The Case for Income Annuities When Rates Are Up
Bonds and cash investments aren't the only assets offering potentially higher income these days. You may also be able to find higher payout rates from income annuities—insurance products offering a guaranteed lifelong retirement "paycheck" (though, the returns are different than those offered by bonds, as we'll see below). Payments from these products tend to track interest rates, and when rates rise, insurers can invest premiums at higher yields. In general, higher yields translate into higher payouts.
This could be good news for two kinds of people:
- Anyone interested in using a chunk of their savings to buy a single premium immediate annuity (SPIA)—that is, an annuity that starts making payments within the coming 12 months or even right away. These contracts can offer payouts for life, covering the purchaser (annuitant) and, for an additional cost, a spouse. They could make sense for people who are in good health, have a family history of longevity, are concerned about outliving their savings, or value having a predictable income stream (in combination with Social Security payments and their investments) to cover essential expenses. Of course, there may be limits to how much of your savings you should consider committing to an income annuity, as you'll want to retain sufficient liquid assets to meet planned—and surprise—large expenses in the future.
- Certain investors who already own a deferred annuity—that is, an annuity promising to make payments at a future date, with the potential for tax-deferred growth along the way—that they haven't "annuitized" yet by converting it to income payments. These investors could consider annuitizing their existing contract now or potentially even exchanging their contract for a new SPIA, assuming they prefer the features and meet certain criteria, which we'll cover below. After all, it's generally preferable to annuitize when payouts in the market are higher, as that locks in future payouts.
So, here are some things to consider.
For the annuities newbie
Annuities are contracts between you and an insurance company. Depending on what type you select, an annuity can provide fixed or variable returns, opportunities for tax-deferred growth, flexible withdrawals, and other features, including leaving a legacy to an heir. Fees and charges—including sales commissions—will vary by the annuity and distributing firm.
With a single premium immediate annuity, you hand a portion of your savings (the premium) over to an insurance company, which in turn provides you with monthly payments that, depending on the contract and option selected, can continue for the rest of your life (assuming the insurer remains solvent).
For example, if you were a single woman living in California who turned 65 on October 1 this year, you could potentially pay an insurer $200,000 and receive a monthly income of $1,058, or $12,696 a year, for life starting in November. (Note that this is just a hypothetical example that assumes the annuity was purchased with after-tax dollars and doesn't include taxes.) For an additional cost, you could add optional features, such as coverage for your spouse or payments that automatically increase in value to help combat inflation.
An income annuity isn't a savings account that you draw down month by month until you hit zero. If it were, the $200,000 in the example above would be gone in about 16 years, assuming you withdrew $1,058 a month. Nor are the payments like interest from bonds or dividends from stocks. Annuity payout rates will almost always be higher. Why? Unlike those other sources of income, which don't include your principal, an annuity payout includes a combination of principal plus an additional return that comes from investments made by the annuity company. This can offer tax advantages, as the portion of your payout considered a return of principal—known as the exclusion ratio—isn't taxable. The portion considered an investment return would be taxed at your ordinary income rate. (The IRS formula used to calculate the exclusion ration involves dividing your net cost—the premium minus any adjustments—by the expected return based on your life expectancy.)
But that's not all. What makes income annuities unique is that the insurer generally guarantees that it will make these payments for a defined period—say, 20 years—or for the rest of your life and, potentially, the life of a spouse if you choose that option.
In theory, this means that if our 65-year-old from above lived to be 95, she'd collect over $380,880 from her $200,000 annuity contract.
Keep in mind, though, that these contracts are irrevocable. Once you pay the premium, you get a brief "free look period" ranging from 10 days to a month during which you can change your mind and ask for your cash back. After that, you're locked into the contract. That said, some contracts do offer an option—called a cash refund option—to pay out any leftover premium to a beneficiary if you were to die before receiving payments equal to at least the original premium (though, this option may reduce the monthly payout).
