Annuities often get bad press. Deservedly so in many cases. Not so in all cases. Before you can determine if one might make sense for you, it’s important to understand the very different annuity types. When applied correctly they can be effective income planning tools that can also reduce risk of stock and bond markets. The biggest problem with these tax deferral instruments has been the cost paid for the deferral. A trend toward lower cost, more transparent product pricing means they could be a viable alternative within your overall portfolio, if they align with what you are trying to achieve.

Not All Annuities are the Same

Variable annuities have taken most of the criticism because they were a poorly designed product, sold because they generate high commission dollars. Typically, the pitch includes numerous rider options. These bells and whistles add to cost, diminish returns, and seldom provide a benefit that outweighs its cost. Heavy upfront costs and ongoing fees stymied their return potential. Money is allocated between stocks and bonds, so there isn’t added diversification to reduce market risk in retirement.

The emphasis in this article is on the three different annuity types in the table below. Unlike variable annuities, these products don’t expose you to the volatility of the stock market. If the underlying insurance carrier is strong financially, they offer a safe way to add stability, income, and diversification without market risk.

Three Annuity Types, Three Different Income Guarantees

1. SPIA – Guaranteed Lifetime Income: A SPIA is priced based on interest rates, your age, and mortality credits (also called risk pooling). Risk pooling means that those who die early subsidize longer payouts to those who live longer. Caveat: You lose access to your principal. The insurance company now owns your money. In exchange, they manage investment and longevity risk for you and give you guaranteed lifetime income. It can be good deal if you live long. If you want to ensure you get your money back if you pass away early, product variations can allow heirs to recoup principal, maintain an ongoing payment stream, or provide an inflation adjustment over time. Payouts are also tax-advantaged until you have received all your principal.

  • The lifetime guarantee can protect core needs-based spending.
  • Guaranteed income is useful for both the spendthrift (who might otherwise run out of the money); or the frugal (who worries too much about running out of money) and needs permission to spend!
  • SPIAs can be a capital efficient way to generate cash flow in retirement, and free up cash to buy enough stock to protect against long-term inflation.

2. FRA – Guaranteed Rate over a Fixed Period: FRAs (3-10-year maturities) are CD-like except you can defer taxes allowing more of your money to compound growth. At maturity, you have the option to extend deferral or convert into another type of annuity. Usually pays a higher yield than a comparable CD.

  • Unlike a bank CD, no tax is paid until you withdraw. Can be used at any time to defer taxation and can be exchanged with other annuity products.

3. FIA – Guarantee NOT to Lose Money: FIAs are a hybrid product (some more complex than others). FIAs are built with bond ladders to generate income. Part of the bond income buys options to hedge stock market exposure to set a “0% floor, with upside potential.” Typically, they track price only indices, so they can’t capture equity dividends. You can add an income rider or death benefit. In my opinion the income rider seldom make sense. Returns are tax-deferred.

  • Market exposures are limited by participation and cap rates which means your returns will never be as high as the stock market. In return, you get a guarantee that your account won’t decline.
  • Carriers can adjust rates subject to market conditions which creates uncertainty about future returns. These products haven’t been in the market for very long(since 1995), history may not be a useful guide to how they perform in the future.
  • FIA critics note that in trying to “multi-task” FIA does nothing well; hence, using a combination of other pure play products may offer better results.

Annuities are not very efficient estate planning tools because they are ultimately taxed to your heirs at ordinary income rates. Heirs don’t receive a step up in basis like they would with stocks and other assets. Still, for those who want an income stream without stock or bond market risk, they can provide stability and added diversification to your overall asset mix that can increase your odds of success as well as strengthen your results.

 

Jerry Matecun helps business owners and individuals discover key planning and investment considerations vital to build and protect the value of your assets. For a no-cost, confidential conversation regarding your unique circumstances call or email Jerry at 949-273-4200, 616-499-2000, or jerry@compoundvalue.com.

PLEASE NOTE: Nothing herein or elsewhere on this site constitutes investment, legal, or tax advice. For details please see Disclosure.