An Explanation of Retirement Annuities
The history of annuities can be traced back to Roman times when, as a means of raising money to fund wars, the government would promise a lifetime of payments in return for deposits from citizens and soldiers. Annuities, as secure retirement vehicles, rose to prominence during the Great Depression as people turned to life insurance companies as the most reliable source of guaranteed retirement income.
Since then, annuities have grown in popularity especially has annuity providers have expanded their offerings to include more features and guarantees. In the ever expanding universe of financial instruments and retirement products, annuities remain as a core vehicle for insuring a secure retirement income.
Retirement Annuity History
The first, widely sold retirement annuities in the United States were fixed “life”” annuities that promised a fixed, guaranteed stream of income for the life of the annuitant. Structured as an insurance contract, the life insurer, in return for a premium payment, would promise to pay a specified amount of income based on the life expectancy of the insured, and a minimum rate of interest. Premiums, or deposits, were made in a lump sum or over time and were credited with a current interest rate.
The promise of future payments can only be secured with a guarantee that the principle that will generate the income is safe and secure. The hallmark of the life insurance industry has been its enduring ability to offer complete protection against the risk of principle.
Retirement planning occurs in different phases and at different stages of peoples’ lives. Depending on what stage of life a person is in, there is different kind of retirement annuity that is best suited for their situation. These different types of retirement annuities are explained here.
Considered to be the “pure” retirement annuity, the immediate annuity is used to convert a lump sum of money into a stream of income – either for a fixed time period (i.e., 5 years, 10 years) or for the life of annuitant. Using life expectancy tables and projected minimum interest rates, a life insurer is able to calculate the amount of income for a person and guarantee that the person would not outlive the income. The “insurance” factor is that the person lives longer than his life expectancy and the company continues to pay him. Gender is also a factor as life expectancy for women is greater than for men.
The payout rate is affected by the age of the person at the time he begins to receive the income. The older he is, the higher the payout because the insurer calculates less years in his life expectancy. An example of the difference in payouts is illustrated here:
- A man, age 65, invests $100,000 into an immediate annuity for a lifetime income. His monthly income: $626
- The man waits until 70 to invest $100,000 for a lifetime income. His monthly income: $717
The added benefit of the man who waits is that a larger part of his income is going to be a return of principle which is not taxed. Immediate annuities are best suited for retirees who need to be able to supplement their income and who have no tolerance for risk or inclination to manage their own savings to produce income.
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Fixed annuities come in many flavors, but, for purposes of our examples of retirement annuities, we’ll focus on the traditional, fixed life annuity. Imagine an immediate annuity with a front end attached to it. That front end provides for a deferral of the income while funds are accumulated over time to be able to provide the lump sum the immediate annuity needs to generate the income.
The insurer will accept a lump sum deposit or periodic payments to accumulate and it will credit the accumulating funds with a rate of interest. While it provides for a guaranteed rate of interest, the insurer will credit a rate that reflects the yield it generates on its investment portfolio which is comprised of quality bonds and fixed yield instruments.
While the money accumulates, the insurer will provide assurances that there is no risk to the principle and that the interest that accumulates will not be currently taxed. The first assurance is backed by the strength and creditworthiness of the insurer and the second assurance comes from the IRS which classified annuities as insurance contracts.
Fixed annuities are long term investments and the guarantees and assurances of the insurer and the IRS can only exist if the annuity owner honors the long term commitment of the contract. Early withdrawals or surrenders, while allowed, will be assessed a fee by the insurer and penalized by the IRS.
Here’s how a fixed life annuity can work for the retiree. Let’s use the same man 15 years younger. At age 50, having maxed out his 401(k) contributions, he contributes $500 per month into a fixed annuity. Let’s say that interest rates average 3.3% for the period illustrated. At age 70 he decides to convert his accumulated funds into an income annuity with a lifetime payment.
Over the 20 year accumulation period his funds grew to $171,200 so his lifetime monthly income beginning at age 70 will be: $1,228
The tax advantage of this arrangement is that the interest earned on his savings was not taxed, and, by converting his lump sum into income, taxes are further deferred until it is actually received as income. Even better, because a large portion of his monthly income is a return of principle, he is only taxed on the interest portion.
Retirement annuities offer a variety of solutions for people planning their retirement. Understanding your particular needs, preferences and priorities is the key to finding the right annuity solution for you.
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