If your clients are looking for ways to create an income stream for retirement, there's a good chance you've at least thought about annuities.
An annuity is an insurance contract through which investors pay premiums in return for a stream of payments for a specific period of time in the future. In some cases, that might include the duration of your client's life.
There are a lot of benefits to annuities, most notably that they can create a guaranteed income stream for retirees. That said, there are nuances to consider, such as complicated fee structures and tax implications.
How Do Annuities Work?
Clients will typically enter into an annuity contract a good while before they expect to receive the income stream from the annuity itself. This initial stage, sometimes referred to as the accumulation phase, involves their paying monthly or lump-sum premiums. The money they put into the annuity will be invested and grow tax-deferred.
Once your client reaches a certain age or period in time, they'll start receiving regular payments from the financial firm providing the annuity. This is sometimes called the annuitization phase.
Is an Annuity a Good Investment?
Based purely on returns, annuities generally perform worse than investing in the market directly. They also tend to extract high fees, especially when compared with simpler investment strategies.
That said, annuities are a way to guarantee income even in a market downturn. They might also offer a benefit to your loved ones if you die, and can be a good idea if you've maxed out other retirement accounts such as 401(k)s. Plus, if you're concerned about spending too much of your nest egg at once, the steady stream of payments can help you pace yourself.
What Are the Pros and Cons of Annuities?
Reasons someone might get an annuity include:
- Steady income: Annuities can serve as supplemental retirement income, especially for people who may not have saved enough to cover all of their needs.
- Deferred taxes: In the accumulation phase, clients won't owe taxes, even while their nest egg grows. They will pay taxes only when they begin withdrawing the money.
- Predictable returns: With a fixed annuity, clients are guaranteed not to lose money. Fixed annuities typically guarantee that the annuity holder will earn at least a certain percentage of their principal investment as earnings.
- Protection in case of death: Variable annuities often include a death benefit; the client nominates someone to receive money if they were to die. In many cases, the death benefit is equal to the amount a person paid into the annuity, regardless of how their investments perform.
Annuities can be the right fit for many people, but there are some drawbacks to consider as well:
- They can be expensive: Annuities sometimes come with hefty fees. These can sometimes exceed 1% of the account's value. Then there are the expense ratios for the investment management of annuities tied to market performance. Fixed and indexed annuities tend to be less pricey, though most annuities have surrender charges, which are added fees if you withdraw assets or cancel the contract early.
- They might underperform the broader market: Many annuities have a participation rate; if your participation rate is 80%, then you'll receive only 80% of the investment growth. If the investment grows massively, you can still notch large gains, but you'll lag the performance of investing in a similar mutual fund directly.
- They may lead to higher taxes: A long-term market investment faces the long-term capital gains tax rate when you make a withdrawal. But withdrawals from an annuity are taxed at the regular income tax rate, which in many cases is higher than the capital gains rate.
- They are illiquid: During the "surrender period," you'd face a penalty if you touched any of the money. In some cases this can last many years, which is why annuities may not be right for clients who are younger or have more short-term liquidity needs.
- They may be hard to get out of: Particularly when it comes to an immediate annuity, a client may not be able to get their lump sum of money back or pass it along to a beneficiary with any ease — or even at all.
How Do I Know Which One Is Right for My Client?
Some annuities protect against loss but have a lesser upside; others have more potential for growth but more exposure to market risk. Some are deferred so that annuitants can't take withdrawals for a certain time period, whereas some are immediate.
Read on to see which one is right for your client.
Types of Annuities
What Is a Fixed Annuity?
Fixed annuities promise a stated, guaranteed rate of return on contributions. The annuity contract will stipulate this rate of return from the outset, and you can expect that same rate for the duration of the contract.
Pros and Cons
The most notable reason to get an annuity is because it provides predictable returns over a period of time, either a specified number of years or until the end of the policyholder's life. The main drawback of a fixed annuity is that you're choosing more reliable returns over potentially higher returns if you were to take on more market risk.
Who Can Benefit?
Many retirees (or people planning their retirement) choose fixed annuities because of the predictable, guaranteed returns. If you're going to be depending on this income for your living expenses, it may make sense to seek stability rather than the highest possible returns.
What Is an Indexed Annuity?
Indexed annuities are basically the annuity version of an index fund. These annuity contracts pay returns based on the performance of an index, so returns won't be as predictable as with a fixed annuity. When the index declines, the annuity holder will receive a minimum rate of return, which can range from 0% to as high as 3%.
Pros and Cons
The main reason to get an indexed annuity is to increase the possible upside; if the market performs well in a given year, then you'll see more of that benefit. One drawback is that gains are typically capped through a participation rate. Indexed annuities might also have an annual cap on how much you can earn, so if the market booms, you might still see only a piece of the earnings. Who Can Benefit?
Indexed annuities may be a good choice for people who want a more affordable annuity — indexed and fixed annuities tend to have lower fees than variable annuities — but have a higher risk appetite and hunger for market gains.
What Is a Variable Annuity?
A variable annuity is also pegged to investment performance. To the extent that an indexed annuity is similar to an index fund, variable annuities are similar to active mutual funds.
Pros and Cons
The main reason to get a variable annuity is if you're seeking higher returns than you could find with a fixed annuity. Of course, the downside is you're exposed to market risk. Many annuities offer a return of premium, meaning you don't lose your initial investment, but if the value of the underlying investments plummets, you might earn nothing in terms of growth. Variable annuities also tend to come with higher fees.
Is a Variable Annuity Right for My Client?
If they're interested in an annuity but want to have a higher upside potential, a variable annuity could be a fit.
