Annuity Nuts and Bolts

You have been saving for retirement for many years and have amassed a nice nest egg of savings. Now is the time to determine the products and services that best fit your retirement needs. First of all, you need to realize that the most important part of your retirement planning is your investing.

You may have one set of products that you use during the “accumulation phase” of planning the saving and investing during your working years; and another during your actual retirement years, where the emphasis will be on wisely utilizing your nest egg.

People use stocks and mutual funds during the”accumulation phase.”  A stock is a share in the ownership of a company. For the company, a stock is a fundraising loan that they needn’t repay, but will typically yield greater income for both the company and its shareholders in the end. As an owner, you are entitled to your share of the company’s wealth.

A mutual fund is a lower-risk investment. Investors pool their money and allow professionals to select stocks for them. While stocks may generate a larger return, mutual funds are better for retirement planning because of their low risk and maintenance. 

A word of caution though, Mutual Funds can also possess much more risk than you thought you were encountering. So beware, stocks and mutual funds can be daunting since there’s always the risk that the company won’t be profitable and you’ll lose your investment. 

In the stock market, many investors will simply look at how a stock price of the company’s doing, and jump aboard only because the price is going up. There may be no profits at all behind that particular company (in fact there often aren’t) but they will still invest anyway, because their stock broker called them up and told them to.

Putting your retirement at risk doesn’t make sense to most retiree’s. What is your aversion to risk? Do you want to embrace investment risk, or do you seek to encounter as little risk as possible.  The high risk outweighs the high return to me.

But how does that nest egg translate to an income stream, and how much income can you take from your savings?

There have been dozens and dozens of studies and methodologies discussing sustainable withdrawal rates from retirement portfolios. Conventional industry wisdom considers a 4 percent withdrawal rate to be a “rule of thumb”.

However, where do you withdraw the 4 percent from? Should you take it from your 401(k), your Roth IRA, or your investment portfolio? Generally, you want to start taking withdrawals from your taxable accounts first, such as your investment portfolio.

Then start withdrawing from your tax-deferred accounts, such as your 401(k), and finally from your tax-free account, such as Roth IRAs. The thought process is that you want to allow your tax-advantaged accounts, like Roth IRAs and 401(k) s, to grow for as long possible. However, you must start taking required minimum distributions from your tax-deferred accounts when you turn 70½.

Some people prefer peace of mind and do not want to be disturbed by everyday fluctuation of the market or bothered by continuous management of one’s portfolio. For investors looking to diversify their retirement portfolio and provide a steady stream of income, annuities may offer a great choice. An annuity is one of the most popular options for investors who are approaching retirement by using an annuity to round out your retirement nest egg.

Converting to Annuity

Easy to understand and administer, this option of managing one’s retirement savings can provide a stable and guaranteed income for a specified period of time or for life. There is a fixed rate of interest associated with this. There are many annuity choices and plans available from which a retiree can make a selection.

Benefits 

For retirees looking for a steady income from a lump sum of money, an immediate annuity has several advantages over other alternatives. The monthly payment amount will usually be higher than other investments and guaranteed by the issuing insurance company. A large portion of the annuity payment will be exempt from income taxes, boosting the after-tax income compared with other investments.

Function 

An immediate annuity is usually purchased to provide a lifetime income to the annuitant. The annuity will pay a regular monthly or annual check until the annuitant dies, whether it is in a few months or after 40 years. Immediate annuities have options that will guarantee a minimum payout or payment for a minimum number of years if the annuitant dies early. Annuities will usually provide a higher level of income than CDs or bonds because the principal amount is paid to the insurance company and will not be returned. The annuity provides an income that cannot be outlived.

Significance  

The Internal Revenue Service considers immediate annuity payments a partial return of principal plus interest. The principal value is divided over the life expectancy of the annuitant at the time the annuity payments are started. For example, if the IRS life expectancy tables showed the annuitant had a 20-year life expectancy, the amount paid for the immediate annuity would be divided by 20 and that amount would be excluded from taxable income on the annuity payment. If the annuitant lives longer than the computed life expectancy, the annuity payments will become fully taxable.

Identification

The insurance company that quotes an immediate annuity will show the monthly or annual payment for the amount of annuity purchased and an exclusion percentage or amount. The exclusion percentage is the portion of each annuity payment excluded from income taxes. Subtracting the exclusion amount from the annual payment will provide the amount of taxable income from the immediate annuity.

An annuity makes regular payments to an insured individual in exchange for either regular contributions over time (a deferred annuity) or one lump sum of money (a deferred or immediate annuity). Annuity income is taxable.

