Protect my principal, and guarantee my income. Those are the goals of many investors today, especially those in or nearing their post-career years. Now that the equity markets no longer are rising steadily upward, investors aren’t looking for ways to match or beat the indexes. They’re looking to protect the nest eggs they’ve worked hard to accumulate and ensure they don’t run out of income.
There are a number of ways to protect your nest egg. But there also are perils in the market for safe, guaranteed income.
When you’re in the spending years and looking to convert part of your nest egg into a stream of income, the immediate annuity is the conventional, reliable strategy. You give a lump sum to an insurer, and it promises you a stream of income for life, or whatever other period you select. The payments to you include both income and principal. But you don’t have to worry about outliving the money. That’s the insurer’s worry.
There are some disadvantages. You have limited or no ability to dip into the principal when spending needs exceed the regular payments. That’s one reason not to put all of your nest egg into immediate annuities. Another downside is there’s nothing left for your heirs or charity after the income payments end. That’s another reasons to use only part of your nest egg to buy an annuity.
The amount of the income payments is fixed. Over time, inflation likely will erode their purchasing power. You need other income or assets to allow your spending to grow as the annuity’s purchasing power declines. Or you can buy an inflation-indexed immediate annuity instead of a standard annuity. Your initial payment will be lower with the inflation-indexed annuity. Normally it’s about 20% to 33% lower. But the payment will increase over time if there is inflation.
When you’re still in the accumulation and saving years, there are other options to guarantee your principal and minimum returns.
You can look at the traditional plain vanilla deferred fixed annuity. With this annuity, you pay a lump sum to the insurer. In return your account is credited with an income return each year. The return usually changes annually in line with either intermediate bond yields or the investment returns of the insurer.
Some insurers complicate these annuities with bonus interest, teaser first-year yields, and other features. Remember these will cost you in some way. Also, weak insurers sometimes use these features or above-market yields to attract investors and gain market share. In those cases, you often pay for the higher yields with below-average returns in the long term.
When you want to try for a higher yield, consider an indexed annuity (once known as equity indexed annuities). These credit your account with a yield based on the behavior of a stock market index. The specifics of the formulas can get complicated. You won’t receive the full return of a stock market index, and there will be an annual maximum return, usually of 10% to 12%, regardless of how well the index does. But when stocks are rising you should receive a higher return than from a fixed deferred annuity and won’t risk losing a substantial sum as you would in the stock markets.
A traditional index annuity guarantees your principal never will decline. (Before 0% interest rates you also might have received a guaranteed minimum annual return.) But index annuities have optional bells and whistles that could cause a decline in principal. These features include guaranteed minimum death benefits and guaranteed minimum (or lifetime) withdrawals benefits. We’ll discuss what these terms mean shortly.
If you choose these riders, an additional fee is charged against your account. When interest rates are as low as they are now and the stock market has low or negative returns for the year, there might not be enough income to offset the additional expense of these riders. That means the value of the annuity account can decline, because principal will be used to pay the expenses. Be sure you fully understand the income crediting and expense rules and whether the account could decline under some circumstances.
Versions of or competitors to index annuities are offered through banks and brokerage firms. You might see them described as principal protected notes, indexed certificates of deposit, and other names. In most cases they’re backed by an insurer, so if you’re considering one compare it with available insurance offerings.
Variable annuities weren’t associated with principal protection and guaranteed income until fairly recently. In the wake of sizeable losses in the early 2000s that scared away buyers, insurers developed the guaranteed minimum annual return/accumulation (GMAR) and guaranteed minimum/lifetime withdrawal benefits (GMWB). These features try to combine some elements of immediate and fixed annuities with variable annuities. The GMAR is what the name implies. But you should read the fine print when you consider one so you understand the limits of the guarantee and what might happen under different circumstances.
Let’s focus on the GMWB. A GMWB rider promises the annuity will pay the owner an annual distribution for life equal to a minimum percentage of the initial investment. The guarantee depends on the owner’s age and how long he or she waits before beginning distributions. For example, a 60-year-old who begins distributions immediately will be guaranteed a 4.5% annual distribution in one popular annuity. A 55-year-old who doesn’t begin benefits until age 60 receives an initial payout of 5%, while a 50-year-old who waits for distributions until age 60 receives a 5.5% payout.
The minimum distribution is guaranteed regardless of the actual returns generated by the investments the annuity owner selects and how long the account owner lives. The distribution could increase if investment returns are high.
The guarantee increases the fees charged to the variable annuity account, which already are high. Because of the higher fees, it becomes more difficult for the account to earn high enough returns to increase the account balance enough to meaningfully increase the annual distributions above the guarantee. So, you’re basically locking in the minimum distribution with a fairly low probability of increasing that amount.
A rider for guaranteed minimum death benefits is a way of protecting your principal for your heirs and buying a form of life in insurance when you otherwise aren’t able to. It’s probably more expensive than straight life insurance if you’re of average health.
You can find more details about variable annuities and these riders in past issues of Retirement Watch available to members at Retirement Watch.
Guaranteed income and principal protection are available in many forms. They’re available whether you are in the spending years or the accumulation years.
When considering any of these vehicles, keep a few points in mind. One point is that you’re transferring risks to the insurer. You’re transferring the risks of low investment returns and a long life. In return you’re taking the risks that you won’t live to life expectancy and that investment returns will be high in the future. If either of those events occurs, the insurer makes a nice profit at the expense of either you or the insurer.
You’re also giving up some liquidity. Withdrawals above a guaranteed or scheduled distribution are limited or prohibited. You also either won’t be able to exit the annuity or will pay a penalty for doing so, at least for a period of years. Of course, you’ll also pay the insurance company’s fees and expenses, whether they’re explicitly stated or not.
Most people evaluate these guaranteed income opportunities the wrong way. They’re presented one product and evaluate it on its own. Instead, you need to determine whether or not you want guaranteed income and principal protection. When you do, first decide how much of your portfolio you want to allocate to it. Then, you should compare the different generic vehicles available. For example, do you prefer the simplicity of an immediate annuity, the protection of an inflation-indexed annuity, or the potential for a higher payout from a variable annuity with GMWB? After answering those questions, you can contact different brokers and insurers to see how the payouts and other terms differ between insurers.
A major disadvantage to buying guaranteed income and principal protection today is the income guarantees are low. That’s because the Federal Reserve is keeping interest rates low. Once you’ve decided on the guarantees you want, consider delaying the purchase. Suppose you decided on an immediate annuity for 25% of your portfolio. Instead of buying the full annuity now, you could buy an immediate annuity for life with 5% of your portfolio each year for the next five years. Or you could buy a five-year annuity now and hope interest rates will be higher in a few years.
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