Redesigned annuities are less expensive and easier to understand and buy, yet still customizable. They can be a vital hedge against outliving your assets.
Learn how recent annuity trends such as lower lump sums, fewer standard benefits, and refund choices can lower annuity cost structures
As retirement draws closer and thoughts of investing for growth begin to give way to thoughts of protecting that growth, many investors start looking at annuities. Like most financial instruments, annuities have their place, especially for investors left rattled by past volatile stock markets and economic upheaval. But what do annuities really do and how do they do it? Maybe it’s time to take a fresh (or first) look at how these tools might help you build a better retirement.
There’s never going to be a silver bullet for every problem or for every investor. But with lower overall costs and an increasing ability to customize, annuities may have earned an important spot in your portfolio, which simply means asking yourself some key questions about financial comfort.
Most investment products are all about maximizing return, but annuities can do something different—they can help serve as a hedge or protection against market volatility and longevity risk. What they really do best is to protect clients against the risk of outliving their investment assets. And once this fear is removed from the equation, investors may be better positioned to make smarter, less emotional decisions with the rest of their portfolio.
For example, rather than systematically withdrawing from a portfolio at a 4% rate but always having that fear of running out of money in the back of your mind (especially if market volatility eats into your portfolio during your retirement years), with an annuity, you can lock in a potentially higher distribution rate and hopefully sleep better at night (and play better during the day!) knowing that this ‘distribution paycheck’ is guaranteed to last your entire lifetime.
In its simplest form, an annuity is just a contract between you and an insurance company. You put up a certain amount of money, either all at once or over time, and an insurance company agrees to pay you a specified amount, for some agreed upon period of time. The amount you get paid can be fixed, or can vary, and the term of the annuity can range from a fixed number of years, until long after you die. Depending on your portfolio, annuities can be just the thing to level out hot-and-cold investment returns and keep a minimum amount of cash coming in during your golden years.
Here’s a key point to remember: When you invest in stocks, bonds, and mutual funds, you’re primarily focused on accumulating a nest egg. When you buy an annuity, that focus shifts from building up a pile of cash to establishing a foundation of security and certainty, typically in the form of a guaranteed payout at some future (or more immediate) date. Annuities give an individual the opportunity to create their own income stream—sort of a personal pension plan—so he or she doesn’t have to worry as much about making the nest egg last.
Annuities are generally categorized as either fixed or variable, and as either immediate or deferred. Immediate and deferred refer to when you’re going to begin taking withdrawals—do you need retirement income payments to begin right away, or not for several years down the road?
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Variable and fixed refer to the method of accumulation (if it’s not an immediate payout), and also to the method of income payments. But don’t let any of the jargon confuse you; it’s simply referring to whether the insurance company is guaranteeing the accumulation and/or payment amount (fixed), or if your annuity assets are invested in the market which determines the amounts (variable). Easy peasy.
Buyers can also add optional benefits and riders to their annuity contract, which can make them more attractive, but which can also increase the overall cost of the annuity or reduce the guaranteed payout amount. More about that in a minute.
The simplest type of annuity is perhaps the fixed immediate variety. You start by paying a lump sum, then you immediately receive a stream of guaranteed payments—either for a set number of years, the rest of your life, or even the rest of your life and your spouse’s life. Sounds a lot like a good-old-fashioned pension plan, right? And who didn’t love those? Of course, the longer the time horizon you ask the insurance company to guarantee payments for, the lower each payment is likely to be.
Another pretty simple example is a variable deferred annuity. Here, the investor either pays a lump sum up front or can continue to add funds over time, but his money goes into investments, which are held in sub-accounts and act similar to mutual funds. The contributions can grow tax-deferred until you start taking withdrawals, making them similar to a 401(k) or Individual Retirement Account. This allows the investor to enjoy some gains if the investments do well, but also lowers the payout if the sub-accounts lose value. As mentioned above, different types of riders can be added for an extra cost, which can guarantee the future payout amount, even if the investment performance isn’t as good as hoped.
Guaranteed lifetime income during retirement sounds great, so what’s the downside to annuities? Historically, cost, and the fact that with some types of annuities your money is more or less locked up. Commissions and annual fees tend to make annuities more expensive than many mutual funds and exchange-traded funds, which is the price you pay for tax deferral and potential guaranteed income or returns. Taking money out of an annuity used to mean you could be hit with “surrender fees” for the first several years.Taxes also can be an issue. Although tax-deferred growth is most often viewed as a good thing, withdrawals from annuities are generally taxed as ordinary income. You would potentially pay a lower rate on capital gains or dividends from a taxable investment account (assuming lower tax rates on gains and dividends remains in effect; consult a tax professional for clarity on current law). The tax treatment of an annuity can also become a burden for heirs.
Certainly not all annuities are created equal. Not all annuities have benefited from cost reductions, not all are introducing new features, and it’s not always true that low cost means good value. So, it’s important to sift through and find the best potential products for your unique situation. TD Ameritrade has done that by being highly selective in determining which carriers and products are invited onto their annuity platform. TD Ameritrade focuses on carriers with demonstrable financial strength and requires a minimum S&P credit rating of AA- or better, all while requiring the variable annuities on their platforms to have no surrender charge and be low cost.
Financial planners generally advise that no more than 30% of assets should go into annuities. Given the plethora of options and the wide range of fees on annuities—as well as the pros and cons of potentially locking up your cash for years to come—it’s best to educate yourself about specific products.
Learn more about investing in income-generating annuities.
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