Using a Retirement Annuity to Fund a Secure Living
One of the biggest fears among retirees and soon-to-be retirees today is that they will outlive their retirement savings. With life expectancies in developed countries at unprecedented highs, this is a justified concern. Many senior citizens will live to see their eighties and nineties, but they may have only saved enough to fund a lifetime equivalent to their own parents’ – perhaps up to their late seventies. Thus, the demand for a retirement “security blanket” is high.
Background of Retirement Annuities
Annuities have been developed as a risk management tool that can minimize or even eliminate a person’s risk of depleting his or her savings before death. A large lump sum is paid by the retiree, in return for monthly or yearly payments, for a predetermined length of time or until death.
Retirement annuities are available that can maximize payouts to a single person but potentially pay out very little if the investor dies too soon, maximize the chances of getting the initial investment back, or anything in between.
Furthermore, the regular payment amounts may fluctuate, as with a variable annuity, or the investor may opt for the stability of a fixed annuity, which guarantees a certain payout but will never pay above that amount, even if the market performs spectacularly.
Types of Annuities for Retirement Planning
Most people interested in annuities as a stable retirement vehicle are thinking of fixed annuities, which pay out a stable amount every month, quarter, or year, depending upon the initial agreement. Variable annuities, which behave much more like traditional investment securities, will pay out an amount commensurate with the market’s return for that period.
Depending on their age and how far away retirement is, the individual or couple must decide whether to invest in an immediate or deferred annuity. As its name implies, an immediate retirement annuity will make its first regular payment once the lump sum is deposited. For retirees who are looking to secure a stable retirement income immediately and do not want to spend time worrying about the issue any longer, an immediate fixed annuity can provide quick peace of mind.
For people who either have not yet retired or who want to live off other funds until an annuity income becomes necessary, deferred annuities will behave like a Certificate of Deposit and accumulate a market rate of interest that will increase the payout amount once payout is requested. Deferred retirement annuities can be a wise investment decision for future retirees who already know they will want the peace of mind that only an annuity can offer, and give the annuity the time to grow and increase the payout as much as possible before the income is needed.
Annuities can also be distinguished based on their payout policy, which governs how long and to whom the annuity will pay out the income.
- Guaranteed Period Annuities will pay out for a certain length of time (10, 20, and 30-year periods are common), and if the original investor dies before the period is up, payments will continue to their designated beneficiary.
- Guaranteed Lifetime Annuities will ensure that regular payments will be made until the insured passes away, whether that is in one year or forty. After the death, any remaining funds will revert to the investment company.
- Life with Period Certain Annuities will pay out for at least a minimum period, and will go on to pay out for life if the insured lives that long. This option ensures that the beneficiary will at least receive income for the period selected if the insured dies sooner than that, and the insured will continue receiving a stable income until death if he or she survives the time period.
- Joint and Survivor Annuities are typically the option that married couples choose. This type of annuity will pay income until the later of the two deaths, ensuring that both partners will be covered for life.
Drawbacks and Limitations of Retirement Annuities
Because people who are looking for annuities are often doing so out of fear, unethical insurance salespeople and other financial workers with incentives to sell annuities may successfully pressure retirees into buying annuities without fully understanding their myriad disadvantages.
For one thing, expenses are very high on annuities, even compared with similar investment vehicles.
- Sales commissions are as high as 10%, combined with regular maintenance and administrative fees, which are based on a percentage of the market value, can reduce the portfolio by several percent every year.
- In addition, surrender charges for cashing in the annuity before seven or eight years can reach up to a 20% penalty.
- To minimize expenses, investors can purchase their annuities directly from an investment company instead of an insurance salesperson, and read the terms very carefully to understand all fees that will be charged on the account.
- Additionally, payouts are taxed at regular income rates, so the actual income a recipient is allowed to keep will be less than the stated payout.
Depending on the payout option selected, such as Guaranteed Lifetime or Joint and Survivor, it is possible that hundreds of thousands of dollars can be invested into the annuity, without it ever paying out a dime. That is the price that retirees will pay for the guarantee of an income stream if they do live a long life, and comparable to the risk of paying insurance premiums for years and never needing to file a claim.
The rates of return on annuities can also be problematic. Fixed annuities are not indexed to inflation, so the purchasing power of the installments will regularly decrease. Variable annuities are more likely to perform better than the inflation rate over several decades, but many retirees do not have the luxury of several decades to wait for the markets to improve, and they could actually see their payouts dwindle over several years.
Equity-indexed annuities offer a compromise that may be palatable to some investors: a guarantee of a minimum fixed income, plus a portion of the increased market value if the market is doing well. However, fees are even higher than usual for equity-indexed retirement annuities, and surrender charges can last as long as 15 years.
A Final Word on Annuities as a Retirement Option
The guarantees that an annuity can offer are often heard reverently by retirees frightened by the thought of living to see their retirement accounts hit zero, but this peace of mind can come with a hefty price tag. The numerous fees that investment companies and fund managers charge, particularly on variable annuities, can eat up 2-3% of the annual rates of return.
In general, it is best to purchase an annuity only if a guaranteed income is of utmost importance to the investor, and he or she has undertaken a thorough review of all the costs involved with retirement annuities.