It wasn’t long ago that employees were rewarded for their loyalty to a company with a pension. For you younger readers the word pension may seem like it’s from a foreign language. It’s true, and in recent years the classic pension plans have been dwindling. Pension plans had a very unique feature that most retirement plans today lack: income for life. That’s right, most pensions were set up to pay you each month for the rest of your life, regardless of how long you live.
That’s a great benefit, right? This feature is what made pensions so attractive. While the actual dollar amount might not be enough to enjoy a lifestyle of the rich and famous, the fact that you could depend on this check coming in the mail every single month for the rest of your life made up for that. For many retirees, after factoring in social security and pension payments there was little need for additional savings since these two gaurnteed monthly payments were sufficient for paying the bills. But with pensions going the way of the dinosaurs what options do younger generations have for creating income for life?
The Role of Annuities
You’re seeing more annuity advertisements these days targeting baby boomers. Insurance companies realize that especially in this economy many retiring baby boomers are wishing they had some form of guaranteed income if they don’t currently have a pension. While it’s true that annuities can in fact provide lifetime income it’s important to understand the different types of annuities, features, and drawbacks.
How Annuities Work
An annuity is a simple concept. Generally, you take a lump sum of money and deposit it into the annuity acount. Then, if you choose to annuitize it, you begin receiving a regular payment (monthly, quarterly, annually, etc) that continues for the rest of your life. As simple as that concept is to understand, these products are actually far more complex than this.
First, you have two different types of annuities: fixed and variable. A fixed annuity is pretty much just what it sounds like and it earns a fixed rate of interest. While the rate may be fixed, there are often situations where the rate can change. For instance, there may be a first year bonus rate that pays out higher interest, rates could change from year to year with a minimum or floor rate that it can’t go below, and so on. But what’s important to note is that this rate is really only important before you annuitize the money. That is, you can deposit the money into the annuity and it will sit there and earn tax-deferred interest at the specified rate. Once you annuitize it you lock in that guaranteed monthly/annual payment for life and the interest rate doesn’t matter. And typically, once you annuitize, there’s not backing out of that decision.
Next, you have the complicated variable annuity. Unlike a fixed annuity the variable annuity gives you different investment choices for your money prior to annuitizing. If you wanted, you could deposit money into the annuity and then invest it in any of the investment options available to you within the annuity. Think of it like a 401(k) plan where you have a handful of various mutual funds to choose from. The drawback here is that depending on how you invest your money you could experience a loss in value. This is why it’s called a variable annuity since the account value will vary depending on investment options and market conditions.
Fees and Riders
This is where annuities can end up hurting an investor. First, annuities aren’t free. You probably know by now that virtually any investment out there comes with some sort of fee. Some investments have low fees such as index funds and other funds may have front-end loads and high annual expenses of upwards of 2%. Annuities are no different. When it comes to fees the fixed annuity is the most transparent. You get a fixed rate of return on your money and that rate is already net of fees. The fees can easily be calculated with the documentation provided with the account.
When you start talking variable annuities there’s a potential to get raked over the coals with fees. First, you’re going to have the fee just for having the privelage of owning a variable annuity. This is the Mortality and Expense (M&E) fee that is charged annually. This fee pays for the insurance guarantee, commissions, selling, and administrative expenses of the contract. In general, these fees in a variable annuity will be charged as a percentage of the average value of the investment. The average M&E of a basic variable annuity contract is between 1-2%. On top of the M&E you also have your investment expenses. Since you’re typically investing in mutual funds you’ll also pay their annual expenses. These can often be between 1-2% as well. So, right out of the gate you could be paying upwards of 4% per year just for opening a variable annuity!
We aren’t done with fees yet. Next, you have to worry about surrender fees. A surrender fee is a fee applied if you cash in before a set amount of time. In many cases the surrender period will be around seven years. What the annuity may do is charge you 1% for each year you take your money out early. So, if you withdraw the funds in the first year you’d be socked with a 7% penalty. Take it out after 6 years and still get hit with a 1% penalty. After holding the funds for 7 years you’d finally be free to take your money without paying a surrender fee. Surrender fees apply to both fixed and variable annuities.
