In the 31 years, I have been practicing retail financial services and retirement income planning, I have never been a big proponent of annuities, in general. My research found annuities to be too expensive and complex; too rigid and not tax efficient. But recently, when two of my wealthy, cautious investors expressed interest in annuities, it caught my attention. Subsequent research led me to rethink my position on annuities, particularly fixed indexed annuities (aka FIA). And especially fixed indexed annuities with guaranteed lifetime income riders.
The evolution of fixed annuities and income riders has led me to believe that many pre-retiree investors should consider these investments as part of an overall retirement income strategy. Like any investment, there are pros and cons, and they are not for everyone, but understating all your options in the rapidly changing world of retail financial services and income solutions, can only help.
The need for guaranteed income beyond social security is obvious. Many retirees can rely on minimum distributions from IRA’s and retirement accounts and systematic withdrawals from taxable accounts for retirement security and make out fine if it is all managed properly. The unique feature of annuities, however, is contractually guaranteed income. When utilized in the context of an overall plan, annuities can improve your retirement outcome by protecting against two systemic risks faced by retirees: The sequence of returns and longevity. The sequence of return risk is the chance that your securities portfolio will perform poorly at the worst possible time; when you begin your withdrawals early in retirement. Longevity risk is the possibility that you live longer than you expect. Perhaps much longer.
A fixed indexed annuity is an investment that is credited a return subject to a floor and a “cap” or a floor and a “participation rate”. The following is a hypothetic illustration of a fixed indexed annuity with a floor and a cap.
Figure 1.0 │ Hypothetical FIA with Floor and Cap
In this example, the account will earn credit each year based on the change in the price of the S&P 500 fund subject to a floor of 0% and a cap of 6.50% (monthly average) or 5.75% (One year point to point) So, if the S&P goes down by any amount you can’t lose anything, you are credited 0. If it rises by more than 6.50% (for monthly average) or 5.75% (for the one year point to point measure), then you earn the appropriate cap. And if it’s in between (i.e. 3%, 4%, 5%), you earn precisely that much credit.
Next is a hypothetical example of a fixed indexed annuity with a floor and a participation rate
Figure 1.1 │ Hypothetical FIA with Floor and Participation Rate
In this example, you earn credit based on the floor of 0% and a cap of 45% of the positive change in the S&P 500 over one year. Once again, if the S&P 500 drops, your account is unchanged. If the S&P 500 rises by 10%, you earn 4.5% (which is 45% of the positive change). If it rises by 12%, you earn 5.4% and so forth. In this scenario, the current participation rate is 45% in the first year but can drop to as low as 15% in future years (the minimum participation rate). This brings up a very important point. You always want to be aware of possible changes to caps and participation rates and choose annuity providers that have a very steady history in this regard.
In both scenarios (cap and participation rate) the underlying concept is the same; the insurance company is compressing the “range of outcomes” of the S&P 500. The effect of which is to limit the downside, as well as the upside, which can be very appealing for adverse risk investors nearing retirement. It can also be a viable alternative for fixed income or fixed dollar investments in today’s market.
The FIA feature with the most appeal is the guaranteed income rider. Adding this rider (for an additional cost) will provide contractually guaranteed income for your lifetime (or your and your spouse’s lifetime if you choose a joint lifetime income). The provider will illustrate how much income is contractually guaranteed at various ages (see Figure 1.2 below). When you begin to take this income, it will reduce your principal balance which is continuing to earn credits based on your floor and cap or participation rate, but even if your principal reduces to 0, the income is contractually guaranteed to continue for your lifetimes.
Figure 1.2 │ Hypothetical FIA with Guaranteed Income Rider
With 10,000 baby boomers turning 65 every day and defined benefit pension plans gone the way of the payphone; guaranteed income products are required more than ever. Experts have long recognized traditional single premium immediate annuities as a viable income solution but losing control of principal has been a big deterrent for many investors. With the recent evolution of annuities, particularly FIA’s with income riders that allow control of principal, downside protection and some equity upside potential, the time has come to re-think annuities.