How To Use Annuities to Create Your Own Pension
Do you have a pension coming to you at retirement? Probably not.
Corporate pensions are few and far between, and the debate over state government pensions continues to broil across the country. Entrepreneurs and other self-employed people also lack guaranteed retirement income. Those of us without a pension are looking for options.
We now have one.
Ten years ago, if you had asked me for advice, I probably would have told you to avoid buying an annuity. The annuities of old weren't appropriate for many investors. High fees and low returns, coupled with high commissions for salespeople, were a big turn-off. But annuities have undergone some big changes in recent years, and I'm changing my mind. So are many other investors, as Mark Miller details in this recent Retire Smart column.
While annuities still are not a perfect fit for every investor, today's annuities can be used to create a retirement income stream that mirrors a pension. Depending on your overall financial situation and your desire for guaranteed retirement income, you may want to consider taking a lump sum from your savings to buy an annuity, which would give you regular payouts in retirement, just like a workplace pension.
Annuities shouldn't make up your entire portfolio. But the investment may be a smart strategy for a portion of your savings.
"It's best to compare annuities with cars," says Peter D'Arruda, a financial advisor in Cary, N.C. "They get better each year and are improved each year to meet the financial needs of individuals. Today, you are likely to find much better guaranteed options with higher returns. Surrender fees and terms have been reduced on the best annuities."
In a nutshell, an annuity is an insurance product that pays out income in the future. You make an investment and receive payments on a schedule -- either immediately or at a later date -- for either a certain number of years or for the rest of your life.
There are several types of annuities.
Fixed Annuities: A fixed annuity will promise a fixed interest rate. These annuities may offer some of the highest fixed interest rates available in the current market. Some include nursing care and terminal illness provisions, which are nice benefits in the event you need to access your money for an emergency. If you want a guarantee that you won't lose money, a fixed annuity is the safest option.
Variable Annuities: A variable annuity will be pegged to riskier investments, such as mutual funds or stock market indices. Variable annuities hold out the possibility of higher returns on your investment, but they have no guarantee that you will not lose your principal because of stock market losses, says Bill Smith, a financial advisor in Sandusky, Ohio.
"For retirees, variable annuities are a bit risky, and we generally do not recommend a retiree own one," Smith says.
Both fixed and variable annuities may fall under the "guaranteed annuity" category. These offer contractual guarantees, such as on an interest rate (5 percent or more), specified income payout, and death benefits, Smith says. Some so-called fixed index annuities are linked to a stock market index, where you're promised to receive the return reached by that index on the upside, but you'll never earn less than a specified rate -- so if the index falls, you won't lose money.
Immediate Annuities: Traditionally, annuities were all "deferred" annuities, meaning the investor wouldn't take a payment until many years in the future. If you're nearing retirement and trying to create your own pension, you'll want to consider an immediate annuity.
You basically pay a set amount for an annuity that guarantees a certain payout, usually monthly, quarterly, semi-annually or annually. Few of these come in variable varieties -- they're usually fixed.
"This is like a pension," Smith says. "You give your money to an insurance company, and they turn it into an immediate income stream."
The benefits of an immediate annuity include reliable income, tax deferral on investments and, with fixed annuities, protection of the principal investment with a minimum guaranteed interest rate.
"Retirees and baby boomers are usually the best candidates for these products because most boomers today will be without a pension when they retire," Smith says. "Using the right annuity could help you develop your own pension in retirement that you can rely on."
How to Invest
Start by consulting a trusted fee-only financial advisor -- someone who does not sell annuities -- to see if the strategy will work with your overall financial goals and means.
Take a detailed look at your retirement expenses and your income sources, such as Social Security. Next, look at all of your retirement savings as buckets -- a short-term bucket for immediate needs and a long-term bucket for the future. An immediate annuity may sprinkle income across your short- and long-term time horizons.
If you determine that an immediate annuity would be a good fit, speak with an insurance professional about the products available.
D'Arruda says when he shops for an annuity for a client, he looks to guarantee daily living expenses and lifestyle expenses so those costs are met for life.
"The guarantees enable us to take more risk with the aggressive, long-term portion of the [retirement] portfolio," he says.
That means you shouldn't tie up all your retirement savings in an annuity. A chunk of your savings would be depleted to purchase the annuity, but you'd maintain other investments -- such as 401(k) or IRA accounts -- to grow for the future, too.
"You never want to put all your eggs in one basket," D'Arruda says. "Annuities are best utilized as part of a diversified plan to meet financial goals."
He likes the buckets philosophy and recommends a combination of safe and aggressive buckets that are viewed as pieces of a puzzle for retirement. He says annuities have been an "overlooked piece of that puzzle," and investors can use the guarantees to work alongside risk-based options such as stocks.
Buyers of old-fashioned annuities often worried about what would happen to the principal balance when the owner died. Back then, the insurance company would keep whatever money was left over after a death. That concern has disappeared for many of today's generation of annuities.
"When you die, the account value moves on to the designated beneficiaries," D'Arruda says. "This goes back to the evolution of annuities. Old annuities required a separate rider to pass on to beneficiaries, but now the best annuities have that as a standard option."
Another traditional concern about annuities was that money would be locked up, and that an account holder would face a multitude of fees to access the funds in an emergency. This used to be true, Smith says. "When annuities were first introduced, you did not have a lot of options available to withdraw money without incurring a penalty," Smith says. "However, almost all annuities will allow you to take anywhere from 10 to 20 percent of your accumulated balance, without penalty, once per year."
Before you buy an annuity, you should ask about:
- Surrender periods: Many annuities have "surrender fees" -- a fee you'd have to pay if you want to pull your money out of the annuity. These can be as high as 8 percent of the balance.
- Commissions and other fees: Make sure you understand all the costs before you buy.
- Withdrawal options: Ask if the annuity has options so you won't face a penalty if you need to access your money.
- What happens when you die: Find out of the annuity will pass on to your beneficiaries when you're gone.
Also make sure you check out the rating and the solvency of the insurance company before you buy, says Linda Homsey, a financial advisor in Winchester, Mass.
"Annuities are not insured by the FDIC or the company selling them," Homsey says. "You want to make sure they are around when you go to collect your money."