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Investing Specialists

How to Invest in an Annuity

If you've decided to purchase an annuity, you'll also need to think through where to hold it, how much to annuitize, and when to make the buy.

As we continue our series on the ins and outs of annuities, we turn our attention to the where, how, and when of incorporating them into a financial plan.

Annuities are among the most daunting products for individual investors to navigate, and in previous columns, we had discussed the who, what, and why of them. We started with most basic question: "Is an annuity right for you?" Then we explored the four basic types of annuities and their respective pluses and minuses.

With this article, we tackle implementation issues. Even those investors who have decided that an annuity makes sense in their situation may struggle with logistics. A major question is what funds to use to buy the annuity: taxable or tax-deferred assets. While critics may point out that buying an annuity inside of an individual retirement account is equivalent to wearing a belt with suspenders--in that tax-sheltered accounts already carry inherent tax advantages--purchasing an annuity inside of an IRA can make sense in some situations. Additionally, would-be annuitants must consider how much to put into the annuity, whether to buy now or wait until some future date, and whether to buy in a lump sum or "ladder" a series of annuities purchased over several years. 

So, if you've decided an annuity may make sense in your situation, consider taking the following steps when making a decision.



Determine Which Assets to Use

Most people hold the bulk of their retirement assets in tax-sheltered accounts like IRAs, so the decision about which assets to use to purchase the annuity are predetermined. But if you have assets in taxable accounts as well as in tax-sheltered accounts, you'll need to decide: Which funds should you use to purchase the annuity?

At first blush, the right answer would appear to be taxable assets--assets lying outside of tax-sheltered accounts that you've already paid taxes on. That's because the annuity provides an additional source of tax deferral, similar to what you receive through investing in an IRA. As long as your assets stay inside the annuity wrapper, they're not subject to taxation. From that standpoint, the annuity adds to the traditional receptacles for tax-deferred savings, such as IRAs and 401(k)s.

After you annuitize and begin to receive payouts from the annuity that you purchased with aftertax dollars, the taxes due on depend on the ratio of assets that have been taxed (your contributions, or cost basis) relative to those that haven't (your earnings). That "exclusion ratio" helps ensure that you're not paying taxes twice on the money you put in. By contrast, if you use IRA or other tax-deferred assets to purchase the IRA, the annuity is considered qualified. You enjoy tax-deferred compounding on your money, too, but any payments you receive from it are fully taxable at your ordinary income tax rate.

From the standpoint of tax treatment alone, whether to use aftertax or tax-deferred assets to purchase the annuity is roughly a wash. The key benefit of using aftertax assets is that it opens up an additional slot for tax deferral, above and beyond what you might have with your IRA and 401(k) contributions.

However, using tax-deferred assets to purchase an annuity can make sense in some situations. A key one is to reduce required minimum distributions that would otherwise commence at age 72. By purchasing what's called a qualified longevity annuity contract, or QLAC, with tax-deferred assets, you can effectively remove up to $135,000 from your RMD-subject assets. (That dollar limit is for 2021; it increases a bit each year.) The QLAC is a type of deferred annuity that begins paying out later in life, often at age 85. As such, it helps protect against longevity risk, like other annuities, while also reducing the tax bills when RMDs begin. If this seems like an attractive proposition, it's a good idea to get tax advice before proceeding.

Determine How Much to Annuitize
In addition to thinking through which funds to use to purchase an annuity, you'll also need to consider how much to put into it. The right amount to annuitize depends on what type of annuity you're buying, of course, and why you're using it.

If you're using an annuity as a key source of retirement savings because you have limited access to tax-advantaged accounts (you don't have a 401(k), for example), you might reasonably steer a larger share of your portfolio into the annuity. Just be sure to investigate tax-efficient investing in a taxable account as well, in that it's possible to obtain a decent level of tax deferral with investments like exchange-traded funds and also enjoy capital gains treatment on your withdrawals. That's better than the ordinary income taxes that are due on the percentage of your annuity payments that consist of investment earnings.