So, whether this is a good investment depends not only on how long you live but also what you value. One investor might prefer the certainty that comes from a guaranteed income they can't outlive, even if it means giving up control of a chunk of their savings that they wouldn't be able to leave to a family member. Another might think it better to keep ahold of their savings and leave them invested in the market, potentially for bigger returns or a bigger legacy for their family. Keep in mind, too, that SPIA returns are fixed, so they won't keep pace with inflation. Both approaches can work and, for some investors, combining both approaches may make sense.
If you are nearing or in retirement, consider categorizing your expenses as either essential or discretionary. It can make sense to think about covering some, if not all, of your essential expenses with predictable or reliable income sources like Social Security, pensions, and possibly annuities.
So, how much should you commit to an annuity? There's no hard and fast rule, but a good place to start is securing enough income to cover your essential expenses in conjunction with Social Security. Beyond that, it will depend on your goals and whether you would prefer to hold onto a larger chunk of your savings. In any case, you could consider keeping the remainder of your savings invested to suit your spending needs and offer growth potential.
It may be best to work with a financial professional to help think through the pros and cons, the costs, and the different benefit options available.
For those who already have a deferred annuity
If you purchased a deferred annuity sometime in the past but haven't annuitized that contract yet, consider working with a qualified financial planner or directly with an annuity specialist to decide what to do next. You could certainly consider annuitizing your existing contract. However, if you can secure higher payouts or additional benefits by exchanging the deferred contract for a single premium immediate annuity from another insurer, you could consider making a change.
This isn't a given, so here are important questions and considerations you'll want to weigh:
- Are you out of your surrender period? An insurer may penalize you if you withdraw from your contract before the end of your surrender period—a period typically lasting between three and eight years.
- Does a new contract offer more appealing features? Other factors to compare are guaranteed benefits, costs, services, and the financial health of the insurer.
- What is the annuitization rate the insurance company is offering? Investors can, and should, shop around, based on age, terms, and other factors.
- How much do you want to annuitize? You don't need to annuitize the entire annuity. You can annuitize just part of it. Are you paying for an optional withdrawal benefit rider? These riders, offered on some deferred annuities, can allow you to take systematic withdrawals from your annuity without having to annuitize.
Remember, deferred annuities can also be used for other purposes, including leaving a legacy. But the details matter, including when the insurer may require you to start annuity payments (typically set at an age between 85 and 95), and other factors. Read the contract closely and work with a qualified planner or specialist before making any decisions.
The bottom line
Annuities can be complex, but their income guarantees can potentially complement many different retirement income strategies. And even though payout rates may be higher when rates are rising, shopping around could be worth it.
The annuities market is vast, with many different guarantees and options available, so be sure to work with a financial planning professional or annuity specialist who can look out for your best interest before making any irrevocable decisions.
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This material is intended for general informational and educational purposes only. This should not be considered an individualized recommendation or personalized investment advice. The securities, investment products and investment strategies mentioned are not suitable for everyone. Each investor needs to review an investment strategy for their own particular situation before making any investment or trading decisions.
This information is for educational purposes only and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, you should consult with a qualified tax advisor, CPA, Financial Planner, or Investment Manager.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
For illustrative purposes only. Individual situations will vary. Not intended to be reflective of results you can expect to achieve.
Investing involves risk, including, for some products, more than your initial investment.
Past performance is no guarantee of future results.
All guarantees are subject to the terms and conditions of the contract and backed by the financial strength and claims-paying ability of the issuing insurance company, not Schwab.
Payments from an income annuity are subject to ordinary income tax, but for non-qualified policies that benefit from an exclusion ratio, a portion of your payments may not be subject to further taxation.
Please note that annuity withdrawals are taxed as current income, not capital gains. This may or may not be beneficial, depending on your tax bracket. Please consult a tax or accounting professional.
Withdrawals and distributions of taxable amounts are subject to ordinary income tax and, if made prior to age 59½, may be subject to an additional 10% federal income tax penalty, sometimes referred to as an additional income tax.
Please reference the prospectus for information about the levels of protection and participation available and other important product information.
Before considering an exchange of your current annuity there are a number of important factors you should consider which could reduce or eliminate the benefit of the exchange. These include surrender charges on your existing contract, loss of guaranteed benefits, and differences in features, costs, services, and company strength.