The Many Benefits of Deferred Annuities
An annuity is an agreement between you and a licensed, state-regulated life insurance company to watch over your money and pay it back to you with interest. Annuities may be thought of as part investment, part insurance.
Although annuities are issued by life insurance companies, they are not life insurance contracts, per se. Life insurance is a contract to pay a lump sum of cash upon death to the owner’s beneficiaries. An annuity, by contrast, is a contract to pay a stipulated monthly income to the owner for his or her lifetime.
Four Types of Annuities
It is helpful to understand that there are four distinct types of annuities:
- Immediate
- Variable
- Fixed
- Fixed Index
While variable, fixed and fixed index annuities have some flexibility, immediate annuities are very rigid. They are built to do one thing: pay income. That income may begin immediately, hence the name.
Immediate Annuities
The reason why immediate annuities are the least popular form of annuity—accounting for less than $10 billion annually in an approximate $230 billion market—is that the owner gives up access to his or her principal. With an immediate annuity, including deferred income annuities (DIA), the insurance company has more control over the lump sum than the owner.
By and large, today’s annuity buyer is not comfortable with that arrangement. They prefer to maintain control over their principal with the ability to cash out or leave money to heirs. Deferred annuities allow for this.
A good-sized portion of annuities are being bought by Baby Boomers looking to replace the income they would have gotten if their company had a pension plan. Annuities are finding their way into IRAs to create a form of personal pension. (For related reading, see: Personal Pensions: Repackaging the Annuity.)
If all you want is the income, you may be comfortable with an immediate annuity or DIA. If not, and you prefer to maintain control over your lump sum like most people, you will want to explore a deferred annuity with an enhancement known as an income rider. The technical term is “GLWB”—Guaranteed Lifetime Withdrawal Benefit. It is an optional benefit that guarantees the payment of lifelong steady income to the owner, even if the principal goes to zero. The combination of a deferred annuity plus income rider is four times more popular than the idea of owning an immediate annuity. It is what’s happening in the annuity marketplace today.
Why Annuities Have Become Popular for 401(k) and IRA Rollovers Among Baby Boomers
Converting a lump sum of 401(k) savings into permanent household income in retirement is a challenge for the 10,000 people a day who are now entering retirement. It has become more challenging than ever in the face of the lowest interest rates since the Great Depression. (For related reading, see: Should Your 401(k) Be in an Annuity?)
Simple math and logic both point to the use of annuities for a retiree looking for more income guarantees and the assurance of not running out of money. As an alert investor, you know that the math changes in retirement. You move from the “contribution and accumulation” phase where you are “buying on the dips” to the withdrawal and decumulation phase.
Suddenly you are no longer buying on the dips but rather selling on the dips. This reverse dollar-cost-averaging can take a very harsh toll during down markets. If your financial plan relies on X amount of monthly income and you continue to withdraw the same amount of income during heavy market declines, an acceleration of loss in your lump sum can occur. This can lead to anxiety over running out of money and indeed can eventually result in that outcome.
Running out of money in retirement is a fear shared by most Americans. An annuity strategy can resolve that issue by guaranteeing income for a lifetime, backed by the financial strength of a legal reserve insurance company. The financial guarantee is part investment, part insurance.
Think about the fire insurance you place on your home. Because very few homes actually burn down percentage-wise, your insurance company can guarantee to pay you the full amount if it ever happens. The insurance guarantee on annuities is similar: because very few people live to age 100, actuaries can calculate the proper amount of income to guarantee you and your spouse income for life. (For related reading, see: What Role Should Annuities Play in Your Retirement?)
Conclusion
Annuities are a combination of insurance and investment. An annuity is a contractual financial trust account with a regulated, licensed insurance company. Except for period-certain annuities, all annuities offer a guaranteed income for life as a key feature. That feature can help fill the gap between retirement lifestyle expenses and the income provided by Social Security benefits. Annuity income does not typically carry market risk or interest rate risk. In exchange for some limitations and potential surrender charges for early or excessive withdrawal, annuities can provide a rate of income return far higher than government bonds. There is a high degree of principal protection with fixed and fixed index annuities.
Some types of annuities can grow capital, however that is not the primary function. From the consumer’s point of view, annuities should be thought of primarily as income and preservation vehicles to take on longevity risk. Consumers can view annuities as having two distinctly different categories: immediate and deferred. Deferred annuities should not be confused with deferred income annuities (DIAs). DIAs are more like immediate annuities because the owner loses access to the principal. Deferred annuities are by far more popular than immediate annuities. Deferred annuities include variable, fixed and fixed index annuities. Guaranteed lifetime income riders may be added to many deferred annuities. This combination offers both access to principal with lifetime income guarantees.
(For related reading, see: Annuities: How to Find the Right One for You.)
Annuity guarantees rely upon the financial strength and claims paying ability of the insurer. Higher rates may increase potential surrender charges for a stated period of time.