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Is an Annuity the Optimal Choice for Securing Retirement Income?
Author: Joel Baretto, CFP®
November 29, 2023
As one approaches retirement, a pivotal juncture is reached where the shift from accumulating wealth over a lifetime to disbursing those resources to provide a steady income for the duration of one’s life takes precedence. This juncture may prompt the question, “Am I susceptible to the prospect of exhausting my savings during retirement?”
Apprehensions among investors regarding the depletion of their retirement assets frequently manifest as a heightened aversion to risk in the years preceding retirement, as well as throughout the retirement phase. This heightened risk aversion sometimes leads investors to pursue financial products that appear to offer a comprehensive solution: a guaranteed income stream, participation in market gains, and the assurance of no loss. Consequently, some investors opt to acquire annuity products. However, the pertinent question remains: Do these annuity products genuinely enhance a sound income strategy?
To commence, let us establish a foundational understanding of annuities.
What is an Annuity?
Annuities are financial agreements extended by insurance companies, crafted to furnish income either promptly or at a designated point in the future. They can be categorized into two fundamental types: immediate and deferred.
- Immediate Annuity – Under an immediate annuity arrangement, the contract holder initiates the contract by providing a one-time, lump-sum payment to the insurance company, in return for which they receive fixed or variable income disbursements that commence on a predetermined date. The payout duration can be either for a fixed number of years or for the entirety of the contract owner’s lifetime. It is imperative to understand that, in this arrangement, the lump-sum payment is ceded in exchange for the ongoing income stream, and should the need arise for additional withdrawals, the contract owner typically faces penalty fees. It is worth noting that such annuities are not commonly favored among investors due to their unattractive internal rates of return spanning more than a decade and a waning inclination among investors to relinquish access to a significant portion of their savings.
- Deferred Annuity – In the context of annuities, “deferred” signifies that the income phase, during which payments commence, is scheduled for a future date. These types of annuities offer flexibility in terms of premiums, allowing for contributions and deposits throughout the deferral period, which, in certain contracts, can extend up to age 90. Deferred annuities can assume various forms, including fixed, equity-indexed, or variable, and they accrue gains with the advantage of tax deferral. It is important to note that any gains accumulated within the contract are subject to ordinary income tax rates upon withdrawal, and an additional 10% penalty is levied on the growth if withdrawn prior to reaching the age of 59 ½. Variable and equity-indexed annuities are frequently marketed with additional features, with the most prevalent being a guaranteed income rider.
Annuity Fees
Let us delve deeper into the fee structures associated with the two most prevalent categories of deferred annuities marketed to investors: variable annuities and equity-indexed annuities.
- Mortality & expense ratio (M/E ratio) – This fee is imposed by the insurance company as a means of mitigating its risk, specifically with regard to the potential event of the policyholder’s demise. The standard rate for this fee across the industry stands at an annual rate of 1.25%, and it is directly deducted from the annuity.
- Surrender Fees – This entails a fee structure characterized by a descending scale, gradually decreasing to 0% over a specified number of years. In the event of withdrawals from the account prior to the conclusion of a surrender period, penalties are applied. Typically, a standard surrender period spans seven years, with initial-year fees that may reach as high as 10%. Most contracts afford the flexibility of partial withdrawals, often up to 10% of the contract’s total value, without incurring associated fees.
- Sub-account Fees – The investment products contained within the annuity are also subject to investment management charges, which closely resemble the expense ratio of mutual funds or exchange-traded funds (ETFs). Just like mutual funds and ETFs, the magnitude of these fees can exhibit substantial variance, although the majority typically falls below the 2.0% threshold.
- Rider Fees – These encompass supplementary fees incurred by investors in exchange for specific features incorporated into the product. The most prevalent of these features include income guarantee riders and death benefit riders. Typically, fees associated with these riders fall within the range of 0.50% to 1.50% for each rider type.
For most annuities containing at least one rider, wherein investors are remitting payments to an insurance company, either directly or indirectly, the average cost hovers around 2.5% to 3.5%. Moreover, investors often commit to these products for a predetermined number of years.
Alternatives to Annuities
1. Financial Plan – The initial phase in establishing a sufficient retirement income stream involves the formulation of a tailored financial plan, which serves as a compass for informed decision-making. A holistic financial plan empowers you to take charge of all facets of your financial situation and facilitates the identification of strategies aimed at generating income during retirement.
2. Diversification – Irrespective of the prevailing market conditions, the prudence of upholding a diversified portfolio remains paramount. The act of investing in a variety of asset classes serves as a risk mitigation strategy, as it ensures that when one sector or investment category experiences a downturn, the performance of another category in an upswing can help alleviate volatility within your portfolio. While diversification does not guarantee immunity from losses, it does diminish the risk associated with overconcentration in the poorest-performing segment of the market.
3. Short and long-term investment accounts – An effective strategy for shielding oneself from market volatility and guaranteeing the availability of ample funds to meet day-to-day living expenses is the maintenance of a reserve equivalent to three to five years’ worth of living expenses in a short-term, highly liquid investment account. Typically, a blend of bond funds proves advantageous in this context, as it not only furnishes capital for opportunistic rebalancing but also generates income. The presence of a short-term bond allocation can serve as a safeguard against the necessity of selling equities at a loss during periods of market downturn.
Conversely, it is of paramount importance to sustain the growth of your assets to counteract the erosive effects of inflation and secure a sufficient income for the entirety of your retirement. Hence, we advocate the investment of any surplus assets, which are not immediately required to meet short-term needs, into a diversified portfolio with a focus on growth and inflation hedging. While this portfolio should align with your overarching risk tolerance and investment objectives, it can accommodate riskier assets compared to your short-term account.
Throughout your retirement, your wealth manager will collaborate with you to pinpoint opportune moments for portfolio rebalancing and make the necessary adjustments in a tax-efficient manner.
4. A tax-efficient withdrawal strategy – An additional means to optimize your retirement income involves the implementation of a methodical spend-down strategy. Collaborating with your wealth manager, you can formulate a tailored strategy that factors in your current financial circumstances and retirement aspirations. This comprehensive strategy should encompass all prospective sources of retirement income, including Social Security benefits.
In conclusion, although annuities are designed for guaranteed retirement income, the guarantees come with a price, which may or may not be worth it, depending on your income and growth objectives, and your risk profile. Because annuities generally pay higher commissions compared to other financial products, it may be difficult to get objective advice from commission-based advisors due to the possibility of conflicts of interest. On the other hand, the alternatives may cost less but you also lose the guarantees and tax benefits inherent to annuities, thereby making the annuity a safer bet for risk averse investors.
Disclaimer:
- The information provided is for educational purposes only and does not constitute personal financial, tax or investment advice and should not be relied on as such. It does not take into consideration any investor’s particular investment objectives, strategies, time horizon, and tax or legal status. Abacus Wealth International (AWI) does not provide tax or legal advice. Please consult a tax or legal professional for corresponding tax and legal advice.
- All material and content have been obtained from sources believed to be reliable. AWI does not guarantee the accuracy of the information provided and shall not be held liable for decisions based on the foregoing information.
- All examples of graphs, financial products and historical returns contained in the foregoing material are for illustration and educational purposes only and shall not be deemed as financial advice or recommendation. Past performance is not indicative of any future investment returns.