Tax on Withdrawals

You are taxed at ordinary income tax rates when making withdrawals from your deferred annuity. Additionally, withdrawals are considered to be a withdrawal of interest earnings and are fully taxable. Principle is withdrawn after interest earnings have been depleted.

Exclusion Ratio

Immediate annuities are subject to an exclusion ratio. An exclusion ratio means that part of the annuity payment is considered to be principal, while part of the annuity payment is interest earnings. The principal payment is not subject to taxation but the interest earnings are. The excluded amount depends entirely on your age and the interest rate the insurance company is paying on the annuity.

Considerations

You will be taxed on 100 percent of your withdrawals in a deferred annuity, but you will have access to all of your savings in the annuity account. With an immediate annuity, you do not have access to your savings. Instead, you receive the exclusion ratio and steady payments from the insurance company.

Tax-qualified money is from retirement plans and IRAs. If qualified money is used to purchase an immediate annuity, the tax rules for those types of plans will apply. A non-qualified immediate annuity is purchased with money from other sources such as savings or investments. The immediate annuity purchased with non-qualified money pays a tax-advantaged regular income.

Reasons for using an immediate annuity

There are some upsides to any product. Ultimately, the question is whether these could sufficiently outweigh the downsides in your situation.

a) Security and stability

That annuity income is secure, stable and must provide an income until the day that you die is a major advantage. The immediate annuity is regarded as low-risk to no-risk.

b) Tax treatment

The income that you receive as an immediate annuity payout is either not subject to tax or enjoys favorable tax treatment. However, this is not a major benefit if you consider that the funds used to invest in the annuity are taxed already.

c) Creditor protection

The annuity also provides a safe haven from the lien of creditors. Annuity payouts are not normally under consideration when you file for bankruptcy or have debt obligations.

d) Qualification for State benefits

That you exchange a lump sum for reduced payments means that you’re giving up capital for income. The nature of this exchange means that for state benefits (such as Medicaid) that have a financial threshold for qualification, the lump sum allocated to an immediate annuity cannot be considered as part of your estate. This can also be used as an estate planning tool- but consultation with an estate planner is required.

The main point is to find out how much money you will need when you retire, and find the right investment vehicle for you to help get you there. Of course, this vehicle will be different for everybody depending on their retirement needs; however, annuities are a great retirement tool.

Annuity–The Right Retirement Decision

Many were poor before being rich.  It is even worse being poor after you’ve been rich—as too many people are learning.  Retirement can be full of worries if one does not have enough funds to live rest of the life in a dignified way. 

Money can help decide whether a person can be able to live his/her retirement life freely or not.

Growing old is not an option.  We don’t have a choice.  But we do have choices that will greatly affect our quality of life for the rest of our life. 

That in a nutshell is how to make the right decisions regarding our resources to maintain a retirement lifestyle similar to the one we have grown comfortable with during our income-producing years of employment. 

There’s much more to retirement planning than accumulating a large next egg. You’ll need to invest and protect your retirement savings, account for health care expenses, and turn your savings into a stream of income.

Because once we retiree our income stops coming, but, our expenses remain as it is and in some cases it rises with the rising inflation. Inflation for retirees is greatest because of they incur larger medical, dental, eye, hearing and other service expenses.

Today, people are living longer thanks to modern medicine and advances in nutritional research and while this is great in a sense, it means making your retirement planning count much more as your nest egg needs to sustain you for a longer period of time.  

The 100% Rule: you may have heard that once you retire you’ll be able to live on 70-80% of your pre-retirement income. However, considering medical costs are rising and life spans are increasing, I’d rather plan that you’re likely to need 100% of your pre-retirement income in retirement just to be on the safe side.

In 1982 a cultural financial shift took place.  Corporate America began doing away with defined benefit pension plans by introducing self-directed 401(k) retirement accounts to their employees.  Essentially, companies started unloading the burden of employee retirement savings off their own backs and onto the backs of their workers.

Instead of looking forward to a monthly pension check from their employer upon retirement, employees were now faced with the responsibility of first saving enough money, and second, investing it wisely so that eventually this account would sustain them throughout their retirement years, or what we can refer to as a 20 to 30 year period of unemployment.

As a result, millions of Americans began turning to Wall Street crowd of stockbrokers for a little help and guidance and came face to face with an industry that was far more concerned about the next commissioned sale than offering prudent, intelligent investment advice. 

