Old-style defined benefit pension plans are looking more attractive to many retirees and near-retirees. A defined benefit (DB) plan pays a fixed monthly amount for life, and many even increase the payment for inflation each year. When the stock market is volatile and uncertain, and bond yields are low, a DB plan can look good.
Fortunately, people can create their own DB plan, even one with payments that increase to maintain purchasing power. One way to create a DB-like plan is with variable immediate annuities (VIAs).
The annuities are immediate, because they begin payments within a year after the purchase. They are variable, because the owner chooses how the account is invested from among options offered by the insurer. The payments vary with the returns of those investment choices.
The owner gets a regular payment that is guaranteed by the insurer and has the potential to increase over time. The major risk, of course, is that the payments might decline. There are steps you can take to minimize that possibility.
When the VIA is purchased, the initial monthly payments are based on the owner’s age, the amount invested, and something called the assumed investment return (AIR). The owner selects the AIR, and we’ll discuss that shortly.
One obvious point is that the older one is when the VIA is purchased, the higher the initial payment will be.
The AIR is where the owner must make careful trade offs. The higher the AIR selected, the higher the initial payments will be. But the payments increase only if the actual investment income exceeds the AIR. If the AIR is greater than actual returns, the monthly payments will decline. Earning positive returns is not the goal, and neither is setting an AIR that gives the highest initial payout. The goal is to select an AIR that can be beaten. Unless the account’s returns exceed the AIR, the income will decline over time.
The insurer often gives the owner three AIRs to choose from: 3%, 5%, and 7%. Most insurers recommend, and most people select, the 5% AIR. That rate gives an acceptable initial payout and is a level that investment returns are likely to exceed over time.
The investment options also require careful selection. It probably is best not to seek the highest long-term return. The account’s returns will have a great deal of annual volatility. The income will rise and fall with fluctuations in the investment returns. Instead, choose a diversified portfolio of margin of safety investments with both income and growth potential.
Some of the insurers offer guarantees with their VIAs. T. Rowe Price, for example, allows the owner to purchase a guarantee that the income payments will not decline more than 20% regardless of how the investments perform. There is a cost to the guarantee. Price’s regular fees on the VIA total 0.55% of the annuity value (excluding investment fees). The fees on the guarantee VIA are 1.4%. You will have to decide if that steep fee is worth the guarantee, and if your investments will be able to beat the VIA after all expenses. The types of guarantees and their costs differ, making it tough to compare policies.
As with other annuities, do not immediately latch on to the VIA with the highest initial payout. There are other factors to consider.
Review the investment options. Examine the number of options to determine how diversified your portfolio can be. Also, check the past performance of the options.
Next, look at fees. There will be several levels of fees. There is a basic administrative, mortality, and insurance expense. There also might be an account maintenance fee or similar charge. Each investment option is going to have its own fees. Check these closely. You don’t want to buy an annuity that charges a 1% fee for an index fund.
Your annual return is calculated after all fees. Your return after fees needs to beat the AIR for income to increase.
Many VIAs will charge a surrender fee. Most surrender fees expire after the annuity has been owned for five to seven years, but some insurers continue the surrender fee beyond that.
Before deciding to use a VIA, consider that all income distributed from a VIA is taxed as ordinary income. If the money were held in a taxable account, dividends and long-term capital gains would be taxed at the 15% rate. In addition, lump sum payments are limited. You need another source for emergency or large payments.
There are alternatives that you might find cheaper and more effective. You could purchase a traditional immediate annuity that pays a fixed amount for life. Supplement that with a portfolio of stocks, bonds, and mutual funds that generate additional income plus growth. The portfolio also is a source for larger sums as needed.
Some insurers, such as Safeco and Lincoln National, offer “growing annuities.” These are immediate annuities that increase their annual payouts by a fixed amount each year, such as 3% or 4%. Naturally, the initial payout is less than with a traditional immediate annuity.
VIAs are relatively new investments. Insurers do not have a track record or experience in pricing them.
A VIA probably is best for someone who is concerned that there might not be enough money saved for retirement or that it won’t be managed well. The VIA provides a guaranteed income floor that cannot be outlived plus the potential for the income to grow. A VIA also can be part of a diverse group of income vehicles such as a balanced investment portfolio, an immediate annuity, and a VIA.
Many insurers offer VIAs. In addition, there are no-load, direct-sold VIAs available from Fidelity (800-544-8888), T. Rowe Price (800-638-5660), and TIAA-CREF (800-223-1200).
Vanguard does not offer a true VIA. But investors can purchase Vanguard’s variable annuity, then select the variable payout option instead of the fixed payout.