By Ashok S. Ramji
Commercial annuities (hereafter referred to as just annuities) are contracts that can be used effectively in the accumulation, preservation, and distribution stages of retirement planning. The contract owner pays in a premium (either one time or over time) and then expects to withdraw this amount and attributable earnings up to his or her lifetime. (We will assume that the owner is the annuitant, whose life span determines the length of time payments are made.) The life insurance company issuing the annuity may make contractual payments for a set period of time or even after the premium(s) and earnings have been consumed. In this way, the fundamental purpose of an annuity is to hedge against longevity risk, where someone outlives his or her income streams.
Since at least Roman times, annuities have been around in one form or another as evidenced by Ulpian's Table. Some types found today are modern innovations. There are income annuities that require annuitization, where a lump sum is irrevocably converted into a series of payments consisting of both a return of and a return on principal. The owner/annuitant can recoup the initial premium if they live long enough. Thereafter, all payments are treated entirely as earnings. Then there are deferred annuities that do not require annuitization and where the owner can monitor the account value. Deferred annuities may be further categorized as either fixed or variable. Depending on their method of interest crediting, the fixed type can further be distinguished as either fixed interest annuities or fixed indexed annuities.
With a fixed annuity, monies deposited into the contract are held as part of the insurance company's general fund. When this happens, the insurance company guarantees that the contract value will not suffer a loss from market risk. This guarantee is based on the strength and the claims-paying ability of the insurer. The purchaser of a fixed annuity generally has a low tolerance for risk and is willing to accept a low single-digit time-weighted return in exchange for preservation of capital.
Conversely, monies in a variable annuity are held in a separate account away from the insurance company and are directly invested in assets that go up and down with the markets. Accordingly, the variable annuity's account value fluctuates, and the contract owner can see both big gains and losses. With the recent advent of structured annuities, the insurer may shield its customer from the first -30% of losses, for example, but thereafter the account value is exposed to negative returns. Fixed annuities are considered insurance products while variable and structured annuities are registered as securities.
We can see then that if the purpose of money is accumulation or to grow the account value, the variable annuity has the most aggressive, yet the most rewarding potential of all annuities. A variable annuity could also have the highest hurdle rate for returns, since its design stands alone in having management fees from the active management of assets in separate accounts in addition to an insured death benefit for beneficiaries.
Annuities have their admirers and detractors, but as Shakespeare wrote in Hamlet, "there is nothing either good or bad, but thinking makes it so." We think that income and fixed deferred annuities offer the greatest element of protection for the income stream, and that fixed indexed annuities uniquely provide total downside protection for the asset in negative markets. It is possible that a variable or a structured annuity offers a rider that similarly protects the income stream, but we do not work with these types and will stick to what we know. Since financial planning involves the use of one's resources to accomplish goals over an unknown time horizon and as a fee-based certified financial planner, we believe annuities very well could have a place in a diversified financial plan that carefully considers future assumptions and present alternatives.
Fixed interest annuities have the interest rate declared in advance for either one year or multiple years. They are similar to certificates of deposit but without the backing of the Federal Deposit Insurance Corporation. On the other hand, fixed indexed annuity contracts state upfront the formula by which interest will be determined if an indexing strategy is chosen. The actual rate credited usually depends on the upside performance of a stock market index, and interest is credited after the term has concluded.
For example, assume a fixed indexed annuity credited half of the movement of the S&P 500 in the coming year up to a specified cap. One year later exactly, let's say that the price level of the S&P 500 Index had advanced 10% from point to point. Assuming this was within the limit, the contract would be credited 5%, or half of the upside movement. If the same market index moved lower one year later, no interest would be credited, but importantly, the principal value of the account would stay intact barring any withdrawals. The fixed indexed annuity tracks the upside movement only but also misses out on any returns from dividends. As an insurance product, we believe that this heads-you-win-modestly and tails-you-don't-lose strategy has positive implications for both the accumulation and preservation of retirement savings.
Let us next consider how these different types of annuities are configured for income generation. Payouts for an immediate annuity can be based on either time or a life contingency. Time-based options are called "period certain." For example, the insurance company may make payments over the next 20 years to the owner if alive or to his or her designated beneficiary if deceased. With this example, payments cease after 20 years.