Unfortunately, for much of the 1980s and 1990s this problem was masked, largely because the stock market generated returns during this period almost twice that of its historical long-term average. 

The good times of great returns came to a screeching halt in the spring of 2000 when the stock market bubble burst and companies like Enron, WorldCom, and Arthur Anderson’s houses of cards fell down.  

What Is a Bubble, exactly? In the simplest terms, a bubble is an overheated market in which there are too many buyers who are too keen to buy. As a result, prices rise way too fast, and this situation becomes unsustainable. Eventually, some people realize this and start to sell out. The whole process goes into reverse equally rapidly, and the bubble bursts, with people selling in panic so that prices plunge. Particularly those who entered the market late in the process suffer substantial losses.

The majority of people got rocked pretty bad during the meltdown. 401(k) accounts plummeted, and investors started realizing they needed to get serious and start making smart decisions about retirement planning. 

Savers generally benefit from regular deposits in volatile markets so that they effectively are buying more shares when the market is low and less shares when the market is high.  Dollar cost averaging is just the thing needed to make a greater return.  The poor retiree is forced to do just the opposite and so loses return. 

Sound concepts for saving and investing elude the vast majority of people.  Even the government does not do well for the Social Security System.  You and your employer are each docked 6.2% for a total of 12.4% of your wages.  If you are not saving at least that much in addition yourself, then it is unlikely that you will adequately supplement Social Security.

Guaranteed sources of retirement income include Social Security payments, pensions, and annuity payments.  Principally, an immediate annuity can help ease the concerns people may have about managing a diversified investment portfolio or, even more frightening, of outliving their assets.

While most working Americans get their income from a single source, retirees shouldn’t count on any one income stream.  When you purchase an immediate annuity, you make a single lump-sum payment and set the starting date for the payout to begin sometime within 13 months. The term and the amount you’ll receive are determined by the annuity contract.

Immediate annuities can be understood as a money management tool which allows you to invest a portion of your savings for monthly payments that you will receive either for rest of your life or for a specific period of time that you have decided. The only disadvantage with immediate annuity remains the fact that you cannot withdraw any cash in case of unforeseen emergency.

With an immediate annuity, you control the term: You can choose income for your lifetime (known as a life annuity) or for your lifetime and that of another person (known as a joint and survivor annuity). You can also add a guarantee period to a lifetime income payout option, under which your beneficiaries will receive the payments remaining in the guarantee period should you die before the end of the period. You can also choose between time-specific or amount-specific payout possibilities.

There are certain advantages offered by an immediate annuity that can make it an attractive choice for retirement income. Anyone who expects a lump sum pension or 401(k) distribution might consider an immediate annuity as a way to convert their funds into a stream of income they can’t outlive.

Annuity income or guaranteed lifetime income from annuities help to mitigate the loss of purchasing power from inflation risk. For the many retirees on a fixed income, the real value of fixed income declines inexorably after retirement. Setting a later maturity date for annuities can give the income boost necessary to sustain the real value of retirement income for a while longer.

In several instances, having your annuity mature at the earliest opportunity may not be the best option. You might yield higher annuity benefits and reduce retirement risks by delaying receipt of annuity benefits.

A major benefit of taking your annuity later than sooner is the higher annuity benefit. This, in turn, reduces longevity risk. The erosive effects of taxation and inflation work against both your retirement savings and retirement income. While immediate annuities do not have a maturity date, the date of purchase is effectively the date of maturity. Immediate annuities can assist with reducing taxation and some can provide income that is linked to market performance.

Most people understand the importance of diversifying their financial portfolio, but when it comes to deciding how to convert their savings into income, many need advice to ensure they are making wise choices.

Boomers Need Annuities

As The biggest generation in history barrels toward retirement, it’s very important that people, as they approach retirement, start to simplify their financial future.

A recent U.S. Census Bureau study notes that by 2050, there will be more than a million Americans age 100 or older.  

Baby Boomers who are retiring today may well be retired for as many years as they were in the workforce.

If they get to age 60 and are married, there’s a 40 percent chance that one of them will reach age 95.  Such life expectancies bring with them a greater need for growth and security.

Boomers do not plan to retire like their parents did, and their retirement years will be marked by a far more complex range of challenges and expectations. 

Given today’s longer life expectancies and frequent medical breakthroughs, Baby Boomers may need to finance 20, 30 or even 40 years of retirement. For many, the only recourse may be work-either by delaying their retirement age or seeking part-time jobs to supplement their income.

