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How to Maximize Insured Retirement Income with Annuities

Last update on: Jun 22 2020

Most people want a steady, reliable income source in Retirement that they cannot outlive. But they also need for their income to grow, to maintain its purchasing power in the face of inflation. That’s a tough combination to get.

In last month’s visit we looked at immediate annuities and fixed, deferred annuities as a way to get steady reliable income you won’t outlive. I also suggested some ways to ensure that income keeps pace with inflation.

There’s another relatively new vehicle you should consider. Its goal is to provide you with a steady source of income that also maximizes your income. It is known as the immediate variable annuity.

You know about deferred variable annuities. In these, you invest money with an insurer and can direct how your account can be invested from among mutual fund-like investments offered by the insurer. All gains earned by the account are tax-deferred until withdrawn. I have analyzed variable annuities extensively in the past, and these articles are available in the archive on the web site.

The variable immediate annuity (VIA), as you might expect, combines features of the immediate annuity and the variable deferred annuity. It can produce a steady, growing source of retirement income. But these annuities can be very complex.

With the VIA, you purchase the annuity and select how it will be invested from the investment funds offered by the insurer. You get an initial monthly income based on your age, the amount invested, and the assumed investment return (AIR). You select the AIR from among options offered by the insurer.

The choice of AIR is important, because it determines your initial income. The higher the AIR, the higher your initial income.

But income payments are adjusted for the actual investment performance of your account. Strong investment performance means steadily rising retirement income. If your investment performance doesn’t at least equal the AIR, the income will fall. For income to increase, your investment returns must exceed the AIR. That’s why most people choose a relatively low AIR. They accept a lower initial income in order to reduce the probability that the income will fall in the future. The most common AIR selected, and the one most insurers recommend, is 5%.

Obviously you are taking a risk with a variable immediate annuity. You have the possibility of retirement income that increases with your investment returns. But retirement income also could fall if your investment returns don’t meet expectations. You could reduce the risk by purchasing an annuity with a guarantee, which I’ll discuss shortly.

A number of insurers offer variable immediate annuities. The initial temptation is to purchase the annuity that offers the highest initial monthly income. But that could be a mistake. You want to look at other features. The policies can be hard to compare because they offer different AIRs, guarantees, and flexibility. But look at all the terms and pick the one that seems to offer the best combination of features for your needs.

Compare the directly-sold annuities offered by mutual fund companies Fidelity (800-544-8888), T. Rowe Price (800-638-5660), and TIAA-CREF (800-223-1200) in addition to those that might be offered by your insurance agent.

First look at total costs. The costs are subtracted from the investment returns. That means high costs will hold down the growth of your income in good markets and increase its decline in bad markets. The major costs are a general charge for insurance, mortality, and administrative expenses. In addition, there are expenses charged on the investment accounts. There also probably will be a surrender charge if you cancel the annuity within the first five to seven years.

Fidelity charges a 1% insurance charge, and the average fund expenses are 0.96%, for a total cost of 1.96%. Price’s total expense comes to 1.35%, and TIAA-CREF’s is 0.5%. American Skandia’s policy, by comparison, has total expenses of about 2.25%.

Vanguard has the lowest costs, but it doesn’t offer a variable immediate annuity. Instead, you can buy its variable deferred annuity. Then at payout time you select a variable payout option instead of a fixed payout.

Next, look at the guarantees. Fidelity has an option that effectively splits your purchase into a guaranteed immediate annuity and a variable annuity. Of course, you might get the same effect yourself by purchasing two separate annuities. Price offers a guarantee that your income payments won’t decline more than 20% from the initial level. But the guarantee costs money. The insurance charge on the regular variable immediate annuity is 0.55%. On the guaranteed annuity it is 1.4%.

Then, look at surrender fees. Most annuities impose a surrender fee if you cancel within five to seven years. The Price annuity charges a 5% surrender fee the first year, and the fee declines by one percentage point for each of the next four years.

There are alternatives to the variable immediate annuity.

You can buy the traditional immediate annuity as discussed last month and supplement it with a portfolio of stocks and bonds. Or you can do all the investing yourself and take a distribution from this portfolio each year. The distribution amount can be adjusted to follow the investment returns of the portfolio.

A final option is an immediate annuity that grows by a stated amount each year, usually 4%. A few insurers such as Safeco and Lincoln National offer these “growing annuities.”

You have to decide which option gives you the best combination of secure income with the potential for growth.

There are two more caveats with the VIA. One is that the products are relatively new, so insurers don’t have a long track record with them. Another is that if all your money is in the VIA your ability to take a lump sum for emergency purchases is limited.

As with all annuities, income distributions from the VIA is ordinary. So you effectively convert capital gains from stocks into ordinary income. Also, an annuity is not for assets you want to leave to heirs.

A variable immediate annuity probably is best for people who might not have saved enough for retirement. They can buy a VIA that gives them some guaranteed floor on lifetime income that they cannot outlive, but it also has the potential for the income to grow if the investment selection do well.

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