But annuities can provide that guarantee. One retirement income strategy that has become popular among some pre-retirees is to purchase a deferred-income annuity during the last five to 10 years before retirement, with the intention of beginning income payments at retirement.
So what happens to the invested amount during the “deferral” period, or accumulation phase? Usually, the company offering the annuity product will provide a fixed return on the investment each year during the time the owner has allotted to wait until the funds are distributed. This means that your investment may not grow as much as your funds would if have if they had been invested in the stock market, but the benefit is that you are guaranteed a predetermined rate of return. This strategy can also potentially yield a higher average rate of return during the deferral period than alternative safe investment options like CDs.
Once that accumulation period is over, the investment is then annuitized into income payments. Depending on the age of the owner, there is a chance that the withdrawal ratio for a deferred-income annuity could be well above the 3% that many advisors use for investment portfolios today.
But just as all investments have tradeoffs, so do annuities. The deferred-income annuity may be the best strategy for maximizing guaranteed income for the pre-retiree, but it comes at the cost of sacrificing flexibility. Much like creating one’s own pension, when a person purchases the annuity, in many cases, he or she would have no more access to that investment as a lump sum. That means he or she wouldn’t have as much cash on hand if other expenses arise. You should work with an advisor to take that into consideration when crafting your retirement plans.
While some annuity products can have riders and add-ons that allow for increased flexibility, those add-ons will drive the benefits down. But if you don’t need those extra perks and flexibility and can afford to part with your money for a while, you’ll be able to get a richer benefit later.
While I understand why some selling practices and poorly implemented strategies have led to distrust among many consumers, those bad apples shouldn’t ruin it for the whole bunch. If structured properly, the right annuity could offer a smart strategy for income-seeking investors.
I’m not advocating for or against the use of annuities in any given portfolio. But for investors focused on income, certain annuities could be a wonderful tool for a portion of your portfolio, provided you fully understand the product, how it fits into your overall plan and whether the advisor helping you purchase the annuity is looking out for your best interests.
This article was originally published on NerdWallet.com and NASDAQ.com. http://www.nasdaq.com/article/some-annuities-can-work-in-retirement-but-proceed-with-caution-cm565819