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Two Types of Annuities for Retirement Income

Key Points
  • Turning your retirement savings into income that will last can be a major challenge.

  • Immediate fixed annuities and variable annuities with or without guaranteed lifetime withdrawal benefits add insurance and income that can’t be outlived.

  • Understanding the unique attributes of each type of annuity can help you decide if they’ll support your income plan.

After diligently saving for retirement for decades, it’s time to put your nest egg to work. One of the biggest challenges retirees face is knowing how to make that money last. Even if your expenses in retirement will be lower than they are during your working years, you’ll still have essential bills to pay month after month—and you don’t want to worry about where that money will come from or whether a market downturn is going to put your finances in jeopardy.

Annuities are one tool that can help generate a stream of income that will be around as long as you are. There are two main types of annuities that we will discuss here to help generate income in retirement:

  • Immediate fixed annuities, which act like a pension by providing you with a set amount of income for life or a predetermined amount of time.
  • Variable annuities, whose income payouts may fluctuate with market conditions, or with the addition of optional guaranteed withdrawal riders can guarantee a minimum annual withdrawal amount no matter how markets perform.

As with some other types of annuities (e.g., fixed indexed annuities), you can add certain riders or options to a variable annuity—known as riders—to help address your specific income needs. Guaranteed minimum withdrawal benefits are one type of rider often added, at additional cost, to variable annuities.  

Let’s take a look at how annuities (including the optional guaranteed minimum withdrawal benefit (rider) above) work and the types of investors for whom they can be most suitable.

Protecting your retirement

When deciding whether an annuity is right for you, start by considering your concerns and risks you’d like to use an annuity to help manage:

  • Does market volatility keep you up at night?
  • Are you worried about outliving your savings?

Unlike a portfolio of stocks and bonds, which are completely beholden to the whims of the market, annuities combine characteristics of standard investments with insurance features. Annuities can provide a reliable stream of income that you can’t outlive, and some can help you reduce the risk of investing in the market.

Annuities are also a way to systematically turn savings into predictable and guaranteed income—which is perhaps one of the most important elements to consider when managing your portfolio in retirement. How, exactly, will you create your retirement paycheck? Annuities can help.

Immediate fixed annuities: taking the market out of the equation

Immediate fixed annuities are the oldest, most common type of annuity: You pay an insurance company a lump sum up front, and in return you receive a fixed monthly payment for life (or some other specific time period). That money is irrevocable, meaning you can’t get it back once you sign the contract.

If there’s money left in the annuity upon your death, it goes to the insurance company unless you choose a payment option that could guarantee your beneficiaries will continue to receive payments for the duration of a predetermined period.

Immediate fixed annuities may make sense if you need income now and don't want to worry about market fluctuations—at least for a portion of your savings. As long as the insurance company is solvent, you'll receive a payment for the same amount every month. That’s why it’s considered a “set it and forget it” strategy. Buying an immediate fixed annuity is a bit like using a lump sum to purchase a pension, backed by an insurance company.

The annual return you’re quoted when you buy an immediate fixed annuity depends on your expected lifespan, not changes in the market. A $100,000 immediate fixed annuity with a payout of 8.2%, for instance, means you’re entitled to payouts totaling $8,200 each year. The payout is made from a combination of an insurance company’s return and your original principal.

If the insurer anticipates that it will be making payments for a shorter period of time, it can pay a higher proportion of the lump sum on a monthly basis. This is why monthly payments from immediate fixed annuities are generally higher the older you are at the time of purchase.

Prevailing interest rates at the time you’re shopping for an annuity do matter, though. It may not make sense to load up on immediate fixed annuities when interest rates are low, as these payments depend, to a degree, on the market. But if you need guaranteed income, it probably won’t pay to wait too long, either.

One strategy to consider is staggering your purchase of immediate fixed annuities over time, much like a bond ladder. If interest rates rise, you’ll be in a position to benefit from higher returns on the subsequent annuities.

Variable annuities with GLWBs: income protection, flexibility and growth potential

In contrast to immediate fixed annuities, variable annuities don’t require you to turn cash over irrevocably to an insurance company. Rather, the investor retains control of the money, holding it within the variable annuity in a portfolio of investments that are similar to mutual funds.

In a basic variable annuity, your regular payouts may depend on the performance of your investments. However, many variable annuity investors add a rider called a guaranteed lifetime withdrawal benefit (GLWB), which provides guaranteed income in the form of minimum annual guaranteed withdrawals from annuity along with growth potential. The GLWB feature,1 which is purchased at an additional cost, may protect against market downturns by guaranteeing your ability to take withdrawals for life at a certain minimum level, no matter how the market performs, without annuitizing the contract. In other words, you can stay invested in the market and benefit from flexibility and potential for growth without having to give an insurer a lump sum that can’t be returned.