Many boomers feel that it’s doubtful that they have the ability to design a 30-year distribution strategy, hedged against inflation? Running out of money is a problem that challenge retirees as life spans lengthen.

Minimizing risk
Many in the 60-and-over group—and probably a lot of younger folks, too—have been hit with a double or triple whammy. Carrying too much risk in the early 2000s many consumers saw their accounts plummet 30 percent, 40 percent or even 50 percent. In many cases, they lost everything.

They didn’t lose it all at once. Like others approaching retirement, many boomers had, over the past three years, watched their retirement account values plummet as the ill winds of stormy equities markets battered their portfolios.

Investors—mostly the over-60 crowd—should limit their exposure and look at a 50-50 or 60-40 blend, and protect and keep half their money in safe, fixed vehicles that can help bulletproof your portfolios.

• Remember that back in October 2007, prior to the most recent market meltdown, the Dow was at 14,000 points.
• Today, it’s at 10,000.
• Consider the Dow, which stood at 7,487 on November 13, 1997, and then was again at 7,486 on March 18, 2009, almost 12 years later.
• When the market drops by 50 percent on your $100,000, taking it to $50,000, you need not a 50 percent gain but a 100 percent gain just to break even. 
• Striking an appropriate balance between risk and reward is critical. 

There are financial tools out there that can reward volatility, whether it’s interest rate volatility or market volatility.  Experts say ever-growing life spans make annuity products a bedrock component of a sound retirement plan. Annuities help older clients get the most out of their money by producing better after-tax returns and guaranteeing a lifetime income stream.

As baby boomers approach what is more often than not a lengthy retirement, many are looking for an income stream that will not only last as long as they do but will offer performance and security as well.  How much money will you need in order to maintain your pre-retirement standard of living?

Annuities are like a safety net.  When you really look at it, people insure their homes, they insure their cars and now they have the option—if they want—of insuring their money.

Annuities offer an ideal combination of growth and security—something that is especially important as the population ages.

Annuities also respond to growing consumer concerns about risk. “The nice thing about annuities is you don’t have to ask what a person’s risk tolerance is. You know their money is safe. They won’t lose their principal, and interest rates are locked in each year. If they’re in an equity-indexed annuity, the gain also is locked in each year. So not only can you not lose your principal, you can’t lose your growth as well.

Most of this money is being moved from the market, and if the market goes down, do you want a negative or do you want a zero?”

This is a strong point, particularly for clients who’ve been through market ups and downs. “Back in 1982, annuity interest rates were 15 percent, fixed annuities were like a CD in the bank; you could get a good guaranteed rate. As interest rates declined, the stock market became more attractive. And many of us who were in fixed annuities gravitated to mutual funds and other more complicated and risk-oriented investments.”

All of that began to change when the tech bubble burst and 2000 came and went. “All of a sudden, we were in a serious downturn. And many of us began to realize we really still want guarantees. That evolution has made annuities more in demand by today’s baby boomers.

There are the traditional advantages with the equity-indexed annuities, for example.  The money inside the policy is free from taxation until you take it out. The tax-deferral features, along with the liquidity features, are very important. Many annuities offer systematic withdrawals of interest and principal most waive the surrender charge in case of nursing-home confinement and offer a terminal-illness benefit.

Annuities vs Drawdown Retirement Income

Most of life’s routine expenses—mortgage payments, electric bills, etc.—must be paid monthly, and there is a need for a guaranteed income that can cover those expenses. 

Yet, retirees generally respond unfavorably to financial products that offer substantial protection and guarantees.  If a product offers a future stream of income or can cushion retirees against a large drop in the stock market, they may not buy it if they can’t withdraw their money whenever they want.   

This is where “loss-aversion” can inhibit their ability to make what we believe would be more sensible financial decisions.

The main two ways people take their income are through an annuity and through a drawdown plan; here we look at the pros and cons of these two methods of drawing on your pension. It is also possible to split your fund between the different options and to phase the purchase of an annuity.

Annuities

An annuity is a consumption plan that guarantees lifetime income.  If you’re planning for retirement, leaving a position and rolling your pension or 401(k) or simply want to start a safe secure investment, you’ll find the fixed annuity is perfect for your situation.

A fixed annuity can be an IRA, pension, 403(b), 401(k) or rollover IRA, which makes the product a qualified annuity. Qualified annuities and non-qualified annuities can be the same product. The difference between the two is the paperwork used to identify that the government recognizes its pension money, and therefore gets special tax consideration.

