How an Annuity Can Help Plug the Gaps in Your Retirement Plan

Key Takeaways:
  • An annuity is a contract between an individual and an insurance company that transfers risk from the individual to the company.
  • Advantages to annuities include tax deferral, limiting or even eliminating market risk and the ability to provide a guaranteed lifetime income stream.
  • Since different types of annuities offer various benefits that may fit an individual’s lifestyle or financial needs, it’s important to have an honest discussion with an advisor about what your goals are likely to be in retirement.

 

Planning for retirement requires a fair amount of lifestyle analysis combined with a financial plan. The key questions are:

  • What are your sources of income? (Social Security, pensions and retirement savings)
  • What will your likely living expenses be?
  • Is there a gap?

If there is a gap and your income will not cover your anticipated expenses, an annuity may be the best option for filling it and making sure you have the income you will need during retirement.

What is an Annuity?

At its core, an annuity is a contract between an individual and an insurance company that transfers risk from the individual to the company. In the simplest terms, you give the insurance company a sum of money – either a lump sum or payments over time – and the insurance company agrees to pay you a guaranteed lifetime income.

Annuities often get a bad rap since some contracts have high fees, require long-term commitments which make them illiquid, and people often do not understand what they are getting into or why. But they are a very useful tool, especially in terms of ensuring that essential needs are met in retirement.

Education is an essential part of the annuity discussion, and a key point to keep in mind is that, while no investment is right for everybody, any investment could be suitable for somebody. In other words, don’t rule out annuities until you have learned more about them. Working with a trusted advisor who understands the annuity market can help you determine if an annuity is an appropriate option in your case, and the advisor can help you match the right annuity product to your personal needs.

Advantages to annuities include tax deferral, limiting or even eliminating market risk and the ability to provide a guaranteed lifetime income stream.

Since different types of annuities offer various benefits that may fit an individual’s lifestyle or financial needs, it’s important to have an honest discussion with an advisor about what your goals are likely to be in retirement, including your anticipated income needs, risk tolerance, taxes and estate planning.

Types of Annuities

  • Single Premium Immediate Annuities & Deferred Income Annuities – Often referred to as pure annuities, the SPIA and DIA offer investors a guaranteed income for a specific period or for life. Investors looking to start income within the next 12 months can contribute a single lump sum to a SPIA in return for a guaranteed income stream. Investors planning for income beyond 13 months can contribute a lump sum or a series of payments to a DIA and receive income in the future.
  • Fixed Annuity – Perhaps the most basic type of annuity, this requires the buyer to pay a lump sum, and in return the insurance company pays the buyer a set rate of return on the investment over a specific number of years. This is a good option for risk-averse investors looking to avoid market volatility and receive a guaranteed return on their investment.
  • Fixed Indexed Annuity – For investors who are looking for downside protection but who want the potential for higher returns, this may be a good fit. Your money is never directly invested in the market, but is placed into an interest crediting model that tracks the annual performance of a market index such as the S&P 500. Usually, a contract will offer several interest crediting model strategies to choose from. If the market index goes up over the course of the year, your account will be credited with the interest due. The amount of interest you get to keep is usually limited based on spread, participation rate, or performance cap. Should the market index lose value over the course of the year your account value will remain unchanged.
  • Variable Annuity – If you’re looking to invest in an annuity but still want to keep your funds invested in the stock market, the variable annuity will give you access to a broad range of investment options called subaccounts that act much like a mutual fund. These subaccounts are usually sub-advised by well-known firms and give you access to a good mix of equities, bonds and cash. Most variable annuity contracts have the option to add guaranteed income riders for an additional fee. These riders can be useful when planning to fill a future income gap in your retirement plan.
  • Registered Indexed Linked Annuity (RILA) – This is a newer concept to the annuity industry with similarities to both fixed indexed and variable annuities. The RILA, or buffered, annuity allows investors to choose different levels of downside protection. In return for participating in some downside risk investors are often rewarded with higher cap and participation rates on the indexing strategies. Another unique feature of the RILA is the concept of a trigger performance rate. If the market index being tracked is flat or positive at the end of the required term, the performance trigger is activated, and your account is credited with the max performance rate.
  • Non-Qualified Deferred Annuity (NQDA) – Many people choose to purchase an annuity with retirement assets such as IRAs and Roth IRAs. However, you can also put after-tax dollars into an NQDA, the money you contribute is your principal and is never taxed again. However, the return on your investments grows tax deferred. When you take a distribution, the growth is taxed as ordinary income and must be withdrawn first before you can take the principal amount. There is no limit to how much you can contribute to an NQDA. It is important to remember when considering an NQDA that withdrawals prior to age 59 1/2 are subject to a 10% IRS early withdrawal penalty, as well as income taxes on the earnings.

These are just a few examples of the types of annuities available today. As part of a well thought out financial plan, it may make sense to reposition some of your assets into an annuity to help you reach your long-term goals. When meeting with your advisor, make sure to ask lots of questions. It is important to understand the contract features, fees and how the annuity fits into your overall strategy.

If you would like to discuss how annuities may help plug the gaps in your retirement plan, contact an Adams Brown wealth consultant.