On the other hand, if you're using an annuity in the traditional sense, to help shore up guaranteed income in retirement, deciding how much to annuitize is more straightforward. Assuming you're fairly close to retirement and have a good handle on what your expenses will be, take a close look at your essential expenditures--your outlays for housing, utilities, food, taxes, and insurance. Next, consider how much of those essential expenditures will be supplied by other nonportfolio sources of income, such as Social Security and/or a pension. The amount that's left over is a good target for how much income you should seek from an annuity--and in turn how much you'll need to put into it in the first place.

For example, let's say you're 70 years old and you've run the numbers about your in-retirement cash flows. You anticipate $48,000 in basic expenses in retirement. If you’re anticipating a $33,000 annual benefit from Social Security, you'd want to find an annuity that pays out the remaining $15,000 annually. Using Schwab's Income Annuity Estimator, which allows you to plug in your desired monthly income to determine how much to annuitize, a 70-year-old female seeking an immediate annuity for her lifetime only would need to annuitize about $240,000 for a payout equivalent to $15,000 annually.

That's an ultra-simplified example. But if you're using an annuity for its most straightforward purpose--ensuring continuity of lifetime income--it's not a bad way to rightsize your annuity buy.

Assess Whether to Buy Now or Wait
We've covered which pools of assets to use for an annuity, and how much to steer into such a product. Next up: when to buy it.

There aren't any age limits around when you can buy an annuity. But most people likely begin to ponder an annuity purchase right around the beginning of retirement, as they're mapping out their cash flows from various income sources. They have a good sense of what their in-retirement income needs will be, and they'll be in a good position to determine how much additional cash flow they need to ensure their basic living expenses.

But even for people on the cusp of retirement and seemingly at the ideal age to purchase an annuity, today's ultralow interest rates might seem to argue against making a big annuity buy right now. That's because, as noted above, the payouts you receive are keyed in part off of the current interest-rate environment. With yields likely to stay low for the foreseeable future, annuity payments are likely to be correspondingly low, too. Should you wait until interest rates increase to buy an annuity?

David Blanchett, Morningstar Investment Management's head of retirement research, argues that waiting to buy an annuity in an effort to capitalize on better payouts via a higher interest-rate environment is "effectively market-timing." And indeed, a quick Google search of when to buy an annuity turns up articles about this very topic dating back to a decade ago, and yields have even declined since that time. Would-be annuitants haven't necessarily gotten paid to wait.

Blanchett points out that the right time to purchase an annuity depends on the individual: your age as well as the complexion of your investment portfolio and what you might invest in while you wait. Older annuitants will be hurt less by the fact that they've purchased an annuity while rates were low because the duration of their payouts is shorter than is the case for younger annuitants, who are locking in a low payout for a longer term. The opportunity cost for younger annuitants is greater. Older annuitants also benefit more from mortality credits than do younger ones. That simply means that the older annuity buyer has a higher chance of dying sooner, which helps plump up payments for everyone in the annuity pool. Younger annuitants, because they're less likely to die soon, benefit less from those credits. Finally, Blanchett argues that it's worth thinking about what the assets would be invested in during the waiting period before the annuity purchase. If the assets would be parked in very safe, low-returning assets as an alternative, delaying doesn't yield much of a benefit.

One way to circumvent the possibility of purchasing an annuity at exactly the wrong time is to make smaller purchases over a period of years. Just as with building a bond ladder, making several annuity purchases over a period of several years allows buyers to experience a range of interest-rate environments. At a minimum, doing so reduces the regret that can accompany any investment decision that turns out to be precisely wrong.

Another benefit of spacing out purchases of an annuity is that you can diversify across insurers, thereby diluting the credit risk of making a single large purchase of an annuity. If an insurer runs into financial trouble and the state guaranty agency backing it up fails, you've put just a portion of your annuity purchase at risk, not all of it. That can provide valuable peace of mind.

On the other hand, laddering annuities undermines one of the key benefits of annuities: the simplicity that accompanies receiving a single paycheck to augment income from a pension and/or Social Security. In addition, Blanchett argues that insurers are generally well capitalized, so the risk of one's failure may be overblown. (We'll delve into how to investigate insurers' health in a future article.) Finally, there are typically fixed underwriting costs associated with each annuity purchase, which argues against making numerous, very small annuity purchases.