You think we’re done with fees yet? Hardly. Now, we have to talk about riders. Riders are additional features that you can add to your annuity contract. Common riders can provide some additional guarantees. They might provide additional guaranteed income, protect against losses, increase payouts for inflation, or extend the death benefit. Obviously, these features cost extra. Riders often cost between 10 and 100 basis points (0.10% to 1.0%) per year. So, if you’re in a variable annuity already paying a 1.5% M&E, 1.5% fund expenses, and tack on riders that add 1% you’re paying 4% a year in fees.
Annuities Have Their Place
Annuities seem like a pretty bad deal after looking at all of the fees and restrictions discussed above, but they do have their place. For one, they really can provide guaranteed income for life. They are insurance contracts and once annuitiezed you’re going to get a payment for the rest of your life. For retirees who want this sort of safety they can be an attractive option.
But here’s the problem. Many so-called financial advisors and insurance agents sell annuities to people who still have many years before retirement. So, what happens is they convince someone to put their money into an annuity, either fixed or variable, and make a hard sell by promoting all of the guarantees. It’s one of the few instances in the world of finance where you can get away with offering a guarantee. So, they get someone who is say 50 years old to buy an annuity contract and then they spend the next 10 or 15 years paying these unnecessary fees before finally retiring.
There are very few reasons to invest in an annuity well before you’re thinking about annuitizing it. If it’s a fixed annuity, you’re playing the rate game. You might get a good rate right now, but how will that rate stack up in 5 years? And don’t forget, you have surrender charges to deal with that could prevent you from moving the money into something with a better rate. And if you’re looking at a variable annuity you’re subjecting yourself to high and unnecessary fees that can erode your earnings significantly in the years prior to annuitizing.
If you really do want a source of guaranteed income for life an annuity can do that, but you should consider an immediate annuity. This means you would only buy the annuity contract when you’re ready to start receiving those guaranteed payments immediately. This allows you to invest your money however you want in low-cost funds on your own and then when you need to begin receiving a fixed income from these investments you can immediately turn it into an annuity and make this happen. This way it doesn’t matter what the rate is on a fixed annuity or require you to negotiate high fees and poor investment options in a variable annuity.
Generating Your Own Income for Life
An annuity is just one way to generate income for life, but you can go about it on your own, too. As you approach retirement you’re probably starting to get a little more conservative with your investments. So, you’re investing more in things like bonds, CDs, and money market accounts. Essentially, after you’ve spent your working years accumulating that retirement nest egg you’re trying to preserve as much of that egg as possible while earning enough to at least keep pace with inflation.
Ideally, you will have created a portfolio large enough so that you can simply withdraw the interest generate each month, or at the very least, draw the interest and a small portion of your principal so that you won’t outlive your money. That is often easier said than done because it requires a few things to fall in place. First, you need to save enough during your working years to build up a portfolio large enough to sustain this withdrawal model. Second, you are at the mercy of the economy, interest rates, taxes, and investment performance. With so many unknowns it’s possible for even the best plan to be insufficient once retirement does arrive. But done right, you can create an investment portfolio that generates enough income that can provide you the money you need for the rest of your life.
That being said, annuities can still play an important role. Most of us, retirees included, will have some fixed expenses throughout our life. For some it’s a mortgage, and others it could be medical costs, groceries, or insurance premiums. Because there are some things that we’ll need to spend money on regardless one strategy is to use an annuity to take a portion of your nest egg and use that to generate some fixed income to cover the necessities while using the rest of your portfolio to tap into as needed to pay for the rest. This way you get some guarnteed income each month while still having control over the bulk of your money.
Start Planning For Income Now
Even if you have 30 years until retirement it’s a good idea to begin planning for how you’ll be generating income once you do retire. Sure, we have no idea what the future holds that far off, but begin thinking about your options and how important it is to have a guarnteed source of income. A lot of things will change, but if you’re aware of your options and know what to expect when it comes to generating income for life you can be better prepared to make the best decision with your money.
And finally, if you’re in you’re still a number of years away from retirement and are approached by someone trying to sell you an annuity just turn around. Tell them to give you a call when you’re 65 and actually getting ready to retire. Their sales pitch may sound great with all of the guarntees, but you know better. Annuitizing some of your money might make sense once you do retire, but until then, keep control of your investments and avoid making the insurance companies rich in the meantime.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.