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Mark Miller: Remaking Retirement

A Primer on Annuities

Contributor Mark Miller walks through the various products and features and discusses for whom they’re best suited.

The annuities market is plagued by an assortment of opaque names for its products. Look under the hood of the industry and you will find that some annuities are fairly easy to understand while others are not. Lately, the most complex ones seem to sell best. 

Sales of annuities are rising--2019 was the fastest year of sales since 2008, with complicated indexed annuities leading the pack. That trend is driven mainly by baby boomers searching for protection from volatility. 

Several recent policy and legislative changes may also be setting the stage for further growth:

 

  • During the Obama administration, the U.S. Department of the Treasury approved rules that gave birth to the Qualified Longevity Annuity Contract, or QLAC, a type of deferred income annuity that could be purchased inside individual retirement accounts and 401(k) plans. The carrot here is that the value of the annuities can be excluded from minimum distribution requirements.
  • The demise of the U.S. Department of Labor’s fiduciary rule restored the unfettered ability of insurance brokers to pitch indexed and variable deferred annuities to retirees rolling assets out of 401(k) plans. However, a number of states are moving toward adopting their own fiduciary rules, which means regulation and consumer protection for annuity buyers may be tighter in some states than in others in the years ahead.
  • The SECURE Act signed into law in December created a safe harbor for workplace-plan sponsors to offer annuities inside 401(k) plans. This isn’t likely to catch fire quickly, but the concern is that the insurance industry will pitch more expensive, complex variable annuity products, rather than plain-vanilla (and less expensive) income annuities.


How to navigate the annuities landscape? Let’s get out the maps.

Why Might You Want an Annuity?
There are two basic ways an annuity can be used: to generate income or to act as an investment vehicle. 

The usual income goal is to bolster the amount of guaranteed lifetime income that you will receive in retirement. But other types of annuities can be used as tax-deferred investment vehicles. Some hold investments similar to certificates of deposit, or CDs, while others can be used to invest and trade in mutual funds. They often have a guarantee against the loss of principal.

“The first question is not whether you should consider an annuity, but what risk are you trying to reduce,” says Kerry Pechter, editor and publisher of Retirement Income Journal and the author of Annuities For Dummies.

"Are you trying to reduce the risk of capital gains taxes on frequent trading in your mutual fund portfolio? Are you trying to reduce the risk of living until you're 90? Are you trying to reduce the risk of market volatility when you're saving for a specific goal at a specific time? There are different types of annuities for each one of these things,” Pechter adds.

Different kinds of annuities have different designs and different purposes. Buyers use income annuities to turn savings into guaranteed income streams, while deferred annuities are used to grow savings on a tax-deferred basis. 

Fixed deferred annuities are like CDs, providing guaranteed rates of interest over specific periods of time. Variable deferred annuities are like bundles of mutual funds that can be used for tax-deferred trading or converted into income streams.

Indexed annuities—fixed or structured—use options to generate returns based on the rise or fall of equity indexes. Most of these indexed annuities have death benefits that are paid if the owner dies; some offer enhanced payments if the owner goes into a nursing home. Annuities have more differences than similarities, which is what makes them so confusing. 

Two big drawbacks for annuities are their high cost--mainly resulting from high commissions paid to advisors, brokers, or agents--and their complexity, which make them difficult for average investors to understand. 

Pechter has said that insurance products are more complicated than investment products--by nature and by necessity. 

“When you buy an investment you're taking on or ‘buying’ risk, and you do that willingly because you want the exposure to the upside. When you buy an annuity, an insurance company is buying risk from you,” he notes.  

“The insurance company wants to make sure that it’s not charging too little for your risk or taking on more risk than it’s paying for—that’s the reason for the long contracts with tons of fine print,” he adds. “You may or may not like their price, but that’s what they are willing to pay. It’s essential to understand that annuities are insurance and not investments. From a risk standpoint, they’re the opposite of investments.”  

The most straightforward annuity is the single premium income annuity, or SPIA. The proposition here is that you turn over a large chunk of cash to the insurer, which then begins sending you a monthly payment, either immediately or up to 13 months after the purchase. There also are deferred income annuities, or DIA, whose payouts may not begin for 10 years or more after you receive them. In both cases, the payments are guaranteed to last until death.  

The second broad category of annuities really should be thought of as investment products with insurance features. This group includes variable annuities, fixed indexed annuities, and fixed-rate annuities. Although these annuities provide income, they really are structured to meet other goals, such as providing downside protection for your portfolio or minimizing taxes on investments.

Here is a run-down of the most popular annuity types. One caveat: These products can be bought with myriad features and options--far too many to describe here. If you decide to pursue any of these annuity types, consult the in-depth resources cited at the end of this article. And, please choose advice from a trusted, unbiased expert (not a commissioned broker), such as a registered investment advisor. 

Income Annuities
Single Premium Immediate Annuities, or SPIA, offer a way to create a personal pension of guaranteed income alongside Social Security. A SPIA also is a risk-reduction tool: You’re reducing or eliminating investment risk, sequence of returns risk, and the risk of running short of money before you die.   

A downside to this type of annuity is loss of liquidity, so don’t go overboard. Most experts suggest limiting your investment to no more than 20% or 30% of your assets.

