By Jon Meyer, CFP®
Key takeaway: Annuities can play a role in your retirement portfolio, but they can also offer you the “opportunity” to use your own money at a higher expense.
When people are getting ready to retire, their biggest concern is usually “Have I saved enough even to retire?” If their answer is no, they start looking for a way to turn that no into a yes. And in their desperate search for financial security, they may buy a “solution” that hurts them more than helps.
Often, one such “solution” is an annuity.
The Variable Annuity
Annuity salespeople will point out the many benefits of such-and-such annuity, but they often fall short on cataloging its faults. As an example, let’s take a look at variable annuities.
Now, with a fixed annuity, your money is placed in a fixed account paying a steady interest rate. But with a variable annuity, your cash is invested in stock market funds—with a twist.
To assuage your fear of running out of money in retirement, insurance companies will promise benefit guarantees, such as the guaranteed minimum withdrawal benefit (GMWB). With a GMWB, you are guaranteed a certain withdrawal rate based on how much you put in, no matter how the market does. So assuming a 5% withdrawal rate, if you put in $200,000 and your account drops to $180,000, you will still be allowed to withdraw $10,000 that year (5% of $200,000).
Look Under the Hood
That sounds great to retirees who need a steady source of income. But digging deeper reveals problems. First, you will pay for that guarantee in the form of a fee—.6% to .85% usually. That number might not seem like much, until you realize it can almost double the expense ratio of your annuity.
Second, your guarantee kicks in only if you run out of money. When your account hits $0, then the insurance company will start paying you. Until then, you’re just using your own money—and with higher expenses to boot.
Third, if you pull out more than the guarantee, your following year’s guarantee will be reduced. And finally, your annuity income stream most likely won’t be indexed for inflation, so you will be losing spending power as inflation rises.
Annuities are taxed on what is called a LIFO (last in, first out) basis. If there’s a gain on your original contributions, you can expect your initial distributions to be taxed at income tax rates rather than capital gains rates, which tend to be lower.
Sometimes your salesperson may pitch the idea that you should add your annuity to an individual retirement account (IRA). But IRAs are already tax-deferred, and adding a tax-deferral product like an annuity adds no value, just expense.
Are There Any Good Annuities?
Annuities do have a place in retirement. For example, if you have a corporate pension, then that is just an annuity.
Moreover, I believe that immediate annuities, in which you put a lump sum and start receiving income for the rest of your life, can serve as an anchor in your retirement. Yet few of our clients ever use them since the decision is irrevocable.
On the other hand, you could do well in retirement without an annuity at all. You will have to research your situation carefully (or talk with your financial advisor) to consider whether one is right for you. My advice? Do not let the fear of not having “enough” for retirement short-circuit your decision-making. By reflecting rather than reacting, you can be in a better position to understand and invest in products that truly help you in retirement.