In the last 30 years annuities have steadily risen in popularity to the extent that the marketplace is now flooded with annuity products all competing for the same investment dollars. That’s good news for you because with hundreds of life insurers vying for your deposit, you are almost assured of finding high yield annuities. The bad news is that there are hundreds of life insurers all offering a broad range of products which can make the search for the best yields extremely daunting. But not to worry, because finding the best yield may be just a few clicks of your mouse away.
It is important to first understand there’s more to fixed yield annuities than an interest rate. Not all fixed annuities are alike in the way they are constructed, and there are a few moving parts inside of an annuity contract that can complicate an otherwise easy “apples to apples” comparison. If your search was simply a matter of calling up the highest yielding annuities and comparing them side by side, you may be missing out on some very important aspects of the contract. With annuities, what you see may not necessarily be what you get in the long run.
High Yield Annuity Essentials
Taking the Bait
It is a very competitive field, made more so because of the transparency and reach that the Web provides for searching and information gathering. Annuity providers know they may have but one chance to get your attention, so many are willing to promote a very aggressive rate to lure you in. The rate you see is very real, meaning the provider will credit your account with the advertised rate. The problem, in many cases, is that the rate is only guaranteed for a year, after which it is likely to be adjusted downward. They may be willing to pay a high yield in the first year as a loss leader because they can make it up in subsequent years by crediting a lower rate.
It’s not really a bait-and-switch; rather it is a bait with a hook, because once you’re in the annuity contract, you’re not likely to leave. Yes, you can transfer your annuity to another annuity; however, your funds may be subject to a surrender fee when doing so. Why go through that aggravation when you can simply look beneath the hood to see what the minimum rate guarantee is, and also see what kind of formula they use when adjusting the rate. From a long term competitiveness standpoint, this is more important than what you earn on your contract with the first year rate.
Some annuity contracts are set up with multi-year rate guarantees. These offer even higher yields because the contract terms are designed to keep you in place longer. The difference between a one-year rate and a ten year rate can be as much as 3 percentage points! When a provider knows they will keep your money longer, they will be willing to pay a higher yield. And, that can be a win-win, if you understand the terms of the contract. Some annuities offer a multi-year rate, such as 5 years, but the actual guarantee is for 3 years. And, as with the high first year rate guarantee discussed above, it is important to know what the minimum rate guarantee is as well as the formula for the rate adjustment at the end of the guarantee period.
The big concern for multi-year rate guarantees is the direction of interest rates. If you think that rates are going to increase over the next few years, you may be better off going for the single year guarantee with a high minimum rate guarantee. If interest rates do increase, the provider will need to keep its adjusted rate competitive or risk losing your deposit.
Watch Out for Expenses
Some annuity providers are able to offer high yields and multi-year guarantees because they can make up their costs by charging higher expenses. In most fixed yield annuities, the contract expenses are limited to an administrative fee, a contract fee, and a mortality fee. There is not a lot wiggle room for inflating these expenses, but they can still differ by as much as a percentage point from one contract to the next.
The bigger expense to look for is in the withdrawal provision. Annuities do allow for monies to be withdrawn at any time, however, they limit the withdrawal to 10% of the account value by charging a surrender fee for any amount in excess. The fee can range from 5% to as high as 15%, but, typically, the fee declines by a point each year until the end of the surrender period which can last as long as 15 years.
So, here’s the deal. A provider may offer a very high yield and/or a long multi-year rate guarantee; however, they may also apply a much steeper surrender fee along with a longer surrender period. This way, they can recover some of cost of the high yield through excess withdrawal fees. You can’t really fault the provider for this as it seems like a reasonable trade-off for higher earnings. And, since an annuity is a long term investment, you aren’t likely to withdraw excess funds if you planned well.
Look for Break Points
Some annuity providers also kick in a bonus percentage for larger deposits. Break points for bonus yields don’t typically occur until the deposits reach upwards of $50,000 or $100,000, sometimes $250,000. But, if you are planning on splitting up your long term savings among different vehicles, you may want to consider going for an annuity break point. It may be worth it to combine your investments into one annuity if you are able to earn an extra percentage point. On $100,000 that not a small difference.
