For many, the thought of retirement is both jubilant and worrisome. While the idea of spending time away from the office and with the ones you love is magnificent, the fear of funding can be paralyzing. If you worry about running out of money in retirement, you are certainly not alone. Studies have repeatedly shown that one of the top concerns of current and soon-to-be retirees is not having the income to last the long haul.
This fear is certainly founded. For generations, our relatives have relied upon employer-sponsored pension plans in addition to Social Security to provide guaranteed paychecks in retirement. But with the disappearance of pensions and the future of Social Security in jeopardy, there is a growing need for other sources of guaranteed income. Enter annuities.
According to a recent Kiplinger article, four out of five workers are interested in adding a guaranteed lifetime income product to their portfolio. That being said, a 2018 Cannex survey found that when the word “annuity” was used to describe such a product, ⅓ of those interested recanted. It’s not very difficult to understand this disparity when you consider the confusion that envelops the annuity industry. All annuities are not created equal, contracts can be complicated, fees have historically been high and the financial professionals who offer them aren’t always acting in your best interest. But before dismissing the idea of an annuity, consider this.
Annuities have evolved a great deal in the past few decades, especially in recent years. Understanding their purpose and recognizing your own unique needs can go a long way in discovering an annuity product that is right for you. Below is a basic overview of the different types of annuity products available and who they are most appropriate for.
Decision #1: When your payments begin
The concept is simple: You pay an insurance company a lump sum in return for a guaranteed income, either for the remainder of your (and your spouse’s) life, or for a designated period. An immediate annuity begins paying income as soon as it is funded. You lose control of the money you put into the annuity, but the risk is shifted to the insurance company who guarantees it.
While this was once the only option for anyone seeking guaranteed lifetime income, this type of product has fallen out of favor because of the loss of control. But if your number 1 concern in retirement is outliving your money, this may be something to consider.
Majority of annuities sold today fall in the deferred annuity category. They are similar to their immediate counterparts in that they are intended for income, however their income streams don’t begin until a later, predetermined date. Deferred annuities provide contract owners with an opportunity for growth using a variety of crediting methods.
If you want a steady and reliable income in retirement, but you don’t need the money right now, a deferred annuity is one to consider. Which type of deferred annuity will depend on which crediting method aligns with your goals and expectations.
Decision #2: How your payments are calculated
The growth rate for the contract value in a fixed rate annuity is guaranteed by the insurance company. The contract owner either pays a lump sum or a series of payments, and that sum is credited growth by the insurance company at a minimum fixed rate. While this rate is usually fairly modest, the hope is that it is enough to keep up with inflation.
With fixed, regular credits of interest, these products are best suited for those who like to invest in similar instruments, such as CDs.
These products are exposed to the market through sub-accounts that act like mutual funds and ETFs, however the sub-accounts grow tax-deferred. The annuity works in two phases, the accumulation phase, when you contribute money and allocate it to the investment funds of your choice, and the payout phase, when you receive income from your annuity. Often, there are no investment restrictions, and your adviser will help you build a diversified portfolio to match your risk tolerance and goals. But with market exposure comes market risk. There is potential to lose your contract’s credits and principal if there’s significant market volatility.
Variable annuities can carry higher expenses and fees and often become for expensive if you add optional benefits, such as living benefit or death benefit riders. But if used correctly, they can create excellent value which are sometimes hard to beat.
These products are designed for people who want the gains that can come with market exposure and are comfortable with some volatility. Often times, these annuities make sense for those who are further out from retirement.
These products are considered a hybrid, combining both variable and fixed rate annuities. Your principal is guaranteed, just like a fixed rate annuity, but you also have the chance to participate in some market-related growth. There are many varieties, but the most common types are cap-rate or participation-rate annuities. For example, with a cap rate of 6%, the annuitant enjoys market increases up to 6% but no higher. With a participation rate, the insurance company allocates only a portion of the growth of the index to the annuitant, usually 35% or higher.
Both variations typically come with a guarantee that you won’t lose anything to the market, but your upside is limited. Similar to variable annuities, you can also add living and death benefit options for an additional charge. Many fixed index annuities have no portfolio fees until you add benefits, making them appealing to investors who are looking for an alternative to bonds.
These hybrid products are most appropriate for those who do not need an income stream immediately and are interested in an opportunity for higher gains without the risk to principal.
There are many factors to consider when choosing the right annuity for you. Liquidity, risk, fees, tax consequences and your timeline are just a few examples. It is always recommended that you educate yourself on your options and discuss them with a trusted financial advisor. For more information about annuity products and how they can help you meet your retirement goals, visit staging.annuityfyi.com.
Written by Rachel Summit
Follow Rachel, aka Finance Mama, on Twitter