Variable annuities can be more complex than immediate fixed annuities, so it’s important to examine the details and talk with a professional to make sure you understand them thoroughly. But at the most basic level, purchasing a GLWB rider with your variable annuity is a bit like adding insurance to the portfolio of investments held within it. If markets don’t perform well, you have protections. If they perform better than expected, you have potential for growth, after accounting for fees and withdrawals.

But there are tradeoffs. Once withdrawals begin, variable annuities generally promise a lower guaranteed payment than immediate fixed annuities. A “typical” guaranteed annual withdrawal rate from a variable annuity with GLWB may be 4.5% a year, compared to 6% or more for an immediate fixed annuity for a 65-year-old couple. (Note that variable annuities usually quote annual rates, while immediate fixed annuities generally quote a monthly or annual payment.)

Another consideration is cost. GLWB riders are not included in the cost of variable annuities, and they average around 1.0% per year depending on the contract. This is the cost of adding insurance protections to the flexibility and growth potential.

How to choose

Both types of annuities—immediate fixed and variable—can be used to provide guaranteed income in retirement, but no single type will be right for every investor. Of course, if you’ve managed to save a large portfolio relative to your retirement spending needs, you may not need to worry about protecting your cash flows.

If you’ve saved little to nothing, an annuity may not be a viable option either due to low payouts, need for full access to your cash, or other reasons.

If you’re like most savers in the middle, though, ask yourself what’s important to you:

  • Do you value maximize guaranteed lifetime income in a simple package, or do you value flexibility and growth potential?
  • Are you still preparing for retirement and looking to protect part of your savings, or are you already well into retirement and looking for income now?

The table below shows factors to consider when choosing which type might make sense for you compared with—or, more typically, as a complement to—a traditional portfolio.

Factors to Take Into Account When Considering Annuities

Factor

Immediate fixed annuities

Variable annuities with GLWBs

Traditional portfolio

Income guarantees*

Insurer pledges to make income payments that last for a fixed period or life

Insurer pledges to protect minimum annual withdrawals from the variable annuity for life

No guarantees on lifetime income; interest paid on bonds subject to credit risk of issuer; dividends at risk of reductions or elimination.

Liquidity

No liquidity after a lump sum is turned over irrevocably to the annuity provider

Investor retains control over assets and doesn't turn over lump sum to insurer; penalties or loss of guarantees may apply if annual withdrawals exceed a guaranteed minimum

Best liquidity, depending on investment choices and market performance

Market participation

None; annuity provider assumes market risk

Owner has potential to participate in market growth, after accounting for fees and withdrawals

Maximum market participation, accompanied by maximum market risk

Flexibility

Inflexible; initial lump sum investment is irrevocable.

Investor retains control over investments, subject to limitations on choices offered in annuity chosen; more flexible than immediate fixed annuities

Most flexible—investor retains full control over investments

Longevity

Simplest form of protection against longevity risk; initial payout generally higher than variable annuities with GLWBs, but generally fixed

Provides guaranteed withdrawals for life from a portfolio of investments; initial payout generally lower than immediate annuities, but potential to increase depending on market performance

A disciplined spending plan can lead to high confidence that assets won’t be outlived, but does not promise lifetime income

Cost

Cost embedded in up-front cost of purchase

Annual fee charged for variable annuity and GLWB rider

No added insurance or annuity fee; transaction fees and investment costs still apply

 

Annuities can be used in combination, not competition, with a traditional portfolio. The annuity can provide a baseline of guaranteed income to cover basic expenditures that will last, providing potential to manage or tap your portfolio flexibly. It’s also possible to choose a combination of all three, depending on your needs; each approach has pluses and minuses that can work in isolation or together. Immediate fixed annuities provide the maximum amount of guaranteed income for the cost, while variable annuities with GLWBs help flexibly protect retirement income from market risk. And, of course, a traditional portfolio provides the most flexibility at the lowest cost, but doesn't include lifetime income.

1. A GLWB is an optional rider available for an additional cost.

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Important Disclosures

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 are subject to the financial health and claims-paying ability of the issuing insurance company. Neither Schwab nor its affiliates provides insurance guarantees.

Payouts with immediate annuities will vary based on the payout method selected, current rates, actuarial tables, and expenses charged by the insurance provider.

The Guaranteed Lifetime Withdrawal Benefit is an optional rider available for an additional charge against the income base. 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. In the absence of an enhanced death benefit, there will be no funds available for your beneficiaries if withdrawals taken prior to your death exceed the actual account value. The GLWB generally 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 reduce the income base.

Withdrawals are subject to ordinary income tax and prior to age 59 1/2 may be subject to a 10% federal tax penalty.

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.

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

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