Retirement Planning

The stage when retirement planning shifts into high gear is perhaps the most crucial time in the individual’s financial life cycle. It begins between the ages of 45 and 55, roughly a decade before the planned retirement date. The individual is entering his or her peak earning period; the combination of experience, sharp focus and career progress has brought productivity to its apex. Most of the prime household responsibilities – mortgage, children’s’ education and children’s’ daily expenses – are fulfilled or nearing completion. Attention focuses sharply on providing enough income for a comfortable retirement.

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Annuities in Retirement Planning

Annuities come into their own in this phase. The core purpose of annuities is to provide security in the form of guaranteed retirement income for life. This has always been important, but assumed added significance in the second half of the 20th century. The tremendous increases in life expectancy in this era were due primarily to progress against diseases affecting the middle-aged and elderly. For the first time in human history, life expectancy at middle age and retirement increased dramatically. Like all forms of human progress, these innovations brought new costs and problems as well as benefits. Foremost among these is the possibility of outliving the income that has been carefully nurtured to last a lifetime. Annuities are the only financial asset specifically designed to solve this problem. Their structure is oriented toward retirement. The tax laws reinforce this orientation. Withdrawals from the annuity prior to age 59 ½ are subject to a 10% penalty imposed by the IRS. Investment growth inside the annuity is tax-deferred; only upon withdrawal (presumably during retirement) are these gains taxed.

Annuities are versatile enough to serve all of the key investing goals: growth, income, and security. The relative weight assigned each of these changes dramatically as the investor enters the retirement-planning stage. Each type of annuity plays its role in seeing the future retiree safely through the remainder of life.

Fixed Annuities in Retirement Planning

Fixed annuities are best thought of as a fixed-income asset with a very high degree of security and the ability to provide lifetime income. (Courts recognize these characteristics when they order defendants in liability actions to buy annuities as compensation for plaintiffs.) Retirement planning is the phase of the financial life cycle in which security and safety of principal gradually assume the prominence formerly assigned to growth. The nature of fixed annuities dovetails perfectly with this shift in priorities.

Fixed annuities guarantee a credited interest return for an initial period. Subsequent reductions in credited interest are often limited by a provision allowing the purchaser to withdraw the balance without penalty if the credited interest falls too far. Even this interest-rate uncertainty can be avoided by purchase of a CD annuity, in which the interest-guarantee period equals the term of the annuity.

Liquidity is limited by surrender charges, but the need for liquidity is less in the retirement planning period, when mortgage, children’s college and living expenses are fading from the picture. Investors can time the annuity purchase so that surrender charges expire at age 59 and withdrawals can begin at the desired retirement age. Annuity expenses can be minimized by shopping for a low-cost annuity.

If the investment position of a deferred fixed annuity is too conservative for the needs of the portfolio, the investor can utilize mutual funds and/or variable annuities for investment, then purchase an immediate fixed annuity at retirement to lock in guaranteed income for life. A more conservative way to pursue higher yield using annuities is to purchase an indexed annuity, whose interest return varies directly with the performance of an index of market performance, such as the S&P 500. Most index annuities are tied to equity performance, although a bond index can also be used. The credited return is limited on both the low end (at zero) and the upper end (by the participation rate and the interest cap). The indexed annuity allows the investor to participate in market runups but not market downturns.

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Variable Annuities in Retirement Planning

Variable annuities are best thought of as mutual funds packaged inside an insurance wrapper. That wrapper provides tax deferral for equity-oriented investments in sub-accounts. The only other way to achieve this combination of growth investment and tax deferral would be to buy a mutual fund inside a tax-advantaged retirement plan such as an IRA or 401(k). Despite tax deferral, variable annuities are doubtful investment choices for younger investors. Their surrender charges make them illiquid (although there is provision for limited withdrawals). Their tax deferral comes at a price – insurance features and management fees add more layers of cost to the product. Withdrawals are eventually taxed as ordinary income rather than long-term capital gains, a substantial disadvantage compared to mutual funds. Consequently, younger investors will prefer to maximize contributions to plans such as IRAs and 401(k)s before turning to variable annuities.

Retirement planning changes the picture dramatically. Investors are entering their highest-income time of life, which makes it likely that they will have money left over to invest after contributing the maximum to their retirement plan. They also face their highest income-tax rates, making tax deferral more valuable than ever. Because security now takes on more importance, the insurance features offered by variable annuities are also more valuable than before. The surrender charges of the variable annuity can probably be timed to expire at or near age 59 ½. Liquidity is less important when mortgage and children’s’ expenses are absent or about to end. Some investors entering the retirement planning stage have been smacked down by previous responsibilities, debts or losses. They need to catch up their investing and maximize their rate of return in order to meet retirement goals, which make the higher prospective returns of variable annuities more valuable than before.

