A few weeks ago, I was golfing at a fundraiser for my alma mater. At the 5th hole, the course offered “golf balls for life” to anyone who hit a hole in one. While I didn’t manage to sink my first shot, it did get me thinking. There are many things we would like to enjoy for the rest of our lives: Penguins season tickets, Chick-Fil-A, or, if you’re my four-year-old son, cookies. On the top of the list for many people would be guaranteed income for life.
Typically, when we hear “guaranteed for life”, we’re skeptical, because it sounds too good to be true, like a “free” car giveaway that comes with a handsome tax bill. Aren’t we taught that the only things guaranteed in life are death and taxes? Well, feel free to open your mind as we take a look into an income source which you can’t outlive, and is guaranteed for life. It’s an annuity, or, your own personal pension.
A Little History
In the 1950s, it was common for people to work until they were 60, retire with a pension, and live until around 70. Today, many of us are still retiring in our 60s, but living into our 90s, with no pension and insufficient social security benefits. That means we need our retirement savings to last potentially 30+ years longer than previous generations.
This dilemma gave birth to the annuity, a way for investors to create their own pension fund. Annuities have gone in and out of style and have come in many different shapes, sizes, and flavors over the years. In fact, they even date back to the Romans, who created a system where citizens could make a one-time payment, called an Annua, and receive a guaranteed income for life. Annuities didn’t hit America until about 1812, starting in Pennsylvania, where they were initially designed for ministers, but later grew to include teachers and government workers. In 1952, the variable annuity was introduced, which allowed people to invest in funds inside the annuity contract to hopefully gain additional growth. Incorporation of annuity products into retirement planning has grown substantially since then; currently, the value of assets held in annuities in the U.S. is over $2.5 trillion.
Driven by the disappearance of pensions, market volatility, caps on tax advantaged retirement accounts, and other factors, annuities have become increasingly popular. This has led to a very competitive annuity market. Competition is great news for the consumer, since it ultimately leads to better annuity products, and lower fees and commissions.
How They Work
Let’s say you have $2M dollars and you want to turn 25% of that into a guaranteed income stream. You could purchase a Fixed Lifetime Income Annuity for $500,000, which could be paid for with qualified (pre-tax) or non-qualified (after-tax) funds, and in return receive a $2,000 monthly payment for life. The lump sum deposited into an annuity grows tax deferred, but income taxes are collected when you start receiving payments (for a qualified annuity, all funds are taxed as earned income, for non-qualified only profits are taxed as income). In a fixed income annuity, you’re essentially paying the insurance company to create a personal pension fund that will pay you set, monthly distributions for the rest of your life. But annuity products come in a variety of contract options with numerous add-on features. Instead of getting plain vanilla ice cream you can add sprinkles (inflation protection) and hot fudge (survivorship benefits) along with a variety of other tax planning, wealth transfer and investment toppings.
Many clients have appreciated the stability and peace of mind annuities can add to their overall retirement plan, especially during economic downturns. There is a lot to be said for safety and security. However, it does come at a price.
How much do they cost?
Historically, annuities came with high fees and commissions. As you can imagine, if an insurance company is going to guarantee a payment for life, they are going to charge a premium for it. Since cost was a significant deterrent for many investors, insurance companies paid their agents large commissions to sell them, earning annuities and insurance agents a negative reputation. Also, many annuity products not only came with high fees, but the contract locked away retirement savings, only allowing access with steep penalties.
However, in the current economic environment, featuring low interest rates and large market growth, annuities have become more competitive, leading to lower fees and commissions, and increased flexibility. We’ve seen fees drop from 4% annually down to 1% or lower in some cases. That is huge! There are now companies offering commission-free annuities to further lower the consumer cost. This has become a win-win-win for the client, adviser and insurance companies, especially within the fee-only, fiduciary realm of financial advising.
When would an annuity make sense?
There are two main circumstances when we recommend clients consider annuities. First, if you are nearing retirement, and have $1M+ of liquid assets, it may be a good product to consider if you would like a solid base for your lifestyle expenses in retirement. For example, let’s say you have determined that you’ll need $10K per month to cover your necessities, bills and lifestyle expenses. $5K is for necessities like food, clothing, taxes and insurance. If your social security payment is $3,000 per month, it could be beneficial to have the other $2,000 come from an annuity, like a discount on your monthly expenses. Another scenario where annuities can be helpful is when they are used as a tax shelter. Typically, clients who have already maxed out their employer sponsored retirement plan and Roth IRA are looking for other tax-advantaged retirement accounts. An annuity is an additional option that allows money to be invested and grow tax deferred.
Do your due diligence
Just like any product that offers to give you something for life, you want to be careful. Make sure you read through the contract and understand how it works, what restrictions there will be on your principal, and what terms, conditions, and fees are associated with the annuity. Also, keep in mind that while it may be nice to have, that doesn’t always mean you need it. Sure, I wouldn’t mind having free golf balls for life, but what if I don’t golf or I already have all the golf balls I’ll ever need? You may already have a sufficient amount of liquid assets and don’t need an additional income stream for your retirement plans.
But if you are looking for guaranteed income as you plan for your post-work life, or seek another opportunity for money to grow tax deferred, an annuity could be a good option.
If you’d like to discuss how an annuity could fit into your retirement plan, schedule a meeting with one of our fiduciary advisers.