Your Annuity Options

By definition, retirement is the time of life when you stop earning income and start living off your assets. Because you are utterly dependent on those assets, you must strive to make them as secure as possible. This entails guaranteeing both the stock of wealth that the asset controls and its delivery of regular income to you.

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Annuities as Retirement

Annuities play a historic role in the delivery of safe and secure retirement income. Indeed, the original role played by an annuity in the eighteenth century was precisely defined as the provision of guaranteed lifetime income. Today, your annuity options are much broader, and they encompass the creation of retirement wealth as well as its delivery. Neophyte investors and those new to the subject of retirement planning should learn their annuity options and review them carefully.

Annuities are made-to-order retirement assets, both in terms of their inherent characteristics and their status in law. They are far from alone in their suitability for retirees, however. Other fixed-income assets, such as bonds, also deserve consideration as potential providers of retirement income.

Annuities and Retirement

The investment gains inside annuities accumulate tax-deferred – unlike, for example, taxable gains inside mutual funds. This is consistent with the tax treatment of life insurance generally, where policyholders can take constructive receipt of the gains only by surrendering the policy. In order to grant tax deferral to annuities, the IRS insisted that investors should not use tax deferral to fulfill shorter-term objectives. A 10% tax penalty is levied on withdrawals made prior to the annuityholder’s age 59 ½. Withdrawals are also subject to taxation as ordinary income.

Upon withdrawal, annuity gains are also taxed as ordinary income. To some degree, this offsets the relative advantage of tax deferral, because ordinary income rates are well above the long-term capital gains rate levied on mutual funds.

Annuity Options: The Immediate Annuity

The classic form of annuity is the immediate annuity. The purchaser accumulates a stock of wealth consisting of non-annuity assets. If this stock represents a capital sum sufficiently large to provide retirement income, the wealth holder can convert those assets to cash and purchase an immediate annuity from an issuing insurance company. That annuity provides guaranteed income in the form of level, periodic payments. (Meanwhile, the insurance company invests the purchase proceeds fairly conservatively, in order to fund the future payments to the purchaser.) Technically, the duration or term of the payments need not be lifelong, but that is the most common form.

Immediate annuities are much more popular in foreign countries than in the U.S. That is probably because some foreign countries have modified or replaced their “social insurance” programs by encouraging private funding of retirement accounts. Immediate annuities are particularly attractive to retirees. Resistance to annuitization is often ascribed to a reluctance to tie up money in relatively illiquid form. In the U.S., however, a substantial fraction of retirement wealth is already “pre-annuitized;” e.g., embodied in programs such as Social Security and private pensions whose payment structure is broadly similar to that of annuities. It seems that American resistance to immediate annuities stems not from absolute unwillingness to annuitize, but rather from reluctance to increase the already-substantial annuitized fraction of retirement wealth.

Immediate annuity payments may be monthly, quarterly, semi-annual, or yearly. Thus, the term “immediate annuity” is a slight misnomer, since distribution payments may begin anywhere from one month to one year after purchase.

Originally, annuity payments reverted to the insurance company upon the death of the annuitant. In response to popular demand, insurance companies began incorporating a death benefit into annuity contracts. A common provision guarantees the beneficiary an amount equal at least to the sum of all purchase premiums paid for the annuity, less any withdrawals or charges to the contract.

In the 20th century, deferred annuities developed. These embody two important changes from the immediate annuity: annuity payments are deferred for some period of years and the investment required to raise the capital sum is done by (or under the auspices of) the insurance company.

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Fixed Annuities

The first deferred annuity was the fixed annuity, which is still popular today. The annuity purchaser makes regular contributions into an accumulation account. The time period over which these contributions occur is called the “accumulation period.” The money is invested conservatively by the insurance company and the accumulation account earns a rate of return that is fixed for a contractually-specified time period of at least one year. The insurance company reserves the right to change that fixed rate, although the annuity contract limits the magnitude of such changes. In addition to a death benefit, fixed annuities also offer a minimum guaranteed rate of return over the life of the annuity.

