More About Annuities
Annuities have long played an important role in people’s retirement planning. As far back as the Roman Empire, people have relied upon annuities to secure an income they can count on. But, as with other types of investments, they have had their ups and downs as far as popularity. If you trace their history, it seems as though their appeal increases during times of economic distress or uncertainty. For instance, during the Great Depression, annuities were the savings vehicle of choice, largely because the life insurance companies proved to be the financial stalwarts as the rest of the financial system was crumbling around them. Now, in the aftermath of the Great Recession, annuities are once again seeing resurgence as investors peer into the uncertain economy that lies ahead. People, as well as financial planners, are rediscovering, or, for the younger ones, discovering for the first time the important role of annuities in securing their financial future.
Annuity products have come a long way since the Great Depression. Their basic, time-tested structure remains the same – a contractual obligation of life insurers to provide principal protection, minimum rates of growth and a guaranteed income, in return for a capital investment – but, due to the proliferation of annuity products and increased competition among the providers, these are no longer your grandfather’s annuity.
The Uncertainty of Certainty
As annuities explained gained in popularity over the years, the number of products increased and the race was on for providers to make their products more attractive and more competitive. Each product iteration introduced new features, new options, more guarantees and more reasons to invest in annuities. But, these wonderful innovations are sometimes overshadowed by the added complexity they create. And, today, investors are faced with a near impossible choice of hundreds of annuity products and deciphering all of the features, options and expenses. So, for people looking to instill more certainty in their portfolio, they’re facing more uncertainty in searching for the right annuity for them.
Matching an Annuity to Your Investment Profile
Knowing how much you need to invest, your time line, the level of risk you can take, the advantage of tax savings, and your overall investment preferences will enable you to narrow down the choice of annuity products by matching them with your overall investment profile. Here is a brief guide for evaluating different types of annuities in light of different investment profiles:
If you are absolutely adverse to market risk, where you can’t tolerate the possibility of a loss of your principal, or if you are trying to counter the volatility of your stock portfolio, a fixed annuity offers the greatest amount of certainty with guaranteed returns and safety of principal. It is important to consider all forms of risk when selecting your investments because a portfolio weighted towards low or zero market risk will be vulnerable to inflation risk which could keep you from achieving your long term objectives. Fixed annuities are the easiest to understand and have the least amount of expenses; however, it is important to know understand the rate guarantee and how rates are determined when they are reset.
Indexed annuities offer nearly the same degree of safety as fixed annuities but are a bit more complex which, for some investors, may be a concern. They are, essentially, a fixed yield product as well; however, the yield is determined each year based on the movement of the stock index to which it is linked. If there is a gain in the stock index, the yield that is credited will be based on some portion of the gain. The yields are capped so that you will never earn more than the stated cap. For instance, if the stock index gains 20%, and your annuity contract allows you to participate in 70% of the gain, the annuity yield could be 14%. However, if the stated cap is 8%, your account is credited only 8%. On the flip side, the contract will also have a minimum rate guarantee that ensures your account will always have a gain.
If your investment profile is such that you want to seek higher fixed yields, without additional risk, an indexed annuity may be right for you. However, if you are adverse to investment products that are more difficult to understand, you may find an indexed annuity unsuitable.
If you understand how the markets work, and you have some experience investing in mutual funds, perhaps in your 401(k) plan, variable annuities can be a great complement to the growth portion of your portfolio. The advantage of a variable annuity that appeals to some investor profiles is the tax deferral of earnings. If your income places you in the higher income tax brackets you could benefit from keeping more of your earning working for you before they are taxed at withdrawal. Some variable annuity products now offer additional guarantee options that can substantially reduce your downside risk, but they also add to the expenses of the product. Variable annuity expenses can run as high as 2.5% when they include any of the additional guarantees, but, for some investors, the potential to earn market returns with minimal risk is worth the additional cost.
Narrowing Your Selection
Once you have decided on the type of annuity product, it becomes easier to compare between the different providers. Expenses, rate guarantees, caps and participation rates (indexed annuities), withdrawal provisions and surrender fees, and can be compared in an apples-to-apples fashion. One of the quickest ways to narrow your list is to establish a criteria for the quality of the provider. For instance, if you decide that you only want to work with providers who have the highest ratings from the ratings agencies, you can narrow your list to about 35 out of more than a hundred. The higher your ratings criteria, the more narrow your list. For instance, if you decide to only work with providers who have earned an A+ rating from A.M. Best, your list could be reduced to 20. Not only will this reduce your time and effort, it will increase your confidence in your annuity selection.