P. Derek Ten Broeck Jr.
TB Group LLC
Here’s a case of an annuity in action. A friend of mine saved for retirement all his adult life, putting his money into equities (stocks and stock funds) so he could capture the most growth. His savings advanced steadily until 2008, when a worldwide financial panic reduced his holdings by nearly one third. His funds recovered over the next year or so, but he never forgot the lesson.
In 2011, my friend was 64 and beginning to plan seriously for retirement. He sold off some of his 401(k) retirement funds to buy a fixed deferred annuity from an insurance company for $150,000. “Deferred” means the annuity would not start its payout until a later date, by which time the principal would have grown larger. “Fixed” means the payment would be the same throughout the life of the contract.
He retired in 2017, and that year he “turned on” the annuity in order to begin receiving the payout. The payment was a little over $1,000 per month. The money is taxed, but because it is part of his retirement funds, it makes up $12,000 of his required minimum distribution (RMD) each year. I will cover RMDs in another blog post, but it means there’s $12,000 per year that he is not required to take from other funds.
$1,000 Per Month for Life
In their retirement, my friend and his wife receive Social Security payments, the RMD from their retirement funds, plus $1,000 per month from his annuity. That payment is guaranteed as long as my friend is alive. In addition, this particular annuity is set up so that if he dies before his wife, she then receives it for the rest of her life. So if one of them lives 12.5 years beyond 2017 (he will be 82 and a half), they will have collected more than they put into it.
My friend might have done better if he’d simply bought $150,000 worth of shares in Apple Computer in 2011. But it’s always easier to predict in hindsight. In fact, Steve Jobs, the legendary head of Apple, died in 2011, and nobody knew what was going to happen to the company and its stock. Ask my friend, and he will tell you that the certainty of having an extra $1,000 per month for the rest of his life is worth whatever he paid — more, even.
Will an annuity fit into your plans? Annuities come in many types and styles, including immediate, deferred, fixed, variable, indexed and enhanced.
Immediate vs. Deferred Annuity
With some annuities, you buy it, and the insurance company starts the payout immediately. This is called an immediate annuity. It works because the insurance company invests the money you pay at the beginning, and it can grow, even while the company is making regular payments to you from it.
But you will probably get a larger payment from a deferred annuity. With a deferred annuity, you put in a lump sum, like my friend, in anticipation of letting the insurance company keep it for some time before they start paying you. This gives your investment a chance to grow for a while, so they will be making your payout from a larger principal.
Fixed vs. Variable Annuity
With a fixed annuity, the insurance company bases the payout on a specified rate of return which doesn’t change. With a variable annuity, the rate of return can go up and down, based on market conditions.
The company is likely to set the rate of a fixed annuity lower than that of a variable annuity, because insurance companies are generally conservative and don’t want to take the chance of losing a lot of money on you if the market goes down. Give them a little more flexibility in the payout, and they will generally reward you for it. And in the case of a variable annuity, when the market has a growth spurt, it will increase the value of your investment dramatically, so they can afford a better payout.
Indexed Annuities
You can view an indexed annuity as a sort of hybrid of the fixed and variable types. With this one, the insurance company pegs your rate of return to the rate of return of the market. It is common for them to use the S&P 500, which is an excellent proxy for the overall growth of the market, since it covers more stocks, and more diverse stocks than, say, the Dow Jones Industrials or the NASDAQ.
Enhanced Annuities
As with insurance policies, annuities can have riders, which is an amendment to the annuity agreement, usually designed to be a benefit to the annuitant. In my blog post on long-term care insurance, I described an annuity with a long-term care insurance rider. This allows the annuity to pay long-term care benefits instead of annuity payments. If you don’t use the long-term care benefits before you die, the company sends your original up-front investment back to you (or, more specifically, your heirs).
I have simplified the story here, because annuities can be designed to be any combination of these different types. You can have a deferred indexed annuity, an immediate variable annuity, or whatever. And riders are limited only by insurance companies’ imaginations, which are much larger than you may think. They all want to out-do each other when it comes to marketing.
I would advise everybody to have an annuity in their retirement plan. They are generally a good return on investment, but their greatest advantage is predictability, which is precious when you reach retirement age. Just ask my friend.
But there’s a lot to sort through when buying an annuity, not just in the bewildering variety of types, but other considerations as well. You need to be certain of the soundness of the insurance company you’re buying it from. And, adding a rider or enhanced benefits complicates the transaction further. At TB Group, we have helped many clients work through such questions and go on to enjoy the benefits of lifetime payments. Click here to set up your consultation with us.
Photo: “Heap of Different Nominal Per Dollars” by Karolina Grabowska via Pexels.