Retire Lady

Considering an Annuity? Understand Their Role BEFORE Committing

Retire Lady

Financial planning is very similar to performing a juggling act. We are constantly monitoring and maintaining many different parts of a client’s financial well-being. Investments, insurance, estate planning, charitable giving, all with an overlay of behavioral coaching can sometimes become a blur. It is important to keep in mind the role that each one specifically plays in an overall plan.

Insurance is by far one of the most misunderstood topics in the world of financial planning. More often than not, it is sold as an “investment vehicle,” which is extremely misleading. Simply put, insurance is the act of removing (or mitigating) risk. Investing is the act of accepting risk with the expectation of a positive return. The two cannot be one in the same since one is removing risk while the other is accepting.

This of course does not mean that insurance is not an important topic for discussion; it just needs to be used properly, and properly is not a universal application to everyone. What is proper in one investor’s situation may not be proper for another.

In the realm of financial planning, the three biggest insurance products are life insurance, longevity insurance (annuity), and long-term care insurance. Each plays a unique role in someone’s financial plan. This article is specifically going to discuss annuities.

In essence, an annuity is a contract in which an investor gives an insurance company a lump-sum of money in exchange for a constant income stream immediately or sometime in the future. The two most common types of annuities are variable annuities and fixed annuities.

In a variable annuity, the payout is not fixed, but determinable by the mix of investments the investor chooses within the contract. In a fixed annuity, the payout is fixed (example: 3.0% of account balance at time of annuitization) and the investor will receive the same payment for life.

The biggest benefit, and often the biggest selling point, for a variable annuity is the tax-deferred growth. In other words, let’s say an investor has already maxed out their company’s 401(k) plan and any other plan (cash balance, etc.) as well as their personal IRAs. They can now take any additional income and put it into an individual brokerage account or possibly a variable annuity. There is no tax advantage from the onset since the investor has already paid income taxes (or planning to pay income taxes) on the principal about to be invested. Now just for an example, let’s say the portfolio that the investor can put their money into is identical (for simplicity, it is an IFA Index Portfolio 60). Any dividends and capital gains incurred in the variable annuity are deferred until the investor decides to make a withdrawal from the annuity. On the other hand, the investor can expect to pay preferential income taxes on the dividends and capital gains taxes in the regular brokerage account. Now the investor will have to pay income taxes on any gains above principal at the time of withdrawal in the variable annuity.

In the grand scheme of things, the preferential tax treatment is only as valuable as the client’s need for guaranteed income, which is almost always unnecessary. If a client has enough time before retirement to seek the benefits of a variable annuity, then they definitely have enough time to change their current savings rates to mitigate the need for any shortfall in their financial plan. Remember, the power of compounding is the eighth wonder of the world.

The biggest roadblock in recommending a variable annuity for an investor is the costs associated with most products in the current marketplace. If it is being recommended by an investment professional, then there is always going to be a sales-load accompanying the annuity. This sales-load compensates the investment professional for recommending the product, which obviously could create conflicts of interest. There are also costs embedded in the product to compensate the insurance company for administering the annuity and the investments inside of the contract. These are usually in excess of 1.00% on top of the investment related costs per year.

For most investors, variable annuities are not necessary. We would first need to agree that at sometime in the future, the investor would need some sort of guaranteed income. It is important to note that everyone already has an annuity to begin with through Social Security. If we begin the planning process early enough with a client, then there will be little need for any type of guaranteed income. Through our financial planning tools, like the Retirement Analyzer, we can run simulations to see how successful we can expect a client’s financial plan will be for any give time horizon. Clients can then adjust their current savings rates to compensate any type of shortfall that can be expected to happen. From our experience, clients can adjust their spending habits in retirement if there is any potential risk of running out of resources.

Fixed annuities are a different story. A fixed annuity, when used properly, may bring benefit to a client. It is important to note that when you buy a fixed annuity, the insurance company is essentially making a bet on when you are going to die. Using census data and in-house actuaries, insurance companies will determine a payout based on your expected life span and current market conditions. If you die when you are expected to die or before, then the insurance company will make a profit on the annuity contract they sold you. If you happen to live beyond when you are expected to die, then the insurance company will lose money. Hence, fixed annuities should only be used to hedge the risk of you living beyond when you are expected to.

Determining the need for a fixed annuity starts with understanding how much resources one needs beyond social security. For most people, social security should be sufficient to cover most necessary living expenses, assuming you have little to no debt. If social security is not enough to cover necessary living expenses, then clients may think about introducing a fixed annuity into the financial plan.

Understanding the role that insurance plays in an overall financial plan is crucial to making sound decisions. Insurance is not an investment. It is specifically utilized to hedge the risk of living beyond your expected life span. If you are working with a financial advisor, then you should know your potential shortfall and either adjust your savings rate to overcome that shortfall or possibly discuss the need for a fixed annuity.

Variable annuities, although are the most popular type of annuity sold in the market place, are seldom needed. They are very expensive way to save for the potential need of guaranteed income.

If you have questions in regards to utilizing insurance in your overall financial plan, you can speak to one of our Wealth Advisors at 888-643-3133.