Immediate annuities provide a series of payments until the client dies, this is also known as a pension.  Annuities are offered by insurance companies and pay you a guaranteed income for life in exchange for your pension pot.

For example, if a retired couple needs $4,000 per month to cover their living expenses, and Social Security and pensions provide $3,000 per month, they could purchase an annuity that would pay out the needed $1,000 per month for as long as either one of them lived.

You purchase the fixed annuity and at the end of one payment period, you receive your first check from the insurance company. Of course today, most people have the income directly deposited into their checking or bank account to avoid the hassle of taking a check to the bank or the worry of someone stealing the check from their mail

This income is taxable. They’re secure and simple. Yet people often buy them begrudgingly. The over-riding reason for this is that if you buy a single life annuity with no guarantee (which many people do), then when you die the income stops.

People tend to think of this negatively because if you die three years after buying such an annuity then your income stops and your pension pot is gone.

This is true, but there is a flip side to this coin: if you live to 100 your annuity will still be paying you a regular income year in year out.

You might be pleasantly surprised by how long you can expect to live. On average, a 65 year old man can expect to live until his 86th birthday and a 65 year old woman until her 89th birthday. Those are just averages- healthier people can expect to live even longer.

If you don’t like the idea of your annuity dying with you, you can opt for a spouse’s pension or for a guarantee period. Adding such options onto your annuity will tend to reduce the starting income you get from the annuity, but it will also mean your pension income could continue to a spouse or to your estate after you die.

Basically because you are statistically more likely to die earlier if you are in poor health or smoke, some competitive annuity providers are willing to give you a higher income because they don’t expect to have to pay out for so long.

Income drawdown

Investment returns, are typically irregular and feel more abstract with regard to expenses. A drawdown plan is very different to an annuity. Instead of handing your pension over to an insurance company in exchange for an income, you continue to keep your pension fund invested. You can then draw whatever income from the fund you wish, subject to a maximum set by the government. As with an annuity this income is taxable.

Unlike an annuity your income is not secure so it’s value could go up or down depending on how well your investments do.

Risks associated with this concept will remain a concern as poor investment performance or large income withdrawals can quickly erode your fund’s value and it is unlikely you will continue working while drawing an income, in which case you will not be able to make up any shortfall.

You do have the flexibility to alter your income to fit in with your expenditure and your other income. There is also the possibility your income could rise if your investments do well.

Drawdown is therefore riskier than an annuity, but is also more flexible. It’s generally more popular amongst investors with bigger pension pots who are willing to take investment risk and are prepared to accept the possibility their retirement income may fall, or even run out altogether.

 You will also have to continue to manage your pension if you go into drawdown, or employ an adviser to manage it for you. Although we strongly suggest you seek advice as it is a more complex option. If you have decided to go into drawdown make sure you don’t end up paying extortionate fees.

Some drawdown providers charge many hundreds if not thousands of pounds a year, which can have a significant effect on your fund size and hence your income.

Eliminating or reducing the chance of default in the portion of a retiree’s assets that provides their basic living expenses can alleviate loss-aversion. Once retirees’ essential spending needs are taken care of, they may feel better about pursuing higher returns with the rest of their savings.

Fixed Index Annuities

A Fixed Index Annuity (also equity-indexed annuity) is a special type of fixed annuity contract that fuses the safety of fixed annuities with higher participation in the financial market. Strictly speaking, it is not an investment- as it is primarily an annuity contract between an annuity investor and insurer or annuity provider. Although Fixed Index Annuities represent an improvement on fixed rate annuities, they inevitably have their merits and demerits.

Guarantees

Fixed Index Annuities- like other insurance contracts- offer investors guarantees on their premiums and returns. Indexed annuities have a rate tied to a financial market index, typically an equity-market index like Standard & Poor’s 500 index of stocks.

The advantages of the indexed annuities are potentially an average return higher than fixed annuities or fixed-income assets, a risk reduction factor that allows the investor to give up higher returns in exchange for a return minimum guarantee, reducing the variance of returns on both the high and the low end.

Apart from safety assurances for contributions, Fixed Index Annuities offer investors minimum (base) guaranteed rates of return. This suggests that even though their performance is linked to an external index, the annuities are insulated from severe downturns in the market.

In conclusion: A major benefit of equity-indexed annuities is that they offer returns that link to market performance through an external index (such as the S&P 500). Annuity investors on this plan can benefit from favorable fluctuations in the market while being insulated from sharp downturns. Fixed Index Annuities also offer higher returns than fixed rate annuities, CDs and Money Market Funds.