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Annuities have recently been touted as an integral part of comprehensive retirement planning. In a previous blog, the advantages and disadvantages of annuities were discussed (See: FINANCIAL PEACE OF MIND: EXPLORING ANNUITIES FOR SECURITY)
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What is an Annuity?
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According to Investopedia: An annuity is a contract between an individual and an insurance company. The investor contributes a sum of money—either all up-front or in payments over time—and the insurer promises to pay them a regular stream of income in return.
The biggest advantage of annuities is that they provide an ongoing stream of income for either a specified period or the lifetime of the policyholder. The biggest disadvantages of annuities are that they are insurance products that are not FDIC insured, they have high commissions, high fees, surrender charges, and have distributions that are at least partially taxable.
For people who are retired, or approaching retirement, income needs and income generation in Retirement take center stage. Retirement income can be generated from many different sources, but few income sources are steady and ongoing. Annuities have taken center stage recently as a steady source of retirement income.
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Experts in the Financial Planning community have touted two huge advantages associated with Annuity ownership, and one huge disadvantage. Over the last few years I’ve changed my opinion several times, and can certainly see the advantages and allure of Annuities. Experts agree that the security of the guaranteed fixed income stream an annuity provides allows the annuity owner to spend more freely. The second big advantage of annuity ownership is that because the remaining portfolio is not needed for current income it can be invested much more aggressively and could potentially provide a greater terminal portfolio value for heirs. The greatest disadvantage is that this income stream is now irrevocably tied to the success and solvency an insurance company. We’ll talk more about this in a minute! I really hate the idea of irrevocably surrendering a large chunk of my portfolio, but I love the idea of a secure and constant income stream!
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The question of annuity purchases is most relevant to the pre-retirees who would be classified as constrained. Pre-retirees and retirees can loosely be classified as underfunded, constrained, or overfunded:
Those who are termed underfunded don’t have funds available to allow the purchase of an annuity. Funds are too tight to allocate a significant portion of available assets to an annuity purchase when those funds may be needed for basic living expenses.
Those who are termed overfunded are at the other end of the net worth spectrum. This group has excess funds available, so annuities are not needed to fund a lifestyle. Income is derived from assets, so in most cases, annuities are considered unnecessary.
Those who are termed constrained have the hardest decision to make. They are in the gray zone of uncertainty as to whether they should retain all their limited assets, or move to the certainty of an annuity by giving away a large portion of their needed money. Either way, the path is fraught with concern because the money used to purchase the annuity is no longer available for basic living expenses. Money is tight for this group, with no room for errors or unnecessary expenditures. These conditions foster hard choices about the best way to allocate limited dollars. Are their limited resources best positioned in an annuity? Are annuities safe and guaranteed?
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Are Annuities’ Income Guaranteed and Inflation-Protected?
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Are annuities secure?
For those retired or approaching retirement, safety, and protection of assets should be of utmost importance. Retirees don’t have adequate time to rebuild an asset base if disastrous financial losses occur. The safety and preservation of assets should be a critical consideration in any major retirement investment.
Annuities are secured by the full faith and credit of the issuing insurance company. Annuities are not government guaranteed in the same manner as CDs and treasury securities.
Problems can occur if the issuing insurance company experiences financial distress or insolvency. This is not a normal or commonplace occurrence. The majority of annuity issuers are financially healthy and can adequately service their policyholders’ contracts. Each of the states in the United States has an insurance guaranty commission that provides insurance in the event of insurance company default, and the level of insurance coverage varies by state.
In 2022, there were 5,929 insurance companies across the United States. Out of this number, six insurers declared bankruptcy in 2022. All six companies were located in Florida and all six were property casualty insurers. These bankruptcies represent approximately 0.1% of the total insurance industry.
The very low incidence of bankruptcies, along with the added guaranty insurance provided at the state level, seems to substantiate the safety of annuity investments.
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Are annuities protected from inflation?
A bigger concern for those retirees or pre-retirees considering annuities should be the long-term effects of inflation on annuity products.
The two main types of Annuities are a “level” or fixed income annuity, or an increasing or “variable” annuity. Policy owners may collect their retirement income through annuitization or a lifetime income rider and will have a choice of either receiving a “level” income or an “increasing” income option:
- Level or Fixed income annuities– fixed income annuities, provide a set and stable income for life but are most susceptible to the effects of inflation. Inflation decreases the purchasing power of payments that remain fixed for the remainder of the policyholder’s life. For example, an annual inflation rate of 5% will reduce the purchasing power of $1000 to $950 worth of goods the following year. Each year the purchasing power of the original $1000 will be reduced by the inflation rate for that year. A 5% annual inflation rate means that the purchasing power of $1000 would be cut in half in approximately 15 years. This can be devastating to someone on a fixed income, who is relying on annuity payments to provide the essentials of life. The following chart from annuity.org visualizes the long-term effects of 6% inflation:
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According to Echols Financial Services: Safety-first planning attempts to shift or diversify more risk from retirees to an insurance company by using a guaranteed lifetime income annuity. Insurance companies can make the promise of a stable lifetime income knowing that some of their retirees will live longer than average and some will die at an earlier age. Risk pooling allows an averaging of these large numbers by the insurance company that individual retirees cannot do for themselves.
