The number one risk in retirement is longevity risk. Once you retire, the amount of money required to cover your retirement needs increases with number of years before death. For example, if you were to die three years after retirement, the amount you need is not significantly impacted, but the various investment risks (i.e., market risk, inflation, etc.). If, however you live to age 85, 90 or older, the amount you need at retirement is significantly lager, and the impact of the various investment risks is significantly more.
Once you recognize the simple truth that longevity risk is such an important factor in retirement, the obvious solution is to incorporate into your retirement planning an investment option that protects against longevity risk. The only one that I can think of is an immediate annuity or a deferred variable annuity with a living benefit rider. Each of these alternatives has guarantees that insure income for life, but they come with a cost and with liquidity restrictions.
Are Annuities a Possible Solution?
1. Immediate Annuities
Immediate annuities are fairly simple to understand. You pay a lump sum to the insurance company and immediately start receiving a fixed guaranteed stream of income that is based upon your investment, your age, the term of the annuity, and whether you elect a feature that guarantees that your original investment (minus any annuity payments made prior to death) will be returned regardless of when death occurs. Payments may be based upon a single or joint life, or for a single or joint life with a term certain, and may include an optional return of investment guarantee. The primary benefit is that payments will begin immediately and continue for the period selected, regardless of market returns or conditions. Immediate annuities have one major drawback—you cannot access the principal invested.
2. Deferred Annuities
The second general category of annuities is deferred annuities, and the variable annuity is the most popular because of the riders available. This is an arrangement where the insurance company, in exchange for a single premium or a series of premiums, promises to make periodic payments commencing at some point in the future as elected by the contract holder.
In its most basic format, premium payments are typically invested by the insurance company in mutual funds that invest in stocks, bonds, money market funds, or some combination of the three. This account is generally referred to as the “Investment Account.” This account fluctuates, up or down, with actual investment performance reduced by the charges for the contract. Any growth in this account in excess of premiums paid, is tax deferred, meaning that no tax is payable on the Investment Account growth until withdrawals are taken from the annuity.
The annuity contract also has as a separate account known as the “Annuity Account” that is established at the same time, and in the same amount, as the Investment Account. Each year, the Annuity Account is credited with the greater of the annual Investment Account return, or a guaranteed minimum amount, which currently is in the 5% range and has a limited duration. Prior to annuitization, the Annuity Account is guaranteed never to decrease based solely upon a downturn in the Investment Account.
At some point in the future, when elected by the contract owner, the Annuity Account is annuitized, and a fixed annuity amount is calculated and paid to the contract owner for the period selected. The amount of the annuity is determined based upon the value of the Annuity Account, the annuitant’s age, and a formula established by the insurance company. At this time, and from this perspective, it looks much like a single premium immediate annuity. The higher the value of the Annuity Account and the older the annuitant at the time of annuitization, the greater will be the annuity payment. Even after annuitization, the Investment Account continues to reflect actual market performance, and may provide a death benefit to the extent the total investment performance less the annuity payments result in a positive Investment Account value at death.
These annuities have an optional feature, which I call the “Lifetime Withdrawal Feature.” Generally, under this feature, the contract owner may withdraw a portion of the Investment Account value each year. The portion that may be withdrawn is usually limited to 10% of the investment in the contract, or the Investment Account earnings for the year, whichever is greater. This feature allows lifetime withdrawals that may increase based upon the Investment Account performance.
The Deferred Annuity Sales in a Nutshell
Tax deferral, upside market participation, minimum guaranteed returns and lifetime income are part of the sales pitch for deferred variable annuities. All of these are true, but should also be taken with a grain of salt and require further explanation. Look for the next article in this series.
If you would like more information on this subject, or have a client who might benefit from a discussion about it, please contact Barry Koslow at bkoslow@mkaplanners.com or (781) 939-6050.
Securities offered through Advisory Group Equity Services, Ltd., Member FINRA/SIPC. 444 Washington Street, Woburn, MA 01801 (781) 933-6100.
This article should not be considered as providing accounting, business, financial, investment, legal, tax, or other professional advice or services. It is not a substitute for such professional advice or services, nor should it be used as the basis for any decisions or actions that may affect your business or you personally. This should only be one part of your research. You should seek authoritative guidance from a qualified accountant or attorney before taking any action.
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