Annuities used to have a bad reputation, and rightly so. In the past, they had long surrender periods (periods when you can’t withdraw all your money without a penalty), offered limited options like tax-deferral and standard death benefits, and were often not implemented properly. But annuities have evolved for the better. If used appropriately, these investment vehicles may make sense as part of your overall financial plan. Here are two main strategies for using annuities.
Annuities as Supplemental Income
An annuity is simply a financial product that ensures payment of a sum of money to someone yearly, typically for life. It’s similar to the pension payments some employers pay retired employees. Unlike pension plans, however, investors can purchase annuities as a personal investment separate from their workplace. Few companies offer pension plans anymore, but annuities can potentially replace pensions as a form of supplemental income for people heading into retirement.
Today, annuities have many options, called riders, that can be added to the base contracts. There are different variations of these riders depending on the issuing insurance company, but the gist of it is, that these riders allow annuities to be used for a predictable cash flow in retirement to cover expenses. For example, guaranteed withdrawal benefit riders typically offer a guaranteed, fixed income for life — even if the market fluctuates — either to cover a single life or a couple without having to cash out your entire annuity.
The annuity payments, in addition to a retiree’s Social Security income, often create a significant guaranteed base of income. This annuity income can be used to meet a portion of one’s overall living expenses, including fixed expenses such as life insurance premiums or mortgage payments, and more. An annuity can allow retirees to increase their “income stability ratio” — the portion of their overall guaranteed income stream, no matter what happens.
Annuities as an Alternative
Another possible rider for your annuity is a long-term care rider, which can be used in place of long-term care insurance. Unfortunately, not everyone qualifies for or has long-term care insurance. There are many reasons for this — health status may be an issue, or the cost of long-term care insurance may be a barrier. But some annuities today offer riders that allow one to access additional funds to help with long-term care expenses.
Actual long-term care insurance is usually a better option, but for those who cannot obtain long-term care insurance, an annuity may be an alternative to consider. The downside is that the earnings portion of the annuity income is taxed as ordinary income versus the tax-free benefits from a long-term care insurance policy.
Along the same lines, for those who cannot qualify for life insurance, annuities can offer an alternative in the form of a standard death benefit. For instance, if one invests $100,000 into an annuity and the value drops below the initial investment amount due to market volatility, the beneficiary will still receive at least $100,000 if the account owner dies. Today, some annuities offer enhanced death benefits such as “roll-ups” or “step-ups,” increasing the death benefit values beyond the initial investment. There are many variations to the different kinds of enhancements that can provide individuals with solutions if regular life insurance is not feasible. It’s important to note again that earnings from this annuity strategy are taxed as ordinary income, unlike the tax-free proceeds from a life insurance policy.
There Is No Free Lunch
Annuities vary in cost, depending on how they are tailored to your needs. In general, the average annuity solution is more expensive than a regular investment portfolio because of the guarantees and features it provides. But depending on your goals and risk tolerance, one may find the expense of annuities to be reasonable. For some investors, predictability and protection are worth any cost.
Annuities are complex and may not be right for everyone, so be sure to seek advice from a CERTIFIED FINANCIAL PLANNER™ professional to help navigate the different options. A CFP® professional can help you determine if an annuity can add value to your overall financial plan.
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