MoneySmart

Not Your Grandfather’s Annuity

A second look at the much-maligned retirement investment.

For years, annuities have had a bad reputation—and rightly so. Annuities of the past had long surrender periods, offered little more than tax-deferral and standard death benefits as options, and were just not implemented properly.

Today, these strategies have evolved. There are many applications where, if used appropriately, these investment vehicles may make sense as part of an overall financial plan.

Supplemental Income

“Annuity” simply means a fixed sum of money paid to someone yearly, typically for life. Think of pension payments from the past, back when employers commonly offered this benefit to retired employees. That is an annuity payment. Annuities can be purchased as a personal investment, separate from having to work for a corporation. As a matter of fact, very few companies still offer pensions. This is one reason annuities should be getting a second look as the Baby Boomer generation continues to head into retirement.

Today, annuities have many different options or features—called riders—that can be added to the base contracts. For example, Guaranteed Withdrawal Benefit riders typically offer guaranteed income for life, either to cover a single life or joint lives, without having to annuitize a contract (meaning to give up the entire contract value in exchange for a fixed payment for life). There are different versions of these riders, depending on the issuing insurance company, but the gist of it is that this strategy allows one to plan on a predictable, guaranteed cash flow in retirement. Many times, this supplemental income—in addition to a retiree’s Social Security and/or pension income, if any—creates a meaningful guaranteed base of income. This annuity income can be used to meet a portion of one’s overall living expenses, or fixed expenses such as life insurance premiums, or mortgage payments. Having this tool allows one to increase their “income stability ratio”—the portion of their overall income stream that is guaranteed, no matter what happens.

Annuities as an Alternative

Other features include riders such as a Long-term Care rider. Unfortunately, not everyone qualifies for or has long-term care coverage. There are many reasons for this—health status may be an issue, or the cost of long-term care insurance may also be a barrier.  There are some annuities today that offer riders that will allow one to access more income, without negatively affecting their guarantee. The thought behind that is so there will be additional funds to help with long-term care expenses. Actual long-term care insurance is usually a better solution, but for those who cannot obtain it, this may be an alternative to consider. The downside, of course, is that the earnings portion of the income is taxed as ordinary income, whereas benefits from a long-term care policy are tax-free.

Along those same lines, for those who cannot qualify for life insurance, annuities typically offer a standard death benefit. For example, if one invests $100,000 into an annuity and the value dropped below the initial investment amount (due to market volatility) and the account owner passed away, the beneficiary will receive at least $100,000.  Today, there are annuities that offer “enhanced” death benefits, such as roll-ups or step-ups in death benefit values, that are over and above the initial investment. There are many variations to the different kinds of enhancements, but some individuals will use annuities for death-benefit solutions if regular life insurance is not an option. The earnings portion of the proceeds from this strategy would be taxed as ordinary income, whereas proceeds from a life insurance policy are tax-free. This is one way to use this strategy—as an alternative if obtaining life insurance is not an option.

There Is No Free Lunch

Annuity strategies can be cost-efficient, but they can also be costly. It really depends on how the strategies are designed to meet your needs. In general, the average annuity solution is more expensive than a regular investment portfolio because of the guarantees and other features it provides. Depending on what one is trying to accomplish, one may find the cost of annuities to be reasonable. For example, predictability and protection may be something that one finds to be invaluable.

It is a good idea to seek professional advice on your specific circumstances, as annuity strategies are complex and may not be right for everyone. They are, however, yet another tool in the financial toolbox, and there can be a place for some of these strategies within a financial plan. Work with your financial-planning professional to see if it makes sense for you, and if it can add value to your financial plan.​

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Please consult a qualified professional regarding your specific situation. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Annuities are suitable for long-term investing, such as retirement investing.  Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.

FB Comments

Grace S. Yung

Grace S. Yung, CFP, is a certified financial planner practitioner with experience in helping domestic partners plan their finances since 1994. She is a principal at Midtown Financial LLC in Houston and was recognized as a “Five-Star Wealth Manager” in the September 2017 issue of Texas Monthly.
Back to top button