Retirees using this “Safety-first” approach seek the safety and stability of a defined period or lifetime income. Purchasers of traditional fixed-income annuities are currently experiencing the detrimental effects of inflation on purchasing power. Unfortunately, annuities generally have penalties and redemption charges for policyholders who choose to redeem or dissolve policies early. Policyholders must hope that inflation mediates to a more normal level to preserve as much spending power as possible as inflation continues to erode current purchasing power.
Is there a better way to secure a steady stream of income with inflation protection included? Insurance companies providing annuities created new classes of annuities with inflation-fighting capabilities. These annuities are termed “increasing income” or “inflation-protected” annuities. This annuity type guarantees a real rate of return that matches or exceeds the rate of inflation.
According to the U.S. Securities and Exchange Commission, the real rate is the true economic benefit offered by an investment after taking into account taxes and inflation. On a pre-tax basis, the real rate of return is expressed as follows:
Real Rate of Return = Stated Rate of Return of Investment – Rate of Inflation
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- Fixed index annuities– fixed index annuities provide options for a level income, increasing income, or inflation-adjusting income (this annuity type may have an income rider as an add-on benefit.). A level income rider guarantees that the recipient’s income will stay the same each year. An increasing income rider provides the opportunity for the recipient’s income to grow each year. The actual increase (if any) varies according to the fixed index annuity’s underlying index (such as the S&P 500 Index.) An inflation-adjusting income rider ensures that the income will attempt to keep up with inflation, based on certain indices such as the consumer price index (CPI) but, fixed indexed annuities do not directly participate in the underlying index that it tracks. Fixed index annuities provide interest based on the performance of the linked index. This annuity type also promises to pay a minimum guaranteed rate of interest, and the value of the annuity will not drop below a guaranteed minimum.
Fixed index pros-
- Tax-deferred growth
- May not have annual contribution limits
- Guaranteed death benefit for beneficiaries
- No penalties for mandatory distributions after the age of 70 1/2
- By annuitizing, you can receive guaranteed income for life
- Like other annuities, they may help to avoid probate
Fixed index cons-
- The amount credited to your account is capped in such a way that the account does not fully participate in the total increase in the underlying index
- Annuity rules and features are complex
- Earnings are taxed at the ordinary income tax rate when withdrawn
- Early withdrawals (before age 59 1/2) are generally subject to a 10% penalty
- Fees are numerous and complex
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- Variable annuities- Variable annuities offer the greatest level of growth potential among annuities but with the most exposure to market risk. Variable annuities are also usually high fees and high expenses.
Variable annuity pros-
- Payouts are normally deferred
- Can be invested in through tax-advantaged retirement plans
- Can be beneficial in retirement planning, and can provide financial benefits to beneficiaries
- Offer the greatest potential growth
- Variable annuities can’t lose money
Variable annuity cons-
- because variable annuity payouts are usually deferred, money is not available early in the contract
- Performance is more closely tied to the underlying index
- Variable annuities have numerous, high, and confusing fee types
- Variable annuities, generally offer many sub-accounts, are usually very complex and are generally very hard to understand
- Variable annuities are most suited to people more than a decade away from retirement
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Moderate inflation is a part of normal economic health, but rapidly rising interest rates and associated inflation can destabilize an economy and decrease purchasing power (this risk is greatest for retirees on a fixed income.) Runaway inflation and cost-of-living increases can destroy a carefully planned retirement.
I am not a huge fan of annuities. But, as stated above, annuities can provide a steady stream of income that has the potential to keep pace with inflation. Inflation-adjusted annuities offer protection against inflation with income guarantees and built-in cost-of-living adjustments. However, these income streams come with higher than-normal fees and complex, hard-to-read contracts.
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Final Thoughts
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- Annuities have the potential to provide a fixed stream of income for the lifetime of a retiree.
- Annuities are generally secure, and defaults are rare.
- Level income Annuities are the simplest type of annuity contract, but may not provide inflation protection over long periods.
- Fixed index annuities and variable annuities can protect against long-term inflation. These benefits are normally associated with complex contracts, numerous and higher than normal fees, and numerous sub-accounts that make these contracts hard to understand.
- Professional guidance in purchasing annuities is always recommended.
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