Retirement Annuity Guide

Retirement planning covers the time leading up to retirement, the conclusion of work and the years spent in retirement. Annuities can play an important role at each stage of the process. An analogy illustrates the role played by investments in retirement.

Medicine – Good or bad?

Medicine is vital to human happiness. There are many kinds of medicine. Each fulfills a particular purpose, either curing or preventing disease. When used for that purpose, it is good. To fulfill its purpose, it is used in a particular quantity. Too little or too much medicine is bad, but the right amount is beneficial. A particular medicine is very good for some people, very bad for others. In fact, a medicine may be good at one stage of life and bad for the same person at a later stage. One dosage may be correct for an individual of a certain age but incorrect for the same individual at a different age. In summary, there is no such thing as good medicine or bad medicine in the abstract; it depends on the context.

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A concrete example: Aspirin

Aspirin provides a concrete example of these principles. It is a proven, effective pain reliever, can prevent or mitigate heart attacks and can relieve joint swelling and stiffness. It is one of the world’s leading medicines. Yet when taken by infants it can cause Reye’s syndrome with fatal results. It can cause gastric bleeding, sometimes with fatal results. The difference between its therapeutic effects and its pathologic ones can be a function of dosage, age or other unknown factors, perhaps including interaction with other medicines.

Investments in general and annuities in particular are closely analogous to medicine, except that the good and bad effects are economic rather than medical.

Retirement Annuity Planning

Retirement planning begins before retirement and the plan follows the individual up to death and beyond, until disposal of the estate. Annuities can play a role in each stage – but only if properly prescribed and dosed.

Annuities are inherently geared toward retirement, both from a saving and funding standpoint. The 10% penalty levied by the IRS for withdrawals prior to age 59 ½ and the surrender charges imposed by insurance companies for premature withdrawals together comprise a steep disincentive to the use of annuities for pre-retirement saving and consumption.  The very concept of annuitization itself arises from the need for lifelong income, a need that exists only because retirement implies the absence of earned income.

Youth to Middle Age: Getting Started

Fixed and indexed annuities are inferior medicine for young investors, whose focus will be primarily on growth, not fixed-income or conservative investments. Since they will need to hold some liquid assets for reserve and contingency purposes, this will comprise the bulk of their conservative money.

Variable annuities are better medicine for this age group for two reasons. First, the mutual fund options are suitable for a growth-oriented portfolio and bond funds can be used to add balance for individuals whose risk-tolerance dictates it. Second, variable annuities may need to be held for at least 15 years in order for the benefits of tax deferral to outweigh the fees, expenses and tax disadvantage of being taxed at ordinary income-tax rates rather than capital gains rates. Tax deferral can be had from IRAs, 401(k)s and other qualified plans – which may include matching employer contributions as well – so variable annuities will be chosen only when contribution limits on all available qualified plans have been met or when no qualified plan is available. Ideally, variable annuities should play a secondary role in retirement planning at this stage.

An exception to this general principle applies to professionals and business owners at high risk of exposure to legal liability. For these people, annuities can be a specific remedy for their risk exposure. Most states exempt the assets inside life-insurance policies from attachment via liability judgments. A professional can shield wealth from liability risk by holding it in the form of an annuity, and a variable annuity is a -good way to maximize long-term growth. (This is really retirement annuity planning, not just risk mitigation, since the assets are held for retirement and the risk exposure only goes away at retirement.)

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Middle Age: Run-up to Retirement

Annuities come into their own when investors begin to get serious about retirement planning – roughly 10 to 15 years before retirement. This timing is just right for Deferred Annuities; the investor will outlast the surrender charges on the annuity (which last 5-10 years) by the time retirement rolls around, just in case withdrawals are necessary. The accumulation period can be set to conclude at retirement, so that distributions can pick up where employment income leaves off. The investor will have passed the age of 59 ½, thereby avoiding the 10% tax penalty.

At this stage in the life cycle, the investor begins reallocating assets towards less risky, fixed-income vehicles and away from high-risk equity investments. Fixed and indexed annuities are now good medicine. Indexed Annuities are ideal for younger members of this cohort, who still need growth but are willing to trade some return for the guarantees of indexation. Fixed annuities are right for older members who are looking for a fixed-income equivalent with guaranteed minima and the privilege of annuitization.

Variable annuities are less therapeutic at this point but might still appeal to younger members of the cohort as a subordinate part of their portfolio. There is still sufficient time for tax deferral to outweigh the income-tax and expense drawbacks of the variable annuity and growth is still important enough to justify the risk of equity investment.

Retirement: The Last Lap

When work ends and employment income ceases, attention turns to generating income from investments. Asset allocation focuses on preservation of principal as well as income generation.

Immediate Annuities

The annuity focus shifts dramatically from deferred to immediate annuities. The latter have no accumulation period but generate (virtually) immediate income – exactly what is wanted during retirement. An immediate annuity is a classic retirement annuity, the specific remedy for the problem of outliving one’s income.

Immediate annuities are prescribed in many different circumstances. Upon retirement, participants in defined-contribution company plans can withdraw their accumulated proceeds and purchase an immediate annuity that will guarantee lifelong income. Employers can fund defined-benefit pension plans by purchasing immediate annuities for participants. Governments can privatize public retirement programs by substituting private annuities for government transfer programs.

Immediate annuities offer a variety of distribution plans, from the straightforward regular level-payment plan to a lifetime annuity whose undistributed income reverts to the insurance company upon death of the holder. There is even a variable immediate annuity, which ties distributions to the investment performance of a portfolio. For more information on this annuity type, see the Immediate Annuity Guide.

The Change in Retirement Annuity Thinking

At one time, decades ago, deferred annuities were considered doubtful medicine for people already in retirement. The thinking was that an asset with limited liquidity and high costs was inappropriate for people whose life expectancy did not extend more than a decade beyond retirement.

The coincidence of two demographic trends – earlier retirement and lengthening life expectancy – has modified this thinking dramatically, helped along by significant changes in the annuity product itself. People retiring in their late 50s and living into their 80s need some measure of growth to protect their principal against inflation. Indexed annuities can provide more growth than fixed annuities while protecting principal with guaranteed minima and index-number modifications. The fixed annuity still provides a modicum of growth along with security.

Recent product modifications in indexed annuities have introduced vesting schedules to improve liquidity. Living Benefit riders to variable annuities have sought to guarantee minimum lifetime withdrawal amounts, minimum accumulation returns and even combined these features with eventual annuitization.

These developments have changed the status of the retirement annuity. Still, retirees should shop carefully for the lowest-cost annuities and also for annuities with the shortest-duration, lowest surrender charges. Even good medicine can have side effects; shrewd patients try to minimize them in order to enjoy the therapeutic benefits.

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