The insurance company must invest the fixed-annuity purchase premiums conservatively in order to assure that sufficient money will be available to meet annuity payment guarantees. Thus, the rate of return paid on accumulation account is no higher than that of a fixed-income investment, such as a bond.

At the conclusion of the accumulation period, the annuityholder can begin to take payments during a “distribution period.” One distribution option is a life annuity, the classic lifetime stream of regular level payments. The annuityholder may also choose to take a lump-sum payment or make discretionary withdrawals.

Variable Annuities

In the early 1980s, the variable annuity was created. Inflation had wreaked havoc on the purchasing power of fixed-income financial assets during the 1970s. With the conquest of inflation in the early 1980s, the stock market rebounded sharply from its decade-long doldrums. The creation of tax-advantaged retirement investment accounts, such as IRAs, encouraged public purchase of equities. The variable annuity was an attempt to combine the advantage of tax deferral accorded to insurance products with the advantages of mutual-fund investing.

The variability of variable annuities relates to the investments made for the accumulation account. Their rate of return and monetary value fluctuates with market conditions. They are managed by the annuityholder, not the insurance company. The primary investment option is the family of sub-accounts created by the insurance company. These are functionally equivalent to mutual funds – diversified portfolios of equities or bonds. Money-market mutual funds are also provided, primarily as parking places for investment funds when the primary options are unappealing.

Variable-annuity sub-accounts differ from mutual funds in one important substantive way. In addition to the annual fees paid to support the mutual-fund investment operation, insurance companies add another layer of expenses to pay for the variable annuity administrative and insurance expenses incurred inside the company. This has earned variable annuities a reputation as a high-cost investment option. On the whole, this is well-deserved, but low-cost variable annuities are becoming more common.

Variable annuities are an excellent way to achieve tax deferral for diversified equity investments when contribution limits to tax-advantaged plans have been reached. They share the liquidity drawbacks of other annuities, so they are a doubtful choice for the youngest investors. One possible exception to this rule of thumb applies to high-earning professionals and business owners who are threatened by the possibility of tort litigation. Many states exempt life-insurance assets from attachment in litigation. In these cases, variable annuities are a good way to simultaneously achieve growth, tax deferral, and protection from legal liability.

At the other age extreme, their equity exposure and liquidity limitations make variable annuities too risky for the oldest investors. One recent innovation in variable annuities has been the introduction of income- and rate-of-return related guarantees, which apply regardless of the actual market performance of the investments in the accumulation account. During the recent recession, some insurance companies have modified or rescinded those guarantees. It remains to be seen whether these variable-annuity features will survive.

Indexed Annuities

In the 1990s, insurance companies once more incorporated an innovative financial product under the annuity rubric. Index funds developed in order to allow investors to achieve a rate of return equal to an average of market performance without having to buy all the assets in the market. This responded to the economic research showing that active management by portfolio managers was unlikely to improve on that average performance. Indexed annuities tie the rate of return in the accumulation account to the performance of a financial-market index, such as the S&P 500.

Since the insurance company needs to buy the index to cover its payments to annuityholders, it cannot afford to credit them with the full return. Instead, various contribution formulas determine the amount of the index fund’s return that annuityholders receive. As compensation for this, the company places a floor under returns (usually zero) and generally guarantees a positive rate of return for the term of the investment.

Index funds possess characteristics of both fixed and variable annuities. On net balance, they more closely resemble fixed annuities because of their insurance features. They are suitable for middle-aged or retired investors who seek a way to juice up the yield on a fixed-income investment without bearing the risk of equity investment.

CD Annuities

CD annuities are another fixed-annuity variant. Their name derives from their resemblance to bank CDs; CD annuities guarantee a fixed return on accumulation account for the full duration of the annuity. This contrasts with the fixed annuity practice of lowering the fixed rate of return on accumulation account after an introductory period of one or two years.

