Annuities can be a helpful tool for managing your savings in retirement. With most types of annuities, you can turn a lump sum of your savings into a pension-like income stream that can last the rest of your life and, depending on which income options you choose, the life of your spouse too.
But there are many types of annuities, and each type may have different features designed for different needs. One annuity contract, for example, may offer income riders and other options that can make them more flexible, but also add complexity or costs.
In this article, we’ll look at one of these types, fixed indexed annuities (FIAs). FIAs can be used to grow savings for retirement or another goal. Here, we’ll focus on FIAs as a tool to stay invested and maintain access to your money (with certain limitations, described below), while generating guaranteed income without irrevocably turning over money to an annuity company.
Before getting into how they work, it's important to note that using an FIA for income requires some advance planning. For example, before considering FIAs as an income tool, you should be in a position to set aside the money to use for retirement income, but won’t need back as lump sum soon. Early withdrawals may trigger extra fees.
After using a lump sum to purchase a FIA, consider adding an additional rider called a guaranteed lifetime withdrawal benefit (GLWB) at an additional fee that can allow your future income stream to grow over time.
FIA in phases
Before discussing optional riders and GLWBs, let’s discuss FIAs generally. Similar to many types of annuities, with FIAs, investors should think of them as having two phases: accumulation and payout.
In the accumulation phase, you turn a lump of your savings over to an insurance company, which then provides a variety of tax-deferred options for building up your savings over a set period, usually based on the performance of a selected underling market index (for example, the S&P 500 Index). Potential returns may exceed the returns of certificates of deposit or Treasuries, depending on market performance.
Typically, the annuity’s return is based on the greater of an annual minimum rate or the return of the underlying index (up to a predetermined threshold and after certain expenses). A non-index fixed annuity–often called deferred fixed annuities, or DFAs, in contrast, usually have a fixed annual rate of return on your investment not tied to the performance of a market index. The potential for a return in a FIA may be higher than a DFA, depending on how the index performs.
As with other fixed annuity options, the insurer may guarantee that your original principal won’t fall in value (so long you as don’t make early withdrawals above limits described in the contract and depending on the financial strength and claims-paying ability of the insurer).
When the accumulation phase ends or you decide that you’ll need income from the annuity, you have a few choices. You can start making withdrawals from the balance accumulated in the annuity. Or you can choose to buy an additional rider known as a guaranteed lifetime withdrawal benefit (GLWB). GLWBs come at an extra annual fee, but they can provide projection in that they can allow you to withdraw a guaranteed amount annually from the annuity.
If the balance is drawn down to zero, the insurance company continues to pay the guaranteed amount annually for as long as you live - or, depending on the rider and contract, the life of you and your spouse. They can be a little challenging to grasp—and come at a cost.
Guaranteed minimum income
When you choose a GLWB rider to add to a FIA, you pay the insurer an annual fee in exchange for a guarantee that you will continue to receive a fixed amount of money from your annuity even if you deplete your account.
An annuity with a GLWB has two parts. The first is the actual contract value, reflecting the amount you’ve saved and earned and which you can withdraw as needed up to the annual limit or, if you choose, a larger amount. Larger amounts, however, may reduce future guaranteed payments.
The other part is a notional amount used to calculate your lifetime income, known as a “protected payment base” or “income base.” With some GLWBs, again, depending on the contract, the payment base may be guaranteed by the annuity provider to increase each year during the accumulation phase, thereby boosting your future guaranteed income.
It’s important to know that you can’t withdraw the notional amount as cash while your savings are accumulating; any withdrawals in excess of the annual limit could be subject to surrender charges and reduce the payment base.
FIAs for a monthly paycheck, guaranteed for life
Let’s consider a hypothetical example. John is 60 years old, plans to retire in 10 years and considers himself a conservative to moderate investor. He is looking to set aside $100,000 to secure a guaranteed lifetime income in retirement, but also wants to potentially increase his future payments.
John buys an FIA on Dec. 31 and adds a GLWB offering a protected payment base. John’s GLWB rider allows the payment base to grow by 7% of the original purchase amount each year until withdrawals start, for an annual fee of 0.75%.
John elects to have his returns track the performance of the S&P 500 Index, with interest accruing annually. He makes no early withdrawals and his contract caps his annual rate of return at 5%. John starts taking withdrawals at age 71.
|Year||Year 1||Year 5||Year 10||Year 15||Year 20||Year 25||Year 30|
|1-Year Point-to-Point (assumes 10-year initial guaranteed period and 5.0% annual cap)|
|Contract Value *||$101,280||$117,600||$126,754||$85,132||$45,336||$0||$0|
|Optional Guaranteed Lifetime Withdrawal Benefit (GLWB) - 10-year 7% simple growth|
|Protected Payment Base||$107,000||$142,000||$170,000||$170,000||$170,000||$170,000||$170,000|
|Guaranteed Withdrawal %||4.50%||5.00%||5.50%||5.50%||5.50%||5.50%||5.50%|
|Annual Guaranteed Income Amount||$0||$0||$9,350||$9,350||$9,350||$9,350||$9,350|
Source: Schwab Center for Financial Research. Assumes an initial contact value of $100,000 with no credit enhancement, insurance charges or management fees. *The annual return is based on hypothetical percentage change in the price of the S&P 500 Index, not historical results. The 1-year point-to-point option assumes a 10-year period with a 5% cap. The cost of the GLWB rider is 0.75% annually and is calculated based on the protected payment base but charged to the contract value. The interest earned on the protected payment base is 7% simple interest, or $7,000 per year. Once withdrawals begin, no more interest is credited to the protected payment base.
The table shows how John’s contract value would have grown from $100,000 to $126,754 over his 10-year accumulation phase. Separately, his protected payment base would have grown to $170,000.
Under the terms of his rider, John can earn a 5.5% annual payout if he waits until Year 10 to start withdrawing–good for a guaranteed minimum payment of $9,350 a year starting at age 71. (Typically, payout rates are based in part on your age when you start taking withdrawals, with older investors earning higher rates than younger investors.)
John’s payout phase starts in year 10 and he withdraws all the money from his account by Year 25. His GLWB insures he continues to receive $9,350 in annual payments for the rest of his life.
When FIAs might work
Again, FIAs can be complex and might not make sense for every investor, especially those who are willing to take on more risk by staying invested in the market or don’t desire guaranteed lifetime income in addition to Social Security or a pension.
However, in general, using an FIA for accumulation could work for investors who:
- Have a lump sum of “conservative money” to invest with potential return over time higher than bonds and a desire to earmark that money to generate lifetime income in retirement.
- Don’t want to be exposed to market risk.
- Want to maintain access to their money, if needed, but also lock in a guaranteed income for life if they don’t.
- Prefer the certainty of knowing exactly how much guaranteed income they can earn with a GLWB.
- Be willing to pay for insurance in exchange for the income guarantees offered by a GLWB.
We suggest that investors who are interested in considering a fixed indexed annuity as part of their retirement savings toolkit should talk with a Schwab annuity specialist and work with a trusted advisor to compare FIA terms with those available from other kinds of annuities and investments and integrate them into their financial plan.