Retirement annuities are often discussed in financial planning conversations, but they can be misunderstood because the topic covers a wide range of products and structures.
Annuities come in many shapes and sizes – fixed, fixed-indexed, variable, immediate, deferred – and paired with countless customization riders. For many reasons, annuities are often “sold” instead of “bought.” Typically, when we run into frustrated families that are on the receiving end of these products, it is because they had a different expectation of the investment rather than what it was designed to do. That, paired with lockups resulting from penalties via a “surrender schedule,” give credence to the average consumer viewing annuities with an attitude of buyer beware.
Retirement annuities can be built for preservation of principal, a particular interest rate, income generation, etc. For the purposes of this article, we will not dive into each of the annuity types listed above. We are going to look at an annuity with the goal of replacing income. At its most basic level, a retirement income annuity is simply an insurance contract designed to provide a guaranteed stream of income based on an investment amount given to an insurance carrier.
This is where the simplicity starts to disappear, and consumer understanding and expectations begin to blur. Depending on the type of annuity you purchased, you could have both “cash value” and an income base. These are two important distinctions. Cash value is what you could remove or leave to a beneficiary, while an income base is what the insurer will use to calculate what your guaranteed income stream will be.
The income received from an income base will be calculated based on an insurer's actuarial tables of life expectancy. The expectation when looking at these is to be able to receive a higher percentage of income from a sum of money than you would be able to generate in a regular investment portfolio without running out of money during your lifetime. Ultimately, if the income benefit is large enough, it is likely that you will run the cash value of this investment down to $0 and leave nothing to a beneficiary, but your income checks will continue to flow in, as the annuity provides a guaranteed income stream.
This concept is not new. In fact, many people already receive income through annuity-style payments without realizing it. We refer to these as “mailbox checks,” and they can be appealing, as the money flow is continual. Pension plans from large employers and Social Security both function similarly by providing a guaranteed payment stream that continues over time, and when you pass, unless you have elected a survivor benefit on the pension or have arranged for spousal social security benefits, no cash remains for an heir. For people interested in creating a guaranteed income stream with their assets, the tradeoff is eliminating a portion of your portfolio to keep payments coming regardless of market and economic conditions. Rate of return is removed in this scenario because you are looking for income base maximization to ensure you have enough funds throughout your lifetime.
Where we often find annuities creating the biggest issues for most people is when they lack a clear understanding of how annuities function, and when annuities are just pitched and sold without being a part of a bigger financial planning discussion.
When evaluating retirement income annuities, it is important to keep several ideas in mind:
- What is my standard of living? How much do I need to maintain my lifestyle?
- Do I need a guaranteed income stream to help maintain this standard of living?
- When will my funds be accessible to me?
- Are the income benefits provided by this annuity substantial enough to justify the costs?
When assessing these needs and determining if you should add retirement annuities to a portfolio, it is important to understand how your advisor is licensed and compensated, and why your advisor is suggesting you invest in annuities. While some investment advisors strongly support the purchase of annuities, others are adamantly against them. Inevitably, retirement annuities are a tool that fits some people's goals and needs, but not everyone's. Make sure you, and your advisor, have a plan that serves your best interests.
Financial Enhancement Group is an SEC Registered Investment Advisor.