Non-Annuity Options: Corporate Bonds

Corporations are legal entities created in order to limit liability. This limitation enables large amounts of money to be invested by passive investors. Corporations attract this money in two ways: by issuing equity and by borrowing. Corporations borrow by issuing bonds, which are debt securities that contractually stipulate the terms and conditions of the loan. Corporate bonds are typically issued in specific denominations and pay a fixed rate of return on that investment over the duration of the bond contract. These interest payments are usually made twice yearly.

Corporate bonds may have long terms (up to 30 years), but investors need not hold them to term. A thriving secondary market for bonds allows bond investors to sell their bonds. Bond prices fluctuate inversely with market interest rates; if interest rates have fallen since the original issue of the bond, then the bond must sell at a discount to make its yield to the purchaser competitive with market rates. The fact of bond-price fluctuations means that a bond buyer can guarantee receipt of the contractual rate of interest and principal only by holding the bond to maturity. Even that guarantee is subject to qualification, since insolvency would cause default of the bonds. As senior creditors, bondholders are first in line to receive any proceeds from liquidation, but this does not guarantee recoupment of their full investment. Fortunately, bond-rating agencies exist to assess this risk of default and publicize it. Bond buyers can examine the rating and decide whether the risk justifies purchase.

U.S. Government Bonds

The federal government also borrows large amounts of money. Short-term debt instruments with maturities of less than 1 year are called “bills,” maturities of 1-10 years are offered in “notes,” and “bonds” offer 10-30 year maturities. Historically, U.S. government bonds have been considered the prototypical “riskless asset,” because their default risk was adjudged to be zero. Now, for the first time, analysts are contemplating the possibility of default at some point in the future.

Government bonds make periodic interest payments to bondholders. The payment interval is usually six months, but investors can arrange for monthly payments if desired. As with corporate bonds, a thriving secondary market allows investors to achieve liquidity at the risk of losing principal if bond prices have fallen since the original issue.

Bond Funds

In the 1980s, mutual-fund companies extended the principles of automatic diversification and professional management to the fixed-income sector by creating bond funds. Analogous to stock funds, these instruments pool fixed-income investment money to purchase and manage a diversified portfolio of bonds. This automatically reduces the risk of default, just as stock mutual funds minimize insolvency risk, by minimizing the impact of a small number of defaults on the overall portfolio. Because the fund consists of a pool of money rather than a particular bond contract, there is no “term to maturity.” Consequently, the risk to principal from interest-rate fluctuations ordinarily makes bond funds riskier than individual bonds.

Relative Risk of Fixed-Income Assets

The primary risk of fixed-income assets is the default of the issuer, presumably due to insolvency. Corporate bonds are rated for default risk; in theory, pricing differences should compensate for that risk. Investment-grade bonds (those with high ratings for safety) seldom default. Annuities carry a low risk of default because insurance-company investments are naturally more diversified than those of a single company. (This is a significant advantage of annuities over company pensions, which run the risk of company insolvency.)

The other major risk of fixed-income investments is interest-rate risk – the risk that a rise in rates will drive down the asset’s value and cause a loss of investment principal. This is an inescapable risk of bond funds, but applies whenever a bond is sold prior to maturity.

Annuities carry a liquidity risk – the risk of suffering surrender-charge penalties for withdrawing money prior to distribution. Tax penalties enlarge the scope of this risk. Careful shopping can minimize the risk, since some existing annuities actually eschew surrender charges. Many annuities also waive surrender charges for contingencies such as terminal illness or unemployment.

Fixed-income investments are less risky than equities. Interest payments are a contractual obligation, compared to the profit-residual status of stock dividends. Bondholders are first in line as creditors; equityholders are last in line. Losses of principal value are not uncommon in equity investment, whereas they are much less likely for fixed-income investments. This explains the asset-allocation strategy of shifting investments away from equities and toward fixed-income assets over time.

Retirement-Income Alternatives

Safety and security of income is the dominant consideration in retirement investment. Risk is defined as variability of possible returns. The term “fixed-income” implies a lack of variability, which explains why residual-income equity investments should be replaced by fixed-income investments in retirement. Even fixed-income investments are not riskless, however, and selecting the optimal retirement portfolio requires tailoring it to each investor’s particular circumstances.

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