An annuity may or may not be right for you. But before you decide to use or not use an annuity as part of your plan, it’s important to understand what an annuity is, said Dana Anspach, CFP, RMA, president and founder of Sensible Money.
According to Anspach, an annuity is insurance that you won't outlive your money. “That being said, there are many types of annuities that come with various bells and whistles that make them appear to function like a savings account or an investment,” she said.
Anspach categorizes annuities into four main categories: immediate, fixed, indexed and variable.
“Some of them are quite complicated with riders that appear to offer a minimum guaranteed return as high as 6% - but it doesn't work the way you think it does,” she said.
Take, for instance, the example of a variable annuity with a guaranteed income rider. Picture, Anspach said, two wallets. In wallet 1, you have real money, and the value goes up and down depending on the performance of the underlying investments chosen. Wallet 2 is an accounting entry that shows you the balance as if it grows by 6% each year. Wallet 2 is not real money - its only purpose is to be used in a formula that determines the annual guaranteed amount you can withdraw each year at some point in the future.
How do you determine if this type of financial instrument is good for you?
According to Anspach, what many people do is compare an annuity to other investments based on its expected rate of return. “But an annuity is insurance, and it is protecting you against a unique risk you are facing in retirement, the risk of living long,” she said.
Here’s an example of how you might determine whether an annuity is right for you.
Let’s say Doug, age 66, could put $100,000 into an immediate annuity and receive $502 per month for life.
- His payout ratio, which is a return of principal and interest income, is 6%.
- And if Doug lives 30 years, his internal rate of return is 4.7%. If Doug lives 25 years, his internal rate of return is 3.8%. The longer Doug lives, the higher the equivalent rate of return.
- Doug's fundedness (a measure of his capital to fund retirement expenses) with the annuity improves by 1% if his portfolio earns 4%. If his portfolio earns 5% or more, his fundedness decrease by 1%. In essence, the annuity protects Doug from poor portfolio returns.
- Doug's liquidation value (bequests) with the annuity is $527,278 and without it it’s $551,919. If Doug's portfolio averages a 5% return, with the use of the annuity Doug will pass along, $24,000 less in nominal dollars or $10,000 less in today's dollars.
- In this case, the annuity would protect Doug’s future income if he lives a long life with minimal impact on his fundedness and liquidation values.
- What’s more, Anspach said Doug's coverage ratio at age 71, with the annuity, is 62%. And without it, it is 56%. So, it’s a 6% improvement in coverage ratio. Anspach defines coverage ratio as a comparison of guaranteed sources of income, such as Social Security and pensions, to retirement expenses. So, a person who could fund all their retirement expenses with Social Security and pensions would have a 100% coverage ratio.
At Sensible Money, Anspach uses the following metrics to determine if an annuity is appropriate or not.
- Internal rate of return, which is a typical performance measurement.
- Fundedness, which measures capital to fund retirement expenses.
- Liquidation Value, a measure of the value of assets left to heirs.
- Coverage ratio. According to Anspach, having a higher coverage ratio is a good protection against cognitive decline. A higher coverage ratio protects you from future bad decisions.
What other considerations should an upcoming retiree think about?
According to Anspach, there are other factors to consider when considering an annuity.
- What kind of options should you choose? Should you purchase income riders, an annuity with a return of principal option, a deferred income annuity, or a qualifying longevity annuity contract?
- Where do you buy the annuity? Do you buy it with qualified or non-qualified funds?
- And do you need a backup plan? For instance, if your assets fall below a pre-determined dollar amount by a certain age, you’ll automatically look at annuitizing a portion of your portfolio to guarantee future income.