Broker Check

Financial Literacy Series--Annuities

April 05, 2023

I had a meeting with a client last week and we were reviewing her investment accounts and her overall liquidity level (the percentage of assets she can readily access compared to assets that would cost her time and money to access).  While she was excited at the progress she's made, she was shocked to learn that we needed to plan for her to live until she's 102 years old when I showed her the life expectancy calculated from her age and from her life insurance rating. This information is important as we continue to plan how much she's saving for the long-term and where she's saving that money.

When I'm thinking through a client's savings goal for the long-term, I'm trying to balance her liquidity needs now with the goals she has coming up during the next few years, goals she has for herself and for her children over the next ten years along with her needs to fund her independence for the rest of her life.  I ask my clients to download their social security statements so they understand what their projected income will be from this resource, and suggest they compare their monthly benefit to what their spousal benefits from their ex would be, if they qualify.  As a practice, I recommend my clients request their spouse's social security statements during the discovery phase of their divorce for this purpose.  By understanding how much income she's expected to receive from social security in retirement, we have a starting point in determining how much income we'll need to create from other sources.  We can also plan how and when to use her other retirement savings accounts to maximize the amount of income she'll receive from social security, and decrease her total amount of savings needed.

Social security is guaranteed income (despite the common belief that it won't be around later on).  It's important to understand the projected amount you'll receive and the recent retirement age changes, and to think through what that means for your plans to retire.  Compare the recent cost of living adjustments to social security and how frequently they happen with the current inflation environment, and you'll start to see the importance of planning how and when you'll use your retirement savings.  Since most people save for retirement in 401(k) accounts and in IRAs for the deferred tax benefits and the employer match (when applicable), their savings dollars are invested and are exposed to market risk.  This is ideal for growing your savings over time, but market risk is not ideal when you're relying on a sum of money to get you through retirement for the rest of your life--especially now that life expectancies have increased, and retirement can last longer than for previous generations.


As always when I'm planning for a gap between funds available and risk (in this situation I'm talking about longevity risk, market risk and inflation risk),  I like to use an insurance product that provides a contractual guarantee that funds will be available should the need arise.  An annuity is a contract between you and an insurance company confirming that the insurance company will issue you payments for a set amount of time. This is a basic agreement that gives you guaranteed income in your later years. It's important to note that all guarantees are dependent upon the claims paying ability of the issuing insurance company. When buying an annuity, be certain to sign the contract with a long-standing insurance company with an iron-clad financial history. In some cases, particularly with deferred payment annuities, you can be in this contract for decades. The insurance company still needs to be viable when it comes time to collect your guaranteed income payments. Also, review the administrative fees for your annuity, as well as other fees that may be associated with your contract. For instance, some annuities have a surrender fee. This means that if you withdraw your money sooner than stated in the contract, you will be charged for this change.  

Like most financial products, annuities can be structured in many different ways:

Fixed Annuities

Generally speaking, fixed annuities are thought of as the appropriate option for people who want to minimize risk. In a fixed annuity, the insurance company guarantees a minimum rate of interest and a set amount for payments. You buy the annuity, and the outcome is known right from the start. In most states, fixed annuities are controlled by the state insurance commissioner, and it’s best to contact your state office to learn about the fixed annuity plans specific to your state.

Variable Annuities

Variable annuities are long term investment vehicles designed to help investors save for retirement and involve certain contract limitations, fees, expenses and risks, including possible loss of the principal amount invested. The investment return and principal value may fluctuate so that the investment, when redeemed, may be worth more or less than original cost. As with many investments, there are fees, expenses and risks associated with these contracts. All guarantees including the death benefit payments are dependent upon the claims paying ability of the issuing company and do not apply to the investment performance of the underlying funds in the variable annuity. Assets in the underlying funds are subject to market risks and may fluctuate in value. Variable annuities and their underlying variable investment options are sold by prospectus only. Investors should consider the investment objectives, risks, charges and expenses carefully before investing. This and other information are contained in the prospectus or summary prospectus, if available, which may be obtained from an investment professional. Please read it before you invest or send money. When you purchase a variable annuity, the insurance company agrees that you can use your payment (either an initial lump sum or payments over time) toward various investment options, such as mutual funds. As a result, the money you put into your annuity varies with the rate of return on the investment.

In contrast to the established income payments you’re guaranteed with a fixed annuity, the payments in a variable annuity are not set from the start. They will vary based on how your investments perform. It’s possible that you’ll have higher earnings than a fixed annuity if your investments do well, but of course, this outcome is not guaranteed and it is also possible to have your contract value decline from poor investment performance and/or fees. Due to the investment aspect, the Securities and Exchange Commission (SEC) regulates variable annuities across the United States.

Fixed Index Annuities

Fixed index annuities give you a limited potential for growth in exchange for protection from market downturns. Fixed Index annuities are tied to the performance of a market index, for instance, the S&P 500.  (S&P 500 Index: The index measures the performance of the large-cap segment of the market. Considered to be a proxy of the U.S. equity market, the index is composed of 500 constituent companies. Source: S&P U.S. Indices Methodology, Standard & Poor’s. Indices are unmanaged, and one cannot invest directly in an index. Past performance is not a guarantee of future results.) As the S&P gains, so will the earnings in your indexed annuity (up to a pre-determined cap), but index annuities are not a direct investment in the index so no interest is earned in down markets. Like fixed annuities, this kind of plan is regulated by the insurance commissioner of your state. Some people consider fixed index annuities to be a good middle-of-the-road option since they have the potential to grow during up-markets, while being insulated from market risk when the index is down.

Deferred vs. Immediate Payment Annuities

Not only do you have options in how you structure your annuity investment, you can also choose how you want to receive payments. When people are close to retirement and want to set up income payments in the near term, they often turn to immediate payment options. In this case, they pay an initial sum, and the insurance company begins payments for a set amount of time, starting shortly after the contract begins.

Deferred payments, on the other hand, are meant for the future. People pay for the annuity over time or all at once with the idea that they will receive annuity payments in years to come, often 20 years or more into the future. With both immediate and deferred plans, you can receive your payments all at once or in installments over time, such as monthly or yearly.

The primary benefit of annuities is to guarantee income in your retirement. In an annuity, the insurance company is contractually obligated to send you the payments agreed upon by the two parties. Buyers also cite the potential tax benefits of annuities: you will not pay taxes on any earnings in the annuity until you take money from it. Also, annuities may provide death benefit options to protect your beneficiaries. For example, if you die prematurely, you may be able to name a beneficiary to receive the outstanding payments in your annuity.

An annuity can provide secure income for your retirement, while also giving you peace of mind. Yet, like all financial products, there are various ways to use this tool. I can help you strategize how and where to save for retirement while building stability for yourself and for your children now.  Schedule a time for us to talk here.

Disclosure:  All investments contain risk and may lose value. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.