Some analysts claim that variable annuity sub-accounts achieve higher returns than comparable mutual funds. The lower withdrawal rate in the sub-accounts enables account managers to hang onto good investments longer rather than having to meet redemptions by liquidating them.

Increases in life expectancy also affect the relative attraction of variable annuities. A generation ago, the conventional wisdom would have frowned upon an equity-dominated investment at or close to retirement. The likelihood that the individual would die within a few years of retirement gave little scope for recovering from a serious market downturn and little incentive to take on additional risk. Today, an individual who retains good health at retirement age rates to live past age 80 and perhaps much longer. Growth must be included as an investment objective, although tempered by the need for income and security.

A final consideration is the advent of variable annuity products and riders that offer guaranteed life benefits – guaranteed rates of return, income and withdrawal benefits that apply regardless of market conditions. Because security becomes more important with age, these guarantees have huge potential value.

The upshot of these changing circumstances and priorities is that variable annuities move near the top of the investor’s hierarchy of choice. Of course, the investor should seek out the lowest-cost variable annuity that meets standards for product quality and company safety. To be sure, the investor should still maximize contributions to tax-advantaged retirement plans before contemplating purchase of a variable annuity. As always with annuity purchases, the investor should pay particular attention to choosing a financially-strong life-insurance company. These caveats do not alter the basic conclusion that the individual’s retirement planning phase is a golden age of variable-annuity investing.

Not that long ago, it might have been taken for granted that deferred variable annuities are the only ones suitable for retirement planning. The combination of an equity- and growth-oriented investment (the variable annuity) and a retirement-specific product (the immediate annuity) would not have made sense. Today, when retirements can last 25 or more years, the matter is less clear-cut. It certainly makes sense to pursue growth even into the retirement phase itself. The immediate variable annuity simply seeks a higher return than the conventional immediate fixed annuity by linking the payout to the market performance of sub-accounts.

The Role of Annuities in Retirement Planning

Each annuity type has a unique role to play in retirement planning. Fixed annuities offer a return approximating that of a fixed-income asset such as a bond, with the bonus of added security, stability and guaranteed lifetime income for the annuitant. Specialized types of fixed annuities, such as CD annuities and indexed annuities, play more specific roles. CD annuities fix the credited interest rate for the duration of the annuity contract and provide more, albeit limited, liquidity than do their bank counterparts. Indexed annuities enable holders to partially participate in market-wide runups in value while strictly limiting the downside risk to annuityholder principal. Indexed annuities come in both deferred and immediate flavors. The deferred version is suitable for the retirement planning period, when assets are still being accumulated. The immediate version is useful when accumulation has occurred and retirees are looking for a current source of income.

Variable annuities are indicated for investors who can tolerate market ups and downs and want to exploit their potential for higher returns. While they should not completely replace mutual funds, they do offer an excellent way to supplement the equity investments in a retirement plan. The living benefit riders serve a different investing goal by offering guarantees of minimum benefits.

Drawbacks of Annuities in Retirement Planning

When properly used, annuities are almost ideally suited to the planning stage of retirement. Their liquidity limitations can be minimized by proper timing. Their expenses can be minimized by judicious selection of a low-cost product. The most serious drawbacks of annuities as retirement vehicles are encountered in income taxation and estate planning.

Annuity gains are taxed upon withdrawal. It is true that tax rates will typically be lower then than in the investor’s peak earning years. Unfortunately, the gains are classed as income, not capital gains, and taxed accordingly. Income tax rates are significantly higher than the 15% capital gains rate that would apply to mutual fund gains. Unlike mutual funds, annuity assets do not receive a step-up in cost basis upon death; the survivor(s) inherit the annuityholder’s original cost basis. This double whammy makes annuities a poor choice if estate planning is paramount. One compromise position is to spend down annuity assets while delaying distribution of alternative retirement monies as long as possible. This will decrease the annuity’s relative role in the estate.


Retirement planning is the foundation for financial well-being in the last years of life. This is the prime time to utilize annuities. Fixed annuities and their variants serve investors who crave extra security and don’t need high returns to achieve their target retirement income. Variable annuities serve those investors who can tolerate fluctuations in the value of their investment and who need growth in order to meet their retirement-income goal.

In the retirement planning stage of life, former roadblocks to annuity investment are dismantled. The 10% IRS penalty for withdrawals prior to age 59 ½ is no longer meaningful, since the annuityholder can structure surrender charges to expire at his or her age 59. Retirement plan contribution limitations don’t affect variable annuities, which have no maximum contribution. There is less need for liquidity but the strong need for growth remains, particularly for those who haven’t saved enough for a comfortable retirement.

The suitability of variable annuities is not universal even among those nearing retirement. Variable annuities mesh poorly with estate planning. Taxation of distributions as ordinary income, rather than capital gains, is another countervailing consideration.

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