Putting together a successful retirement strategy that takes into consideration investments, taxes, income needs (including social security), medical/healthcare needs and estate planning is like fitting together the pieces of an intricate puzzle. The one major difference in this metaphor is when it comes to your retirement puzzle, some of the puzzle pieces are constantly changing! As a result, the puzzle is never really finished. You have to constantly work with your plan to make sure it’s headed in the direction you want it to go.
When you consider the part of your retirement plan that deals with your income needs, the safety of guaranteed income streams offers some very strong appeal. And, when it comes to guaranteed income, many financial advisors recommend annuities, which may offer the peace-of-mind of consistent monthly income that could outlast your retirement years.
But, what exactly are annuities?
Annuities are tax-deferred financial products offered by insurance companies. They are contracts with the insurer and based upon the claims-paying ability (or financial soundness) of the insurer. Traditionally, annuities are designed to pay you income at some point in the future in exchange for premium payments you put into the contract that is then enhanced by the contract’s interest or investment performance over time. Converting your premium payment into an income stream is called annuitizing the contract. Payments can last for fixed periods of time, as long as you live – or even longer. On the surface this sounds great, but annuities can be complicated and are among the most commonly misunderstood and at the same time misused financial products.
Because there are so many different types of annuities it’s not appropriate to make a claim “all annuities are good” or “all annuities are bad”. That’s like making a statement akin to “all movies are good” or “all movies are bad”. And, there are as many opinions regarding annuities by both financial professionals and consumers as there are annuity products. Professional opinions of advisors tend to be agenda-driven by non-fiduciary sales professionals in the financial services industry. Consumer opinions, on the other hand, tend to be emotionally-driven rather than by facts and logic. Most often they are based on a negative experience personally or from a friend who got “burned” typically by an inappropriate recommendation. What are the facts versus the fiction on this topic? Let’s explore a few that come up quite often.
Annuities are just too expensive.
FACT: First of all, the cost of the annuity is dependent on the type of annuity…and as we’ve pointed out, there are many different annuity types. In a broad sense, there are variable and fixed annuities. Within these broad categories, there are additional variations as well.
Some believe variable products, which transfer investment risk to the annuity owner (you), are terrible because of:
· High fees…which typically can be 2+%, before investment fee’s, depending on riders and other factors
· Steep early surrender penalties
· Limited investment options
· Longer contract terms, and other factors
For variable annuities, the investment return and principal value of the variable annuity investment options are not guaranteed. Variable annuity subaccounts fluctuate with changes in market conditions. The principal you invest in the annuity may be worth more or less than the original amount invested when the annuity is surrendered.
Fixed and Indexed Annuities
Some think fixed annuities of various types, whether immediate or deferred, fixed-rate or indexed, have some of the same problems, although they are typically less expensive in aspects related to fee/cost when compared to variable products.
Fixed Annuities are long term insurance contacts and there is a surrender charge imposed generally during the first 5 to 7 years that you own the annuity contract. Withdrawals prior to age 59-1/2 may result in a 10% IRS tax penalty, in addition to any ordinary income tax. Any guarantees of the annuity are backed by the financial strength of the underlying insurance company.
Indexed annuities are insurance contracts that, depending on the contract, may offer a guaranteed annual interest rate and some participation growth, if any, of a stock market index. Such contracts have substantial variation in terms, costs of guarantees and features and may cap participation or returns in significant ways. Any guarantees offered are backed by the financial strength of the insurance company. Surrender charges apply if not held to the end of the term. Withdrawals are taxed as ordinary income and, if taken prior to 59 ½, a 10% federal tax penalty. Investors are cautioned to carefully review an indexed annuity for its features, costs, risks, and how the variables are calculated.
No matter what type of annuity you’re considering, the truth is, any product can be expensive if used improperly.
Just as with any financial product purchase, you should consider the investment objectives, risks, charges, and expenses carefully before investing in Variable Annuities. The prospectus, which contains this and other information about the variable annuity contract and the underlying investment options, can be obtained from the insurance company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
How To Determine if An Annuity is Right for You
The first step in determining if an annuity is a good solution for your retirement income plan is to have your advisor do a cost/benefit analysis for you.
A thorough annuity cost/benefit analysis should cover the following key points:
· How, specifically, a recommended product is in your best interest
· Comparison of fees versus alternatives
· Understanding if the advisor earns a commission and how that impacts you for good or bad
· What the advisor’s process of discovery is for finding the right product fit
To summarize, in context, there are no bad annuity products per se, just bad application of them. If a product of any kind doesn’t fit your needs, it shouldn’t be recommended as part of your income plan.
Annuities are great for income in retirement but that’s about it.
FACT: I would say that this statement is partially true. It is true that annuities are designed primarily for income and with the advent of some of the newer lifetime income riders*, they have become even more flexible and attractive in this respect. However, the notion that variable annuities and stock or bond markets directly are THE place to go to meet the needs of a retirement plan is simply outdated. Why? Because there is an inherent risk in these areas.
Alternatively, fixed indexed annuities are not used just to provide a predictable income any longer and they don’t necessarily need the risk exposure of the market to perform quite well. For instance, fixed products can be designed as individual bond replacement strategies. They can be laddered like cd’s and more.
For example, it is not uncommon anymore to use fixed indexed annuities alongside a solid investment plan to diversify various risks. This is not to say that all fixed annuities are good for such things nor that the ones that are good perform well all the time….because products are constantly changing and evolving for various reasons. However, you have the same issue in the debt and equity markets.
It’s true not every retirement plan needs an annuity. Fixed and fixed index annuities typically will NOT in the long-term deliver an equivalent rate of return when compared to the stock market. However, as Roger Ibbotson, Ph.D. and Professor Emeritus of Finance at Yale, concluded in his recent study on fixed indexed annuities with Zebra Capital Management, LLC, “FIA’s (fixed indexed annuities) have many attractive features as both an accumulation investment and as a potential source of income in retirement.” Bottom line: annuities, particularly fixed indexed annuities, are not just about income anymore! Primarily, it’s about outsourcing various types of risk.
The insurance company will keep my annuity money if I die during the income phase.
FACT: This can be true or false. If you are utilizing annuities for income in a traditional fashion through annuitizing the contract, it is possible this could happen. Whether or not this happens depends on the payout choice you make and the date of death of you and your beneficiary. However, with the variety and flexibility of products today, the likelihood of this happening is almost non-existent with a knowledgeable advisor.
There is so much more to consider when it comes to these products but our goal here was to dispel some common myths regarding annuities. I hope you found this helpful. Remember, a plan should always precede a product. If your adviser is pushing you to products without a plan, you’re just getting sold.
If you’d like to learn more, consider our complimentary Game Plan Retirement Review, we’d be happy to help you put your retirement puzzle pieces into place. Contact us and let us know your questions. We are always excited to make new friends!
Wotton Financial Group, Inc. does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstances.*Riders are available for an additional fee – some riders may not be available in all states.