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Part of the Plan

For many investors, saving for retirement is the effort of a lifetime. It takes discipline to craft a savings plan and then stick to it. But when they finally stop working, some investors may find themselves unprepared for the reality of turning their savings into a steady income.

Spend too much too fast, and there may not be enough to cover essentials in the years ahead. Spend too little, and you risk leaving too much behind. And what happens if the market dips or low interest rates make it difficult to generate income?

Investors who are looking for a way to generate a stream of reliable income could consider an annuity to fund part of their retirement spending. An annuity is a contract with an insurance company under which an investor turns over a lump sum or pays annual premiums in exchange for a guaranteed stream of income. Annuities can last for a defined period or for the rest of your life—and can include the life of a spouse.

Annuity payments, along with Social Security and other sources of regular income, can serve as a reliable source of funds for essential expenses. There are some tradeoffs, though. Annuities may not be as flexible as traditional investment accounts, and the costs can be complicated. Also, payments and other guarantees from annuities are subject to the financial strength and claims-paying ability of the issuing insurer.

“Annuities are often maligned because of the confusing cost structure or high commissions charged for some products. However, not all annuities are high-cost or high-commission, and they add useful insurance and planning features that may be difficult to achieve otherwise,” says Rob Williams, Managing Director of Income Planning at the Schwab Center for Financial Research.

Let’s look at how two common types of annuities—a fixed immediate annuity and a variable deferred annuity with an optional rider called a guaranteed lifetime withdrawal benefit (GLWB)—can help transform savings into a stream of paychecks and simplify income planning.

Fixed immediate annuity

Buying a fixed immediate annuity is a little like setting up a pension for yourself—you’re basically converting some of the savings in your 401(k), IRA or non-retirement investment account into a steady stream of payments. When you buy this type of annuity you make a single up-front payment to an insurer. In exchange, the insurer will deliver a series of steady payments based on your initial lump sum, your age, interest rates and other factors at the time of purchase.

As the word “fixed” implies, the size of these payments generally doesn’t change over the life of an annuity, though some contracts allow for increases at a defined rate or that are linked to the pace of inflation. In such cases, the payments you receive will generally start at a lower level and then rise over time.

To see how a fixed annuity can help simplify your income and spending plans, imagine you had $1 million in savings and expected to spend $20,000 a year on essentials after retiring. If you were 65, you could buy a $400,000 fixed annuity offering to pay out $24,000 per year for the rest of your life.1 That translates to an annual payout of about 6% of your original lump sum payment.

As expenses are already built into the income stream you’ve purchased, there are no ongoing fees with a fixed immediate annuity. When you make your initial payment, the insurer adds your money to a pool of funds from which it makes payments to you and other annuity holders. Some of the people whose savings are in the pool will pass away before retrieving the full value of their contributions. Others will live longer, collecting more. In other words, annuity holders who pass away at a younger age are effectively subsidizing the income streams of those who live longer than average.

One tradeoff is that when you buy a fixed annuity, it is irrevocable. Your money is in essence converted into an income stream. You cannot liquidate a fixed immediate annuity if you change your mind after buying one.

Variable deferred annuity

A variable deferred annuity is a very different way to structure your income plans. Unlike a fixed immediate annuity, a variable annuity is both an investment product and an insurance contract.

This type of annuity allows you to invest in the market on a tax-deferred basis, and then provides guaranteed lifetime income based on the value of your investments. Many contracts also offer an optional GLWB—which you can add for an additional charge—that sets a baseline for the lifetime income guarantee. That baseline holds even if you deplete the value of your account or the market tumbles. It can also reset at a higher level if the value of your investments rises (after taking withdrawals and fees into account). In other words, a variable annuity with a GLWB can offer growth potential on the upside, while also setting a floor under future income streams on the downside.

One area where a variable annuity with a GLWB differs from a fixed annuity is that you retain control of your money and can access the value of the assets in your account if you need to, rather than converting your savings irrevocably into a series of fixed pension-like payments.2

Given these dynamics, you could start investing through a variable annuity with a GLWB before you reach retirement age, potentially giving your investments time to grow. You could then start making withdrawals once you need the income.

