Converting retirement account holdings into actual income can require even more work than accumulating savings in the first place. There can be thorny tax considerations and challenging timing issues about when to sell a security. If you need predictable and steady monthly income payments from your retirement investments, you need to create and manage a process to do so.
Annuities, by contrast, can do nearly all this work for you. You still need to convert retirement account holdings into the money needed to buy or fund an annuity. But once the product is in place, it can provide steady and guaranteed payments for the rest of your life. Annuities also often include death benefits and other insurance features that may make sense to you. In exchange for all these features and certainty, investors traditionally have put up with high fees, stiff surrender charges for voiding their annuity contract, and cumulative returns that can be tame compared with stock market gains.
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Demand for annuities has recovered from the dismal levels following the stock market decline in 2007 and 2008. Many insurance companies that sell annuities (they are considered an insurance contract) have begun lowering annuity ownership costs. And as millions of baby boomers reach retirement age this year, their need to generate reliable retirement income is providing solid underlying demand for the products.
Annuities are complicated, and have no shortage of detractors as well as supporters. Some advisers shun them in favor of traditional retirement portfolios, citing their high fees and often lackluster returns. After the market crash, however, the guaranteed minimum returns promised by many annuities protected owners from serious losses, and won converts to the product. They also remain the only standardized private product that can provide what most retirees want—regular and guaranteed income payments for life. (Annuity performance guarantees are made by individual insurers and may be backstopped by state insolvency funds. Annuities are not insured by the federal government, as are bank account deposits.)
"What investors really need to understand is what is the benefit they're really looking for," says Tim Holmes, a principal with Vanguard Annuity Insurance & Services. Vanguard has been expanding its annuity services as part of its retirement offerings. With many of the big mutual fund company's customers nearing retirement, Holmes explains, it makes sense to offer more options for generating income upon retirement.
"You should understand what the benefit is, and whether it's a benefit you need and are willing to pay for," he says. Annuity contracts may bundle benefits together, he explains, making it difficult for investors to see the cost of exactly the benefits they want in their annuity. As with all financial products, consumers should not make a commitment unless all their questions are answered. "The big trade-off is that you're giving up" the dollars used to buy the annuity to the insurance company, Holmes says. "Once you put money into an annuity, it's not easy to get it out." So, make sure you will not need access to these funds for some time before putting them into an annuity contract.
There are three primary attractions for annuities, Holmes explains. First, any investment gains from an annuity contract are shielded from taxation until investors have triggered the annuitization phase of the contract, and have begun receiving regular annuity payments. For people who have already made all allowable contributions to 401(k)s, IRAs, and other tax-deferred retirement programs, annuities can be an attractive option for achieving additional tax protection. Second, the guaranteed income streams from annuities may be appealing, particularly to investors concerned about outliving their funds. Third, Holmes says, the insurance elements of the product and other minimum payment assurances are of interest to many Vanguard customers.
When investors know the types of annuity benefits they want, they then can look at the different types of annuities and see if any meets their needs. Vanguard offers user tools and information on variable annuities (VAs), immediate income annuities, and fixed deferred annuities. (A fourth type of annuity is an equity index annuity, which offers some of the security of a fixed annuity and the possibility of higher returns linked to stock market performance.)
VAs are often called mutual funds with an insurance wrapper, as they permit investors to place their annuity funds in various mutual funds and increasingly, exchange-traded funds. Investors have higher potential return with VAs than other annuities and can help offset the risk of investment losses with a range of payout guarantees.
Immediate income annuities are usually purchased with a lump-sum payment and begin generating regular income payments right away. Investors know at the time they buy the annuity what their future payment stream will be. Income can be taken for life by the investor or for the life of the investor and his or her spouse. They also can be taken for specific periods, which will provide higher payments than an open-ended lifetime income stream.
Fixed deferred annuities are designed to begin making payments at a future day. In the interim, the fixed nature of the product means that investors are guaranteed a specific rate of return on their investment. During the build-up or accumulation phase of these annuities, Holmes explains, there is a reset of the guaranteed rate of return, typically every five years. Investors can renew their commitment at that time or make another arrangement if they find the new rate unattractive.
Vanguard recently launched a VA cost comparison tool that includes the basic VA features and costs from other insurers. You need to enter a specific annuity contract to launch the tool, but it is possible to pick different contracts and see the underlying fees from many VA providers. Vanguard offers what it touts as a very low-cost VA, and Holmes says the company has successfully used the tool to win conversion business from owners of other VAs.