Annuities present something of an investment puzzle. On one hand, they can help you simplify your income planning in retirement. But handing over a portion of your savings to an insurance company isn’t always an easy move to make.
First, the sheer variety of annuities can be baffling. There are fixed, variable, immediate, deferred, and equity-indexed annuities—just to name a few. In addition, each annuity can come with a (sometimes lengthy) menu of riders and options that can expand its coverage, sometimes adding cost and complexity.
Despite these hurdles, annuities can offer real benefits if you want to bring order to your retirement-spending plans, says Rob Williams, director of income planning at the Schwab Center for Financial Research. “Annuities can provide insurance for your retirement,” he says, helping to mitigate some of the risks, such as market and longevity risk, that retirees face.
A valuable complement
An annuity is a contract with an insurance company. Depending on the type, you typically pay either a lump sum or an annual fee, and in return, the insurer generally promises to pay you income for a set period of time—or for the rest of your (and potentially your spouse’s) life, when you start taking income. Of course, payments and other guarantees from annuities are subject to the financial strength and claims-paying ability of the issuing insurer.
Whatever type of annuity you choose, know that you don’t have to hand over your entire life savings. In fact, Rob suggests committing no more than half of your investable assets to annuities and says it’s better to think of these products as just one potential part of a larger retirement-spending plan.
Rob says it’s helpful to divide your potential sources of retirement income into two categories:
- Predictable sources of income, which could include Social Security, pensions and annuities. Use this income to cover essential expenses, like housing, food and supplemental healthcare costs. It’s your baseline.
- Portfolio income, which is more variable, includes dividends, capital gains, interest from bonds, and distributions from IRAs, 401(k)s and investment accounts. Use this to pay for discretionary expenses such as travel and entertainment. At the same time, knowing your essentials are covered by your predictable income streams should give you the confidence to keep more of your portfolio invested for growth over the long run.
Another option is to calculate how much of your retirement income will come from other predictable income sources, such as Social Security, and divide that by your total retirement income needs. For example, if Social Security will cover 20% of your income needs, then 80% will have to come from your portfolio. Does this feel like too much risk to you? If so, consider boosting that guaranteed income percentage with annuities.
The benefits of guaranteed income
Using an annuity to create a predictable income stream can help address some common retirement needs. Here are some:
- Annuities provide steady income. Figuring out how much you can withdraw from your 401(k)s, IRAs and other investment accounts each year is no easy task. Placing some assets from such accounts in an annuity can help smooth things out. “Annuities can help turn a lump sum into a disciplined series of paychecks or distributions,” Rob says, “and creating a disciplined spending plan, for a least a portion of your essential expenses, can be one of the more difficult tasks in retirement.”
- You can plan and spend more comfortably. Many of today’s retirees are living longer, and for many couples there’s a good chance one spouse will live past age 90. Dedicating some assets to annuities to provide income that you—and potentially your spouse—can’t outlive can take the pressure off your investment portfolio.
- You can better manage market swings. One annuity, called an immediate income annuity, delivers steady payouts that aren’t subject to market volatility. When you buy one, you’re effectively transferring your market risk to an insurer. That can alleviate financial worries during a bear market and minimize sequence-of-returns risk—helping you avoid taking withdrawals from investment accounts when they’re down and, potentially, managing the rest of your portfolio more flexibly.
- Annuities can keep your plan on track. At 85 or 90, you may not have the desire or cognitive capacity to actively manage your investment accounts and maintain a withdrawal plan. Steady annuity payouts can simplify your retirement income.
Two annuities to consider
- An immediate income annuity: Also known as a single premium immediate annuity, this can be a smart option if you want fixed payments that won’t fluctuate based on the markets. You make one lump-sum payment, and the payouts start immediately.
One thing to note: The payments are based in part on interest rates (along with the size of your initial lump sum, your age and other factors) at the time of purchase. Pouring a large chunk of your assets into a single premium immediate annuity when rates are low might not make sense. One strategy would be to buy several immediate income annuities over time, a strategy called “laddering,” spreading out your annuity purchases and boosting your payments as your guaranteed income needs grow.
- A variable annuity and a guaranteed lifetime withdrawal benefit (GLWB): If you don’t need immediate income and would prefer to keep your money invested—but you still want a reliable source of income down the road—this could be an attractive option, Rob says. With this product, your money is invested in the markets, where it benefits from the potential for tax-deferred growth. By annuitizing the contract, you can begin receiving guaranteed income for life based on the performance of the underlying investments. If you want further assurances for your income, you can purchase an optional rider called a Guaranteed Lifetime Withdrawal Benefit (GLWB), which guarantees you a minimum level of lifetime income. If the portfolio’s value rises, your income can rise. If you want protection from market fluctuations, Rob suggests purchasing the optional GLWB rider as it ensures that your eventual withdrawals will never be lower than a pre-determined minimum. (But note that the GLWB protects your income only, not your contract value.)
Another important factor to consider when thinking about an annuity is the cost, says Rob. The fees can vary widely, with variable annuities typically carrying higher annual costs than immediate income annuities. And if you add a GLWB option to a variable annuity, it can increase the annual fees you pay by roughly 1% of assets under management, per year. Shop around, and look for a variable annuity with the riders that make the most sense to you, at a cost you’re comfortable with in exchange for the protections provided.
“Remember,” Rob says, “annuities add insurance for your retirement, and while it’s tempting, try not to compare them exactly to investments in your portfolio.” Annuities are designed to protect you from challenges in retirement that are difficult to manage on your own and to help ensure you’ll have income for the one “risk” you want to experience—a long, comfortable retirement.
What you can do next
The best annuity for your portfolio depends on your specific situation and risk tolerance. A financial consultant can help you weigh your options and understand the costs.