Article by Robert F. Schneider, CFP®, RICP® Vice President, Relationship Manager
According to the Insured Retirement Institute (IRI), $56.7 billion of annuities were sold first quarter of 2016, a 7.6% increase over first quarter 2015 sales. Fixed annuity sales were at their highest levels in seven years, but variable annuity sales were down. At the end of 2015 there were a total of $804 billion in fixed annuities and as of March 31, 2016 net variable annuity assets totaled more than $1.87 trillion.1
Why does any of this matter? Well, with trillions of dollars invested in annuities these products clearly hold a significant spot in retirement income planning. Upwards of 70‐80 million baby boomers will reach retirement age (65) over the 19‐year period that began in 2011. A good number of these folks will be looking to minimize the financial risks they will face during retirement tied to longevity, sequence of returns, inflation, interest rates and liquidity.
Annuities, when used properly, as a piece of a comprehensive financial plan. The trick is determining if and how an annuity fits into your financial plan. Deciding whether or not an annuity is best for you can be complicated. “Your Annuity Guide” is a series of four posts to help inform your decision. In the series, I will review various annuity options and share insights into when and how each type can be used most effectively. As my first post, I review immediate and longevity income annuities.
This product is used to generate income now. There is no deferral period. The purchaser of a SPIA contract deposits a lump sum with an insurance company in exchange for guaranteed payments over an agreed upon time period – life or a specific number of years. Payments must begin within 12 months of contract purchase.
If funded with taxable dollars each payment received represents a portion of gain and a return of principal. Ordinary income tax is owed on the gain. If funded with tax‐deferred (IRA, 401k, SEP IRA, SIMPLE IRA) pre‐tax dollars each payment received is 100% taxable at ordinary income tax rates.
We don't recommend placing an entire nest egg into a SPIA. The best use for a SPIA is to establish a base level of income. For instance, one could choose to establish an income stream to cover monthly fixed costs. This would ensure that no matter what happens with other variable investments, there will always be enough income coming in to cover the necessities.2 One key consideration for doing this is inflation. The cost of goods and services will rise over time, but fixed annuity payments generally do not adjust for inflation. So you will want to limit the length of your annuity or seek out an insurer that does offer a SPIA with inflation adjustment.
With interest rates at historical lows, annuity payout rates are low as well. So this isn't a purchase you would make intending to experience significant returns. Rather, this is a purchase you make to help prevent you from spending beyond your means. This is also a way to diversify the risk of your total portfolio. With your fixed costs covered, you may be willing to take more risk in your variable investments.
The DIA is a relatively newer product that has gained in popularity in recent years. It is essentially a SPIA with payments that begin many years into the future. In some cases as far as 40 years from now. DIA's are used to protect against increasing longevity and therefore are sometimes referred to as longevity annuities or longevity insurance. The individual guarantees an income stream for their final years of life by parting with a portion of their savings while younger.
Qualified Longevity Annuity Contract (QLAC) A QLAC is a deferred income annuity that is structured properly to be used within retirement accounts. To qualify as a QLAC the contract must meet certain requirements. This is discussed in a separate article, “Is a Longevity Annuity Right For You?”
Deferred income annuities are taxed the same way other deferred annuities are taxed. They grow tax deferred while in deferral. Each payment is a return of principal and gain. Only the gain is taxed – at ordinary income tax rates. How can a DIA be used most effectively?
Deferred Income Annuities (and QLACs) really have one specific purpose – to protect against longevity risk. So the best way to use them is to buy them at a younger age like early to mid‐60's and begin receiving payments at an older age like 80 to 85.
The main drawback to deferred income annuities is giving up access to a significant amount of principal. Since money used to fund the contract is intended to be left for use 10 to 15 to 20+ years into the future, you must be comfortable giving up access to what could be a large percentage of your investable assets. The first DIA's did not have any death benefit or return of principal features. This meant that if you died prior to beginning payments the money was kept by the issuing insurer. That has now changed and most DIAs offer some level of premium return or death benefit. But either way, you must be comfortable committing to the long term nature of the product.
In part two of this four‐part series, I will be discussing different types of deferred annuities.
Robert Schneider is a CFP, RICP, Vice President, Relationship Manager with Cleary Gull Advisors, a Johnson Financial Group Company. Cleary Gull Advisors does not provide tax advice. Investors should consult with their financial and/or tax adviser prior to purchasing an annuity.
1The IRI tracks variable annuity total assets on a quarterly basis and fixed annuity assets on an annual basis.
2Annuity payments are not guaranteed. Payments are backed by the insurance company’s claims paying ability which may or may not be viable in the future.