Most workers today envision a comfortable style of living once they retire and work toward that glorious time in their life. The generation of workers that built solid pension plans to fund this anticipated comfortable lifestyle have mostly passed on and the generations that are replacing them are not able to depend on the same type of pension largely due to a regulatory environment that has deflated the dream of yesterday.
Companies are now pitching highly regulated products known as deferred-income annuities, which will allow the individual earner to create their own sense of well-being when they have decided they no longer wish to participate in the worker’s race to the top. Typically, the consumer (worker) will pay a lump sum of money to an insurance company or pay into the plan over time, in exchange for a paycheck for the rest of their life.
The worker has no way of knowing for sure if this annuity purchase is a perfect way of accumulating retirement funds because they cannot possibly predict how long they will live after the distribution begins. Even with taking this unpredictability into consideration, the annuity could be the best answer to providing some form of certainty during the retirement years.
For the conservative investor wondering what they will do for a financially secure retirement, they consider that bonds will not deliver the returns they need, and equities are too risking for their liking. So then, the annuity fits right in the middle and brings peace of mind since the risk is much lower, and returns are higher. Yes, you will need to invest significant sums to generate the income you’re striving for, but the cost will decline the longer you wait to access the funds. Take, for example, a male who purchases an annuity at age 68 and promptly begins to collect a lifetime income of $12,000 a year or $1,000 a month. That is going to set him back about $170,000. Purchasing the same annuity ten years earlier and then waiting until age 68 to make the same $12,000 annual withdrawal would reduce the investment required to $100,000 or $70,000 less. If he waited an additional ten years, age 78, the cost would be reduced even more, to $40,000.
The popularity of annuities has allowed three major players to rise to the top. According to Limra, MassMutual, New York Life, and Northwestern Mutual account for over 90% of the deferred –income annuity market in 2013, and there are more players entering the race every year with new products that are gaining significant traction in the marketplace.
It’s interesting to note that deferred-income annuities have been around for quite a while and are not new. Historically, they were marketed as a type of longevity insurance to insure against outliving a retirement plan. They were purchased at or near the age of retirement, but withdrawals were postponed until the annuitant was about 85. The insurance companies were very much in favor of this approach since most annuitants did not live long enough to exhaust the original investment which created solid profits for the product. This approach did not sit well with consumers, however, because the idea of coughing up a large chunk of money that may or may not have ever been withdrawn seemed unattractive.
Purchasing retirement income when retirement is clearly on the horizon requires less guessing. For example, some people will choose to purchase an annuity to fund their basic living expenses, such as housing and food, because they have a good idea of what their income sources might be and then potentially close any remaining gaps with income insurance. Consumers must understand that it is insurance and that there is always a cost for that guarantee.
Deferred annuities are still considered to be a great deal for those who delay making withdrawals because half of the consumers purchasing them will probably die earlier than their life expectancy. This means that the unused premiums remain in the insurer’s pool of money resulting in a benefit to people still receiving withdrawals, thus resulting in greater returns on their investment than what would have been made in the markets.
“No matter how good a cook or an engineer you may be, you can’t bake this in your own kitchen,” said Moshe A. Milevsky, a finance professor at the Schulich School of Business at York University in Toronto, who said he would wait to begin collecting until 70, or even later.
It is no secret that there are many people that are sincerely reluctant to part with such a large amount of money and, as a result, the insurers sell options, although somewhat pricey, to help make people a little more comfortable with their decision. A typical example would be if an annuitant dies before receiving withdrawals of sometime after that, the heirs would not receive the remaining funds unless the annuity owner opted for the cash refund feature.
This is a very popular option that most people purchase even though it may add over 10% to the premium. Other options have become available so that the $12,000 income example used earlier, adds quite a bit more to the $170,000 cost of a lifetime of income. It’s almost as if purchasing all the bells and whistles for the annuity turns it into an expensive bond fund.
Another risk that should be considered is that the annuitant is relying on the unwavering financial stability of the insurer for many years into the future. However, in almost every state the insurer is part of the guarantee association that would step in to pay claims in the event the insurer goes belly-up but not every state guarantees the actual balance of the fund.
The annuitant should also consider the rate of interest being paid. Insurance executives state that consumers can buy the income over time to offset locking in only today’s rates, however, rates would to increase significantly in order to have a major impact on income. Certainly, with any investment vehicle, there are tax issues that must be considered. The tax liability will depend on whether the annuity was purchased using after-tax dollars. By purchasing with after-tax dollars, the annuitant gets back benefits equal to the contributions paid in on a tax-free basis since those funds (basis) have already been taxed. Once the basis funds have been withdrawn, any remaining funds are fully taxable which can cause a financial shock to the annuitant if not taken into consideration when the retirement plan was developed.
If the annuity is purchased with before-tax dollars, then the benefits withdrawn will be fully taxable. The rule will apply for benefits from a public or private pension plan that does not contain employee contributions, a 401k account accumulated from employer contributions or employee deferrals, or a traditional IRA funded with before-tax dollars.
The early distribution rules must also be taken into consideration along with how the IRS treats annual minimum required distributions after age 70 ½.