Annuities – A Retirement Income Stream Option?

During the course of previous discussions, we have identified three general stages in an individual’s investment lifecycle: building a fiscal foundation (conducted during your 20s and 30s), accumulating wealth (occurring between the early 40s and mid-50s), and pre-retirement, the five-year period prior to your desired retirement age.

Insurance - Annuities

During the pre-retirement stage, debt is eliminated and a plan – considering the withdrawal rate (e.g. the 4% rule) and the order of withdrawal from the various retirement accounts – to draw down the retirement nest-egg is developed.

With a sufficient nest-egg in place, debt eliminated, and an understanding that the nest-egg has to be drawn down in a manner to ensure that it will last 30+ years if necessary, the question then becomes, “How can I turn my retirement savings into a reliable retirement income and what type of investments should be held during the retirement period?”

Last week we talked about one potential option. Income funds. These types of funds are geared toward individuals already in or entering retirement. As the name suggests, an income fund is a type of mutual fund that emphasizes current income, either on a monthly or quarterly basis. These funds attempt to meet the objective of providing steady income throughout retirement by holding some combination of government, municipal, and corporate debt obligations, preferred stock, money market instruments, and dividend-paying stocks.

Develop Your Withdrawal Plan [RetirementSavvy]

This week we take a look at annuities as an option for turning your retirement savings, your nest egg, into a reliable retirement income stream. There are basically three types of annuities: variable, fixed, and equity-index.

These can either be immediate (you make a single lump-sum payment and set the starting date for the payout to begin sometime in the very near future) or deferred (you build your retirement savings over a period of years, deferring when you begin to receive the income).

Pros and Cons of Annuities – How to Evaluate Annuities [New Retirement]

Variable Annuities: A variable annuity allows individuals to invest their money within a range of mutual fund-like investments options offered by an insurance company. These investments are referred to as sub-accounts. As the name suggests, the returns of a variable annuity are not stable. They will vary with the ups and downs of the stock market. There will be downside risks as well as potential upside gains. Generally, over a longer time horizon, a variable annuity invested in a stock sub-account will likely provide a much better opportunity for inflation-protected income than a fixed annuity.

Fixed Annuities: In short, a fixed annuity offers a guaranteed minimum rate of return for a stated period of time. While a fixed annuity will provide a stable retirement income, the fixed return is very likely to be eroded by inflation.

Some fixed annuities do offer the option to have the payments increase each year. However, as you might suspect, there will be a cost associated with that feature. The cost of the inflation protection aside, these types of annuities generally cost less compared to variable annuities.

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Equity-index Annuities: A newer flavor of annuity, this type earns interest that is linked to a stock or other equity index. One of the most commonly used indices is the S&P 500. They differ from other types of annuities because of the way it credits interest to your annuity’s value. Most fixed annuities only credit interest calculated at a rate set in the contract. Conversely, equity-indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited. How much additional interest you get, and when you get it, depends on the features of your particular annuity. Additionally, equity-indexed annuities, like fixed annuities, also promise to pay a minimum interest rate. That rate will not be less than this minimum guaranteed rate even if the index-linked interest rate is lower. The value of the annuity will also not drop below a guaranteed minimum.

What Annuities Offer a Retirement Plan [Financial Advisor]

There you have an overview of the three types of annuities. While I have touched on some of the pros and cons, instead of repeating what is already out there, I have included the links to a few articles that do a good job of laying them out in greater detail. As with all decisions regarding retirement planning, I strongly recommend you conduct your due diligence, paying close attention to all fees/costs, prior to committing to any of these products.

Blogger-in-Chief here at RetirementSavvy and author of Sin City Greed, Cream City Hustle and RENDEZVOUS WITH RETIREMENT: A Guide to Getting Fiscally Fit.

14 Comments

  1. Don’t know a lot about annuities, but now feel just a bit $marter. Thank you, James!

    • There are a lot of strong feelings with respect to annuities. While I believe they can serve a purpose for some, most people are probably better off sticking with traditional investment products and avoiding this insurance product.

  2. I’m not a fan of the fees in many annuities, but do believe they can have a place in an overall portfolio. I’ve maxed out all my 401K/IRA options, so now am adding money to a Vanguard variable annuity. It has the lowest fee structure I could find and lets me hold off deciding what I’ll do with the funds until I’m ready.

    What will I do when “ready?” Probably roll it into a deferred fixed annuity to help mitigate inflation in my oldest years.

    • I purchased an annuity years ago when I was looking for another option for my money after maxing out contributions to my IRA and before I had access to a 401(k) type plan. Like you however, I am generally not a fan of the products, because of fees, and while I still have the annuity, I don’t add anything to it on a regular basis. For me, there are better options for retirement.

  3. Hey there. You’ve done a fantastic job. I will definitely recommend to my friends. I’m confident they will benefit from this site.

  4. Imagine having signed up twenty or thirty years ago for an annuity with AIG (or equivalent): you would most definitely have a guaranteed fixed income for life. Yeah, a fixed income of zero, guaranteed for life.

    Until and unless there is 100% FDIC-like guarantee, thanks, but no thanks. We’ve just seen what can happen.

    • I personally am not a fan of annuities. However, my understanding is that insurance companies are obliged to keep a far larger percentage of their assets in safe instruments, such as U.S. Treasury Bonds, than traditional corporations because of their unique role; because of the reliance of the policy holders that they in fact stay solvent. Moreover, I believe that insurance companies cannot touch the pool of money that is set aside for future claims to finance day-to-day expenses.

      Understandably, state regulators closely monitor insurers and the failure of an insurance company is rare. Even if an insurance company goes bankrupt, it is unlikely the policy holder will lose much money, if any, as States maintain insurance guaranty funds for exactly such an occurrence and will cover the losses – up to the minimum – stated in the annuity policy. The limits vary by state, but my understanding is that all states cover the first $300,000 of losses, with some states guaranteeing a substantially larger portion.

      If you have specific examples of insurance companies going bankrupt, and annuity policy holders losing their money, I hope you will share as I would be interested to read about the circumstances surrounding the collapse. Thanks for stopping by and commenting, LifeAnt.

  5. Good summary, James. I’m a fan of using a portion of retirement assets to purchase an annuity as it provides a good protection against longevity risk. I’ll probably consider a deferred annuity for myself to protect against this risk.

    • Thanks, Kay. As I noted in a previous discussion of ours, I am not a huge fan of annuities; however, I think they can serve a role for someone with limited access to other guaranteed retirement incomes and they would like to use them as a hedge against longevity risks, as you note. I purchased a deferred annuity about 10 years ago and I still make the occasional contribution. However, between the wife and I, we will have five pensions; therefore, my primary focus right now – with regards to contributions – is on our TSP (401(k) equivalent) and IRA accounts.

  6. Nice summary here on annuities. I am a long way away from purchasing if I ever do. I think they are a good product for some people. But not sure if it will be the right move for me when I retire. Lots of fine print too.

    -RBD

    • Thanks for kicking off the conversation, RBD. One of my personal criteria for considering an annuity is that an individual should be maximizing contributions to retirement plans such as 401(k)s and IRAs first’ then perhaps look at a deferred annuity as an option. As you note, there is a lot of fine print that should be read, good due diligence should be performed. I do have a deferred variable annuity; however, I do not contribute a significant amount to it…instead I focus primarily on my (and the wife’s) TSP and IRA accounts.

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