When to Convert Your Savings Into an Annuity

When investment markets are volatile and you can’t afford losses, annuities can be a solid option.

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The stock market remains the most attractive place for most investors over the long term, beating out bonds and other low-risk investments. However, to earn those higher returns, investors face more volatility. Last week's string of losses is a case in point, lest anyone has forgotten the market plunge of 2007 and 2008.

Many older investors simply didn't have enough time before retirement to risk a big loss. Even investors who are confident they can earn superior returns from stocks may reach a point where they want to lock in some of their gains in case the markets turn fickle.

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Fidelity Investments recently laid out a compelling illustration of how uneven market performance would affect two investors. Fidelity presented a 21-year cycle of annual market gains and losses. At the end of 21 years, the market had achieved identical percentage gains and losses each year. But in the case of one investor, annual losses were bunched in the early years, while market increases occurred later on. For the second investor, the pattern was reversed.

Beginning with $100,000, each investor took out $7,000 a year in retirement income. For the investor who experienced early market declines, the portfolio was exhausted by year 13. For the second investor, however, early investment gains bolstered the portfolio against later losses. Total holdings, even with $7,000 annual withdrawals, reached a peak of more than $580,000 in year 18. Even after absorbing three poor years, the portfolio still held more than $350,000 at the end of year 21.

To avoid the risk of an ill-timed market downturn, Fidelity suggested retirement investors consider using some of their nest egg to purchase an annuity. By buying a slice of guaranteed lifetime income, it said, investors could be protected from future market declines while locking in a portion of their retirement needs.

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Fidelity has lately boosted its emphasis on annuities to generate retirement income, and it's hardly alone. Annuity sales rose 17 percent in 2011's first quarter from the year-earlier period, and were also up more than 5 percent from the fourth quarter of last year, according to the Insured Retirement Institute, an industry trade group.

Still, annuities are very much an acquired taste. Many investment advisers do not like their high fees or the prospect of tying up client funds in a relatively illiquid investment.

The bulk of annuity sales are of variable annuities (VAs), which allow investors to place assets in mutual funds and therefore participate in stock market gains. VA assets hit a record $1.6 trillion at the end of March, the Institute said.

However, most VA contracts are sold long before their holders begin using them to generate retirement income. By contrast, fixed annuities, which promise guaranteed rates of return when first purchased, are more heavily used to generate lifetime income payments.

Fidelity is recommending a deferred variable annuity that includes what's known as a guaranteed lifetime withdrawal benefit (GLWB). It allows investors to participate in future market gains while still protecting them from market declines.

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Jeff Cimini, president of Fidelity Investments Life Insurance Co., said in an interview that investors who have come of age using 401(k)s and other defined contribution plans want to continue to have some control over their assets and that GLWBs provide that control while still guaranteeing lifetime income payments.

If you decide at age 60 to buy a GLWB for $100,000, Cimini says, Fidelity will charge you a fee of $1,900 a year if the product covers only you, or $2,500 a year if you want the product to provide income for your lifetime and that of a surviving spouse.

In exchange for this money, you are guaranteed annual income payments of $5,000 a year. Fidelity puts your $100,000 into a balanced mutual fund that has 60 percent of its assets in stocks and 40 percent in bonds. This fund also charges annual management fees of about 80 basis points, or 0.8 percent. But as Cimini notes, you'd be paying fund management fees even if you decided to forego the annuity and keep your $100,000 in the market.

On each anniversary date of your annuity, the following year's 5 percent payout guarantee is reset, and will equal 5 percent of either your original $100,000 or of the actual account value as of the anniversary date, whichever is larger.

In the case of a $2,500 annual fee for a joint survivorship annuity, the net value of your annuity's balanced fund investments would have to rise by about 7.5 percent to maintain its $100,000 value. In other words, it would need to rise by enough for you to get your $5,000 guarantee and pay the $2,500 annual fee.

Now, if the market value of your account rises by more than this amount, the resulting total will become the new floor for your payments for the rest of your life (and the life of your spouse). Let's say it rises by 9.5 percent and totals $102,000 at the end of the year. You will then be promised annual payments of 5 percent of $102,000 every year.

If the market does poorly and your account value slips below $100,000, you'll still be promised $5,000 in annual payments (5 percent of the funds you first placed into the annuity).

Cimini says a GLWB variable annuity would not usually pay as large of a monthly payment as a fixed annuity. But fixed annuities provide no possibility of leaving an asset for heirs, and also do not allow for possible market increases, as do GLWB variable annuities. "If you're impervious to leaving a legacy," he says, "a fixed immediate annuity is a better way to go."

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Even if the cost and terms of an annuity contract seem attractive, there are some fundamental questions that need to be addressed before buying an annuity:

1. Annuities are illiquid. If you change your mind about an annuity contract, there may be steep fees for the early sale of the annuity. Can you afford to leave your annuity funds untouched for a long time?

2. Are you so far away from retirement that it would be better to leave your retirement funds in the market?

3. What are the financial and tax consequences of assembling the funds needed to buy an annuity? Annuity gains are free from taxes until the product "annuitizes," or begins generating retirement income. So, they are particularly attractive in taxable portfolios. That's because investment gains in tax-deferred retirement accounts are already tax-exempt. However, if you need to sell taxable investments to buy an annuity, make sure the annuity still makes sense.

4. Annuities are particularly helpful when it comes to paying fixed retirement expenses such as housing, utilities, and other essentials. If you already have enough income from Social Security and pensions to pay your fixed expenses, do you really need another layer of guaranteed income, or would you be better off leaving your funds in the market?

Twitter: @PhilMoeller