Retirement is beginning to pose a lot of challenges to Baby Boomers. Few feel prepared to cover basic life or medical expenses, let alone have enough funds for a comfortable retirement. Baby Boomers looking to retire should consider other options outside of the stock market.
One potential solution for them to add to their retirement plan is an annuity. These products can provide guaranteed lifetime income at a time when retirement outlooks are seemingly bleak — and they provide key advantages above most traditional financial vehicles like CDs, savings, or money market accounts. Since the income is guaranteed, you can receive payments immediately or defer them, allowing the earnings to accrue tax-deferred (they are later taxed as income unless in a traditional or Roth IRA). There is no income limitation on how much you can place in an annuity. (For more, see: 4 Mistakes to Avoid With Your Retirement Plan.)
How Do Annuities Work?
The first thing to understand is that annuities are basically contractual responsibilities agreed upon by you and the insurance company providing the product. You transfer funds into the product, and in exchange the insurer follows through on the terms agreed upon in the annuity contract. The most basic of these agreements is the insurer's commitment to make fixed payments to you. You choose the time that payments begin and they normally continue for the rest of your life or, depending on your annuity terms, the rest of your spouse’s life.
If you leave money in the annuity, it grows tax-deferred until funds are withdrawn (unless in a traditional or Roth IRA). Certain measures factor into your returns: the size of funds you pay into the product, your age, and how far off you intend to push the start date of your payments. Payments can be doled out in a lump-sum or in periodic disbursements.
There are also various types of annuities. Fixed annuities, as their names suggest, promise you fixed payments over a set period. Variable annuities allow you to put your funds into mutual fund investments you can manage depending on selection from the insurance company. Payments will be based on the performance of your investments. Finally, fixed indexed annuities allow you to have your investments be contingent on a certain percentage of gains in a particular index, like the S&P 500. These annuities offer a minimum guaranteed interest rate and potentially increased earnings since payments are based on the performance of one or more stock market indexes, however with these investments you don’t need to actively control them. (For more, see: What You Should Know About Fixed Indexed Annuities.)
Beyond the basic promise of receiving payments from the insurer, you can customize your contract to leave money to your spouse or your estate, and can work in guarantees that you’ll at least be able to get your premium back should performance from your investments be less than satisfactory, and so forth. However, be wary that guarantees and other provisions in your contract may come with added fees and costs — or can cause added fees, costs, or taxes if you aren’t aware of timing for withdrawals, etc. As is obvious, you want to enter into the product as informed as possible or with the best investment advice you can get.
You may be asking, "with all these things in mind, why would I want to consider an annuity?" Well, one of the first benefits is that annuities help insulate you from inflation. Fixed and indexed annuities offer the opportunity to fight inflation and the lessening purchasing power of today’s consumers. As mentioned above, fixed and indexed annuities, depending on the insurer you purchase them from and the contract you draw, may offer guaranteed annual interest and earnings linked to increases in the index. For example, if an index rises from one annuity anniversary to the next, so will the interest earned. Or some insurers are even offering annuity holders more options for further crediting on fixed and indexed annuities. These strategies from insurers are helping retirees combat inflation and work around interest rate uncertainty.
The timing of your investment portfolio is crucial. This timing is called sequence of returns risk. Understanding this term will be the difference between running out of your retirement savings and never having to worry about retirement ever again. Market conditions can sway a bit based on random occurrences, but portfolio size and timing can be extremely instable. A good and substantial portfolio can yield big returns for 20 years and then in one year set back all prior gains.
Strategies to work around this risk include withdrawing and spending at a constant — not inflation adjusted — rate, utilizing a good amount of fixed-income assets (e.g. annuities), and of course withdrawing less than you think you might need in the first years of retirement to guard against market conditions, plus saving is still necessary in those first few years. (For related reading, see: How Annuities Can Boost Your Retirement Confidence.)
Bond prices move inversely with interest changes, bond holdings have been dropping in the last year, and they will continue to drop since interest rates have been predicted to increase in the coming years. Many retirees and investors have tried to combat this with dividend stock investments, but these can be volatile and risky, sometimes offering more problems than a bond holding.
One strategy that has worked to insulate retirees from bond and stock market conditions while allowing them to retain income like a bond investment is indexed annuities. As mentioned above, these annuities allow you to participate in the stock market but your investments (which you don’t have to actively control) are linked to an index and offer a minimum guaranteed interest rate and potentially increased earnings since payments are based on how one or more stock market indexes perform.
Indexed annuities can be single premium or flexible premium. The former is one single investment while the latter allows the investor to pursue further investments after the first. With both, you distribute your investment between a fixed account and at least one indexing product. The fixed account yields a return over time that's typically equal to or more than a bond or CD of similar length.
Pros and cons of this arrangement? With an indexed annuity you don’t participate in the gains and losses of a traditional investment. When the index’s yield is negative, you don’t get a loss on your account. Yet if the amount yielded is positive, interest earned to your account may be capped. So while you won’t have the losses, you won’t be able to obtain your potential full gains if they outperform the cap. Besides this and protection from the market as stated above, advantages include removal of bond default risk, gains from the successes of stock market indexes, tax deferred growth, and simplification of investment management (which includes not having to pay management fees!). (For related reading, see: Annuities: How to Find the Right One for You.)
Given these benefits, indexed annuities from highly-rated insurers — which is very important — can be a suitable alternative to the bond section of your retirement portfolio if you are able to commit to their long-term nature.
Finally, while this was touched upon briefly in the intro, indexed annuities can be superb tools because of the principal protection, since your initial deposit is secured from losses encountered in the index along the way. Unfortunately, variable annuities do not offer principal protection unless you pass away and had kept the contract (unnecessarily paying for a mortality expense). Fixed annuities don’t require this because accounts don’t go up and down, so you get your investment back over time with interest.
Surrender charges are the only downfall to consider with fixed and fixed indexed annuities. With variable annuities, consumers have to additionally pay for riders — in the form of an extra expense charges that can be as high as 2% of the account each year. Most companies make investors wait five to 10 years for surrender charges to vanish. After the term, you can take the money and spend it or do whatever you’d like. This may have tax consequences so be sure to work with a tax advisor and discuss options before doing this. (For related reading, see: Variable Annuities: What You Must Know About These Controversial Products.)