Investors are taking a closer look at annuities. Fed up with the volatility and uncertainty of the stock market and wanting to preserve what they saved for retirement, retirees and near-retirees are taking a fresh look at vehicles that were shunned during the bull market. Industry sources say investors are allocating more to annuities and sales are rising. The more conservative annuities are drawing the most attention.
The problem for investors seeking safety is that annuities are difficult to compare. There are many types of annuities, and within each type insurers offer vastly different features and options. Also, many people begin the annuity investment process the wrong way. They begin by examining a specific annuity that’s been presented to them and try to decide whether or not to buy it.
First you need to set your goals and then decide the risks you are willing to take. Also note the risks you want to avoid. Then, look for the investments, including annuities, that fit your profile. After selecting a type of annuity, shop among several insurers, because the payouts among insurers vary even for annuities with similar terms.
Annuities can help meet several goals. Foremost, annuities protect against the happy outcome of living a long time. You receive income for life, no matter how long it is. Most annuities also insulate you from some or all market volatility.
Annuities are not without risks. You risk missing the high returns of a bull market. You also take the risk the insurer will fall. Another risk is locking in a low payout rate because interest rates are low at the time you purchase the annuity.
Those are the general risks and rewards. Specific types of annuities have their own trade offs.
Here’s an overview of the annuity world.
Immediate annuities. These are the traditional, plain vanilla annuities. You deposit an amount with the insurer, and the insurer begins making regular payments. Payments can be monthly, quarterly, or annually. Most immediate annuities make fixed payments, but some offer variable payments. The variable payments can be inflation indexed or be tied to the portfolio of investments selected by the annuity owner.
You can receive payments for your life, the joint life of you and a beneficiary (such as your spouse), a period of years, or life with a guarantee for a minimum period of years. The highest payout is for your life or a period of years shorter than your life expectancy. The other options result in lower initial payouts.
Studies show that having a portion of your retirement portfolio in immediate annuities reduces the risk of running out of money during retirement. Annuities help stabilize a portfolio’s value and returns. They also can allow you to take more risk with the rest of your portfolio.
Equity index annuities. These are deferred annuities. The account compounds returns tax deferred until distributions begin. The returns of these annuities are tied to the performance a stock market index. Usually there is an annual floor or guaranteed return of 2% to 3%. Many also have an annual cap or maximum return of around 10%.
The difficulty when evaluating EIAs is understanding the formula for computing the annual return. The account rarely is credited with the published return of the index. Instead, the insurer uses a formula of its own creation to calculate the return. There are about 29 different formulas in use, and they can credit the account with returns dramatically different from those of an index fund. The account also is credited only with a portion of the calculated return, known as a participation rate, up to the annual cap. The details of the formulas and EIAs were discussed in past visits, and you can find them in the Annuity Watch section of the Archive on the web site.
EIAs usually guarantee the account against losses. Sometimes 100% of the principal is guaranteed, sometimes only 90% or so is guaranteed.
EIAs generally are for conservative investors who want a chance at higher returns than traditional conservative investments but can’t tolerate the risks of stock markets or other growth investments.
variable annuities. These are mutual funds combined with annuities. The investor selects investments from those offered by the insurer, and the account compounds tax deferred the returns earned by those investments, after subtracting fees and expenses. Most variable annuities are deferred. But some immediate annuities are variable; the annual payouts vary with the returns of investments selected by the insured.
VAs were very popular until the bear market that began in 2000, when investors suffered large losses in their annuity accounts. Insurers are trying to bring investors back to VAs with new features. Many of the VAs now have guaranteed death benefit guarantees and lifetime withdrawal benefits.
A guaranteed death benefit guarantees the policy beneficiary will receive at least a minimum amount when the original owner dies. Some policies guarantee the initial amount invested in the policy. Others guarantee the policy’s highest value on the anniversaries of its purchase.
A guaranteed lifetime withdrawal allows the insured after a certain age to make annual withdrawals of at least 4% to 5% of the annual base amount for life. The base amount could be the amount invested in the policy or some other amount.
The trade off in VAs is these features cost money. The basic VA’s fees on average are 2% or so of the account’s value each year. As these other features are added, the costs increase. There are low-cost variable annuities from Vanguard, Ameritas, and some other financial services firms, but for all of them you have to determine if the benefits are worth the costs. For example, could you achieve similar results yourself by purchasing life insurance or zero coupon bonds with a portion of your portfolio?
Longevity annuities. These are relatively new. You give the insurer a lump sum. The insurer promises to begin paying you annual income beginning at age 80 or 85, should you live that long. That ensures you will have income if you live a long life. If you don’t make it that long, the insurer keeps the money. A typical offering today is that $25,000 invested by a 65-year-old female will generate monthly payouts of $1,169 at age 85.
Hybrid policies. We discussed in a recent visit how some annuities can be used to pay for long-term care. A typical combo policy will pay up to two or three times the account’s value for long-term care over a period of about six years. For example, an annuity’s value is $150,000 when the owner needs long-term care. The policy will pay up to $300,000 to $450,000 after a long-term care claim is filed. The annuity does not earn income after a claim is filed, and the account’s value for other purposes is reduced.
Consider carefully before choosing an annuity, because it is a long-term investment. Purchasing an annuity generally locks you in for the long term. Most annuities charge surrender fees if you want to withdraw your investment within seven years, and some have much longer lock-in periods.
There are many annuity features to choose from. You need to remember that each of these features and protections costs money. It will reduce either your earnings or your payout. The reason to buy an annuity usually is to create a stream of guaranteed retirement income. Adding other goals, such as ensuring something remains for your heirs, reduces your income. Inflation protection is the feature most likely to be worth the cost. Another buying tip: The longer you wait to purchase an immediate annuity and begin income payouts, the higher your lifetime income will be.