For many years, annuities were simply a method of receiving a stream of payments in exchange for a large chuck of money up front. During the latter part of the 20th century, annuities were modernized by the insurance industry so that they fit just about all financial situations.
Annuities offer flexibility in many of their provisions. You have flexibility of how and when money goes in to an annuity, how and when it comes out, and the investments that will be used by your money is in the contract.
If you are lucky enough to have a defined benefit pension plan, you actually already have an annuity. Once you retire you will begin to receive payments for the rest of your life under some type of payout option. In this situation, you may wish to buy an annuity to supplement that pension income. However you will probably want to put any additional assets into investments which allow for greater capital gain during your retirement years. This might include various types of mutual funds, or a combination of stocks and bonds.
As you can imagine, each person’s financial situation is different and, therefore, the reasons for buying an annuity differ also. Let’s look at some of the more common reasons.
Guaranteed Lifetime Income
Having a guarantee that you will receive payments for the remainder of your life is probably the primary reason people buy annuities. An annuity can be bought at any time. You can start an annuity program in your 20s and contribute a small amount each month into the contract. In this case you would have a deferred annuity since payouts will not start for a number of years in the future.
You can put your money into a contract all at once, such as just before you retire. In this case you would have an immediate annuity since you begin to receive payments shortly after you pay the entire premium. This latter method also gives you complete flexibility during your working career to invest your money in any type of investment program you desire. However, when you retire, you may desire more security in receiving monthly payments, and that is the point at which you would buy the annuity.
There are a couple of considerations you will have when deciding to buy an annuity. Your first concern should be the safety of the insurance company. Since you are making a very long term commitment with your assets, you want to be sure that the insurance company is going to be in existence for a very long period of time. However, insurance companies do become insolvent periodically. For this reason it is imperative that you select an insurance company that is well-known, healthy, and is highly rated by the rating agencies. The primary rating agency that you should review is A. M. Best.
Another consideration is being locked in long term to a single interest rate. The advantage of having a fixed payment each month for your entire life, also becomes a disadvantage. Inflation is the number one problem that a retiree faces over a long period of time. Living on a fixed income each month may be nice at first. However inflation will erode your purchasing power steadily during your retirement years. A new car which costs $20,000 today may cost $40,000 a number of years into retirement. A can of soda which today costs one dollar, may cost you $2 dollars in the not too distant future. Your fixed annuity will not keep pace with inflation.
It is the inflation problem that prompts many financial planners to suggest that you do not place or your assets in a fixed annuity. You need some of your assets placed in investments which will outpace inflation. So if you are considering a fixed annuity at retirement, you may place half your assets in an annuity contract, and invest the other half in a portfolio of high-quality stocks and bonds or mutual funds.
Annuities are used in various situations in which periodic payments are required. An annuity does not always have to be paid for life. Also an annuity does not have to be bought from an insurance company. Any form of periodic payments is technically deemed an annuity. Insurance companies are needed if you wish to receive additional guarantees of payments for life.
One such situation involving periodic payments might be a corporate buyout situation, in which a company pays a business partner for a specific period of time. Or, the company could be a partnership in which one of the partners wants to leave. Here, the partnership would pay the departing partner over a number of years.
Even your state lottery uses annuities for periodic payments. Most people think when they win the lottery that they will get a lump sum. However many of the states have lottery rules where the amount of winnings will be paid over a certain period of time, such as 20 years. You may still be able to select a lump sum, however you will receive much less than you think. For instance, as a general rule from, if you win $1 million, you can expect 50% of that to pay for federal and state taxes. If your state has a rule that the winning amount will be paid over 20 years, and you want a lump sum, you can expect another 25% reduction in the overall amount. So the amount you actually receive in this example will be roughly 25% of the overall lottery winnings. This is not widely known and is a shock to state lottery winners.
Annuities can be used during the asset accumulation phase of your career. The annuity product was originally constructed so that you put in monthly amounts and when you finally retire you would begin to receive payments. The interest credited to your account is guaranteed at all times and you are guaranteed against loss of principle.
In order to stay competitive with the mutual fund industry, insurance companies developed the variable annuity. This type of annuity contract allows you to invest your account value in various mutual fund investments. The purpose is to allow greater growth potential by having your assets invested in stocks and bonds type funds. Of course, such investments carry additional risk. So the insurance company is not providing guarantees of interest and principal during the accumulation phase of the contract.
The variable annuity contract is also fairly expensive when compared to ordinary mutual fund investments. For this reason, many financial planners suggest that you place your assets in various high-quality usual funds during your working career and then by a single premium immediate annuity at retirement.
Contributions to annuity contracts are made with after-tax dollars. You get no tax deduction on your contributions. However, while your money is in an annuity contract, you are not taxed on any earnings are capital gains. You are only taxed when you make withdrawals.
High earning workers will usually make the maximum contributions to their 401(k) plan and, if eligible, to some type of IRA plan. If they are still looking for additional tax deferred investments after that, they might consider an annuity. Tax deferrals under annuities can be delayed all the way up to age 70 1/2. At this age, the tax law forces you to start taking withdrawals.
For those who buy the annuity to receive lifetime income, the tax on any earnings is spread out over the life of the recipient. Your beneficiaries also have tax advantaged options in when and how they wish to receive payments after your death.
Relative to the guaranteed income stream that you receive during retirement, the greatest advantage of an annuity is the feeling of security you receive when you retire. You can go to bed at night with the assurance that you will receive payments each and every month while you live.
Financial planners do not emphasize this point enough. Even if you have a large portfolio of stocks and bonds, you may still have the nagging feeling in retirement that you could outlive your assets. With an annuity, this feeling goes away. You might wish that your payments for higher each month, however, the feeling of certainty is a very real advantage of an annuity. You may not know this feeling until you retire. So, ask a retiree who does not have an annuity, and he will tell you that his number one fear is outliving his assets. With an annuity, you will not have this fear.