To see how you could make a variable annuity with a GLWB part of your income and spending plans, let’s say you had $1.25 million in savings and expected to spend $25,000 a year on essentials after retiring. At age 65, you could buy a $500,000 variable annuity with a GLWB offering a guaranteed annual withdrawal rate of 5%, or roughly $25,000 a year. (As with a fixed annuity, the guarantees are subject to the financial strength and claims-paying ability of the issuing insurance company.)

One of the potential strikes against variable annuities with a GLWB is that some of them can be costly. Generally, you pay a base annuity fee as well as an extra cost for the GLWB. In addition, you will have to pay the underlying investment expenses, such as the operating expenses charged by the funds in which you’re invested. At Schwab, the base fee and rider together range between 1.60-1.65%,3 but across the industry fees can vary widely.

And it is important to note that although the GLWB sets a baseline for a guaranteed stream of income, the value of that baseline isn’t equivalent to an account value and can’t be withdrawn as cash when you want.4 As with a traditional investment portfolio, your account value will shrink with each withdrawal.

A tool for generating income

Annuities can provide a reliable stream of income that you can’t outlive. Whether an annuity would make sense for you really comes down to how much you value the added protections to your income plan. Some investors may feel confident in their ability to sustainably support themselves with withdrawals from a traditional portfolio or to reduce spending in a down market. Others may feel reassured by the protected lifetime income offered by annuities.

1Source: CANNEX Financial Exchanges. This example is based on rates as of 2/4/2015 and assumes a single female age 65, lifetime only, qualified funds, in California, with income starting one month after purchase.

2Withdrawals in excess of the specified annual amount will reduce your future income and withdrawals prior to age 59½ may be subject to tax penalties.

3There are base variable annuity fees of 0.6% for the Schwab Retirement Income Variable Annuity® and 0.65% for the Schwab OneSource Choice Annuity Variable™ as well as a 1% GLWB fee. This total cost does not include fees associated with underlying investment options and/or any death benefits, as applicable.

4The benefit base is the notional value on which your guaranteed annual income is calculated.

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Important Disclosures

Variable annuities are sold by prospectus only. You can request a prospectus by calling 888-311-4887 or by visiting schwab.com/annuity. Before purchasing a variable annuity, you should carefully read the prospectus and consider the annuity's investment objectives and all risks, charges and expenses associated with the annuity and its investment options.

The contract value of a variable annuity may be more or less than the premiums paid and it is possible to lose money.

All annuity guarantees, including an annuity's payment guarantees, are provided by and only as strong as the financial position and claims-paying ability of the issuing insurance company. Neither Schwab nor its affiliates provides insurance or other guarantees. Consult the insurance company's ratings for its financial strength and read the annuity contract and/or prospectus before investing. Insurance company ratings do not apply to the performance of variable subaccounts. Ratings are subject to change.

The Guaranteed Lifetime Withdrawal Benefit is an optional rider available for an additional charge. It is not a contract value, cannot be accessed like a cash value, and will not preserve your account value, which will deplete with each withdrawal until it reaches zero, though payments under the terms of the rider will still continue for life. On certain contracts, the GLWB must be elected at the time of purchase and cannot be changed later. Upon electing the rider, you may be limited to a pre-specified selection of investment options. Withdrawals in excess of the specified annual payout amount may permanently and significantly reduce your future income.

Variable annuities are long-term investment vehicles designed for retirement purposes and offer tax deferral on potential growth; however, withdrawals prior to age 59½ may be subject to a 10% federal tax penalty in addition to applicable income taxes. Variable annuities are also subject to a number of fees including mortality and risk expense charges, administrative fees, premium taxes, investment management fees and charges for additional optional features. Although there are no surrender charges on the variable annuities offered by Schwab, such charges do apply in the early years of many contracts.

Charles Schwab & Co., Inc., a licensed insurance agency, distributes certain life insurance and annuity contracts that are issued by non-affiliated insurance companies. Not all products are available in all states.

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security. The investment strategies and the securities shown may not be suitable for you. We believe the information provided is reliable, but Charles Schwab & Co., Inc. ("Schwab") and its affiliates do not guarantee its accuracy, timeliness, or completeness. Any opinions expressed herein are subject to change without notice.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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