The long-running, low-interest rate environment has hurt the attractiveness of income annuities, notes Pechter.

“The level of interest or income that insurance companies can offer you depends on what they earn by investing in bonds, so they really have been squeezed--and you can easily see that in the rates offered on income annuities right now,” Pechter adds.

Before considering an income annuity, take a careful look at your projected household Social Security income and look for ways to optimize it through a delayed claim. Think of this as a way to buy an annuity from Social Security, if you consider the cost to be spending portfolio assets and/or income from work in the early years of retirement to fill any gap in living expenses, before claiming Social Security at a later age.

The cost of a Social Security annuity will beat anything available in the commercial market, and it comes with free inflation adjustments--the annual cost-of-living adjustment, or COLA, awarded to beneficiaries. Social Security optimization can be especially beneficial for married couples .

After estimating Social Security income (and any expected defined-benefit pension income), it might be reasonable to use a SPIA to plug the gap between that figure and your estimated nondiscretionary expenses in retirement (housing, food, transportation, energy, and so on). Then, you can use savings for nondiscretionary spending, like travel, entertainment, or spoiling grandchildren.

Inflation is an important retirement risk, and it has the potential to erode the value of an income annuity significantly. 

“When you think about a retirement that could last 20 or 30 years, that could reduce the value of the income stream by half or more over that timeline,” says Todd Giesing, director of annuity research at the Secure Retirement Institute.

It’s possible to buy SPIAs with inflation-protection riders that boost payments either by a small fixed percentage annually or at a rate tied to the Consumer Price Index. However, there is almost no market for annuities indexed to the Consumer Price Index .

Deferred Fixed Annuities
This is a deferred annuity that guarantees a rate of interest through the accumulation phase. It is generally higher than a certificate of deposit or short-term bond.

These annuities are structured like high-rate certificates of deposit, with a guaranteed rate and a set term of investment (three-, five-, seven-, and 10-year terms are the most common). At the point of this annuity’s termination, you can either take your money and run, roll it into another fixed-term vehicle with the same insurer, or convert it into an annuity stream.

Deferred fixed annuities include guarantees on principal and minimum interest rates. If the broker who sold the contract to you was paid a commission by the life insurance company that issued it, there will be a surrender period when large withdrawals will be penalized. Large withdrawals after a rise in prevailing interests rates may be penalized by a market-value adjustment. But withdrawals of up to 10% of the annuity value can be taken anytime with no penalty.

This type of annuity also includes death benefit protection, so that if you die before payments begin, beneficiaries receive at least the amount you contributed minus any withdrawals taken.

The drawbacks include loss of 100% liquidity and uncertainty about the interest rate that will be paid after the first year of the contract, as the rates can fluctuate.

Fees are built into the contract’s interest rate.

Index Annuity, or Fixed Indexed Annuity
This is a type of fixed annuity. Gains are indirectly linked to the performance of an equity market index, such as the S&P 500, or something more exotic. Indexed annuities also put a floor under market losses. The principal and credited interest of an index annuity are guaranteed not to lose value due to index losses (subject to surrender charges). Some offer death benefit protection.

An argument in favor of index annuities is that they can offer the safety of bonds with the potential—all else being equal—for slightly higher returns than bonds. A key downside is product complexity: index annuities use derivatives or options to generate gains. Also, the volatility of the stock market means you can’t necessarily rely on index annuities to provide steady returns.

Variable Annuity
Think of these annuities as tax-advantaged containers for holding mutual fund investments, with some insurance features stuffed inside. There are a couple of possible rationales for using variable annuities, including the ability to trade and shift money around among the annuity’s sub accounts without generating a capital gains tax liability (ordinary income tax is owed on accumulated earnings when you withdraw funds). In this sense, annuities generally appeal to people who have already contributed the maximum to their tax-deferred retirement plans or IRAs and need a place to put additional after-tax money for tax-deferred growth.

The insurance feature is known as a guaranteed lifetime withdrawal benefit, or GLWB. This offers guaranteed lifetime income along with withdrawal rights.

Further Reading
Annuities for Dummies. Kerry Pechter’s book on annuities is one of the best resources I’ve found. Like most books in the Dummies series, it is organized well and offers clear descriptions using layman’s terms. Pechter provides frank, balanced analysis of the pros and cons of annuities. Begin your annuity research here--you won’t be sorry.

Guaranteed Income Across Annuity Products: Withdrawal Guarantees Compete with Income Annuities. This 2018 study by CANNEX, compares various annuity types, aiming to determine which are best for retirees. Unsurprisingly, it concludes that the answer to this question varies depending on the investor’s life situation. But there’s some interesting reading and research here. 

Finra guide to annuities. The self-regulatory body for broker/dealers has published a six-part guide to annuities.

Podcast
Listen to my podcast discussion with Kerry Pechter on the annuity market. 

Mark Miller is a journalist and author who writes about trends in retirement and aging. He is a columnist for Reuters and also contributes to WealthManagement.com and the AARP magazine. He publishes a weekly newsletter on news and trends in the field at Retirement Revised. The views expressed in this column do not necessarily reflect the views of Morningstar.com.