The subject of annuities brings many different reactions from people. Those who are nearing retirement, and will have their pension plan benefits coming in the form of lifetime annuity are naturally quite pleased with their financial situation. Then there are those who voice the fact that you lose control of your assets when you buy an annuity.
The main agreement appears to be lifetime guarantee in exchange for long term commitment of your assets. There are many different types of annuities, so we will focus on the type of annuity where you pay the entire purchase price at one time near retirement, and receive lifetime guaranteed payments. This is known as a single premium immediate annuity. You put your money in and start receiving payments within a month or so.
Annuities Compared to Stocks
In trying to decide if you should buy an annuity, you need to look at what the alternative would be if you kept your money invested yourself and tried to receive monthly income. Financial Planners will recommend a portfolio of stocks and bonds. Stocks will provide long term appreciation which is not available to an annuity owner.
Any comparisons of annuities to a stock portfolio will be done using stock market performance for the last 20 -40 years. This performance will probably be in the area of 10% return. So the financial planner will tell you that a portfolio of stocks should return approximately 10% over the long term in the future.
The problem is stocks carry much additional risk of losing your principal, and will not produce a fixed income. While you could just decide upon a fixed amount to withdraw each month from a stock portfolio, you are totally at the mercy of the companies in which you invest foregoing dividend payments. There is a total lack of security and risk of loss when looking at stocks for long term pension payments.
If you need to withdraw principal at some point, you risk doing so at exactly the wrong time, which would be during a recession. You still have the control that you wanted over your portfolio, but during these market downturns you will probably wish that you had locked up your money in an annuity.
Annuities Compared to Bonds
Annuities are usually compared with a portfolio of bonds in deciding if the annuity is a good deal. This is a good comparison since a bond portfolio will produce a steady flow of interest payments which can be withdrawn each month as your pension payments. This is also a good investment to compare since it is closer to what an insurance company would invest in when quoting your annuity.
Insurance companies take your annuity premium and invest it in their general account. The general account of any insurance company is the giant fund or holding bin for all income producing assets. It this fund which, by law, backs all the future payments that will be made under all of the company’s guaranteed products, such as life insurance policies and annuities.
Due to the nature of the products and long term guarantees, the general account contains conservative fixed investments. These investments will vary, but will include large blocks of treasury bonds, corporate bonds, private placement bonds, loans and some real estate. Stocks will not be included in the general account or will be a very minor portion of the account.
Theoretically, the insurance company will take your annuity premium and buy a portfolio of bonds. In reality, your premiums merely get added to the general account. But the general account is buying and rolling over maturing investments every day. The insurance company will base its pricing model on the investments that can be purchased that week or month. So the insurance company will actually base their pricing on the movements of the bond markets at any particular point in time.
The comparison of your buying a portfolio of bonds, vs. the interest rates the insurance company quotes to you, is actually a very real comparison. If you can buy a diversified portfolio of short and long term bonds earning a certain level of interest, the insurance company can do the same. Actually, the insurance company’s general account is invested in longer maturity bonds than you would buy. The general account has enough cash and maturing investments to cover short term liabilities so new money coming into the account is usually invested for longer periods.
Your Bond Portfolio vs. the Insurance Company Pricing
If you buy a bond portfolio to create payments over your entire retirement period, you will diversify this into short, medium and long term bonds. You need short term to ensure there is always enough cash to pay your benefits in case interest payments should drop at some point.
Since the insurance company is investing longer term with any new premiums, the company should be able to provide a higher monthly payment than you could achieve with your bond portfolio. Long term bonds normally produce more interest than shorter term bonds. This is normally true and you also get the insurance company guarantee for life.
However, the insurance company needs to reduce their quoted interest rate a bit for safety and to pay for the guarantees they are quoting under the contracts. They also have expenses, which will be higher than those in running your own bond portfolio.
So, what can you expect when getting an annuity quote? The quote you receive as your monthly guaranteed payment will actually be fairly close to the payment you can achieve when investing in your own portfolio of bonds. That’s right, the two numbers will not be that far apart. If they are, you need to look at the types of bonds you are considering buying. Are they lessor quality corporate bonds? Are they smaller company bonds? If so, you may be taking more risk in your portfolio than you should. With the insurance company general account, the assets are invested in fairly high quality, diversified, fixed income investments.
Commitment vs. Guarantee
The question really comes down to your making a long term commitment compared to keeping control over your portfolio. If you are getting a good interest rate quote from the insurance company, and you cannot get much more on your own, why not go for guaranteed lifetime payments? Many financial planners would say that if you can earn almost the same amount as the insurance company, why not keep control over your assets in case your financial situation changes.
This is a great question and the primary decision point that you have. However, remember that you are now entering retirement, and you want security. Even if you have a large portfolio of bonds giving you a satisfactory level of monthly payments, you will always have the nagging feeling that something can go wrong. Some event will cause your bond portfolio to go off track and not produce the desired level of payments 20 years from now.
If you ask any retiree about their greatest worry in retirement, they will say that it is outliving their retirement assets. So there is a psychological advantage to having the insurance company guarantees attached to your monthly payments.
Diversify the Assets
If you can’t choose whether to buy a long term annuity for the guarantee, or build a bond portfolio for the flexibility, then do both. Take a good portion of your assets and buy the annuity. Take the remainder of your assets and build portfolio good quality investments that can give you more asset growth over the coming years. You do not, and should not, have to put all your retirement assets in one investment. Diversifying the assets will give you both the guarantees and flexibility you desire for the long run.
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