The other payout option is based on a life contingency. In his book on Life Annuities: An Optimal Product For Retirement Income, Moshe Milevsky, finance professor at the Schulich School of Business at York University in Toronto, likens this type of income annuity to a high-yield corporate bond, where the insurance company making payments actually gets to default upon the death of the contract owner. The big concern with this type of payout option would be for the annuity owner to exchange a large sum of money for only one or two payments. More often than not, the life-based option has a time-based component as well. For example, it might be a life annuity with a ten-year period certain. If the owner dies before 10 years, payments continue up to year 10. If the owner lives beyond the 10 years, payments continue for as long as he or she shall live.
There is an added bonus for long-lived annuitants using income annuities with a life contingency. This is sometimes referred to as "the mortality credit." As Milevsky explains in another of his books, Pensionize Your Nest Egg, "The investment return from a life annuity -- the cash flow you are entitled to -- is made up of three things: your money, interest, and other people's money (or mortality credits). And when some participants die and leave their money on the table (so to speak), the remaining participants benefit from those mortality credits -- often significantly, especially at advanced ages."
We were recently exploring options with a married couple that were both age 71, in the state of Washington. Using a stated amount of premium, an Internet search for average estimated quotes for a life annuity with a 10-year period certain showed an immediate payout of about $15,500 per year. No explicit fee was charged but annuitization was required. Separately, a fixed index annuity with an optional income rider showed a comparable payout, with payments commencing in as soon as 30 days. The similarity in payouts doesn't always work this way. In this instance, the fixed indexed annuity charged an optional fee for guaranteed lifetime income, but did not require annuitization. We will show you how the fixed indexed annuity is designed to pay out income.
Besides making the account value available for a lump sum distribution, some fixed indexed annuities offer an optional income rider. We will refer to it as the guaranteed lifetime withdrawal benefit (GLWB). As its name implies, this is the annual dollar amount that the insurance carrier stipulates can be withdrawn even if the account value eventually goes to zero. If funds are withdrawn before electing this rider, then the GLWB would also move lower. Let's say that the account value is $100,000 and the GLWB payment is $5,000 per year. In this simplistic example without any interest being credited and fees being deducted, the account would mathematically be exhausted in 20 years. In year 21 and thereafter as long as one spouse is alive and a joint payout elected, the insurance carrier would continue to make the same $5,000 annual payment until the surviving spouse dies.
Unlike annuitization, a decision to activate the GLWB rider is not irrevocable. The account owner can stop this process and surrender the contract for the account value net of any withdrawals, GLWB fees, and surrender charges. If the account owner dies, the spouse has the right to continue the annuity for a period of time depending on whether the single or joint lifetime income option was selected. If the spouse dies and the account value has a positive balance, the remaining funds are distributed to designated beneficiaries.
If purchasing a fixed indexed annuity with a guaranteed lifetime withdrawal benefit, pay close attention to any rider charges. The fixed indexed annuities with the highest guaranteed income payouts sometimes have the greatest GLWB rider fees, which are deducted from the account value. That could be fine if the income plan requires that amount. If flexibility is needed on the other hand, the higher fee could reduce future optionality. We also consider the earliest date for the GLWB rider to be activated, and for the issuing insurance company to have a strong credit rating and a commitment to quality customer service.
It is possible to use annuities in retirement to grow and protect your assets and to generate predictable income as well. As you have seen from this article, there are different types of annuities that work in completely distinct ways. If you are contemplating whether or not annuities belong as part of your diversified financial plan, work with a professional who is knowledgeable about these different types and can show you the various pros and cons.
Under the CFP Board's Code of Ethics and Standards of Conduct, we disclose our methods of compensation, conflicts of interest, and alternatives to our recommendations. Your financial professional may or may not be a certified financial planner, but be sure to similarly get this type of information to make an informed and knowledgeable decision.
About the author: Ashok S. Ramji, CFP, ChFC, CLU, leads Washington state-based TOP Planning LLC, which offers insurance products and services. He is an investment adviser representative of Insight Folios, Inc., a SEC registered investment adviser. TOP Planning LLC is not a registered investment adviser and is not another name under which Insight Folios provides services.