How to Find the Highest Yields
Armed with the high yield essentials, you can gain instant access to the vast marketplace of annuities by tapping into an annuity product aggregator. These are websites that compile all of the key data on annuity products and providers that enable you conduct side-by-side comparisons. You should be able to find the essential information such as the yield, the length of the guaranteed period, the minimum rate guarantee, the length of the surrender period, the surrender fee schedule, break points for bigger deposits along with all of the options the product offers. The key is to find the right balance of high yield with guarantees and flexibility (withdrawal provisions) that best matches your long term needs.
There are hundreds of annuity products, so you could wind up spending a lot of time and doing a lot of second guessing. One way to narrow the field quickly and eliminate second guessing is to restrict your search to only those companies that have earned the highest rating from the independent ratings agencies. This will narrow your choices significantly and ensure that your money is invested with the strongest and most financially stable life insurance companies. Annuities are among the safest investments you can own, but a little extra peace-of-mind may be worth it.
Annuities have been providing financial security for people for a millennium. As a financial instrument there is none older, and as savings vehicle there are few that more misunderstood. Still, people who are beginning to get serious about their retirement savings are turning to them in record numbers. Because, what many people do understand about annuities it that the can be a source of financial security unlike any other investment. But, clearly, they aren’t for everyone. To truly answer the question, “Should I buy an annuity?” you would have to first seriously consider your own financial situation to determine if it is the right solution for you.
Annuities are more than just financial products. They are financial solutions that fill a need or address a concern, whether it is for tax savings, guaranteed income for life, portfolio stability, guaranteed growth, or simply some peace-of-mind. But, they are also somewhat complex, which is, perhaps, why some people shy away from them. But once you more clearly understand your own needs, priorities and tolerance for risk, it is much easier to consider annuities as a solution, and as a way to fill a need or address a concern. And, that’s the only reason why you should buy an annuity.
What are Your Needs and Concerns
I am concerned about outliving my income: That’s not an uncommon concern. Recent studies reveal that the majority of the American public is extremely anxious about having enough money to last their lifetime. Annuities today offer the same promise as they did to Roman citizens 2000 years ago, and that is that the income generated from a cash deposit, is guaranteed to last as long as you do, regardless of how long you live. Your annuity contract with a life insurance company becomes an obligation, backed by the assets of the company, to make monthly payments based on a cash deposit and your life expectancy. If, as more and more people do, you live beyond your life expectancy, the company is still obligated to make the payments.
I’m concerned about keeping up with inflation in retirement:
This is a concern that many people haven’t really considered. The fact is that, if you do live for 20 or more years in retirement, your cost-of-living will likely double based on the current rate of inflation. It’s one thing to have enough income to last a lifetime, but, if it can’t keep up with your actual expenses, it can make life pretty difficult. Many people are relying up their retirement funds to keep growing in their retirement accounts. In order, for their income to increase over time, their retirement funds will have to be invested in growth investments which are risky.
Most annuities include an option that ties your income to an inflation index so it will automatically increase. Variable annuities offer an option that enables your income to increase in rising equity and bond markets, while protecting it from declines. While these options do cost extra, they can turn out to be priceless when the economy goes sour again.
I’m concerned with the safety of my principal:
As are millions of people who lost significant sums of money in the recent market crash. Even the people with money in the bank lost some sleep when hundreds of banks were closed during the financial crisis. Fewer people are feeling secure about the Federal Deposit Insurance Corporation (FDIC) which could actually run out of funds if too many banks fail at once. Annuities have always been considered among the safest of all savings vehicles. During the Great Depression when customers of failed banks were receiving cents on the dollar, life insurance companies were making their annuity customers whole.
Unlike banks, which are required to maintain a small fraction of reserves on hand to cover immediate obligations, life insurance companies are required to have nearly 100% of reserves on hand in the form of safe, liquid assets. Sure there have been a few life insurance companies that became insolvent, but the states ensure that their reserve requirements will be met by other life insurance companies. Annuities are sleep insurance. For an even better sleep, try to work with companies that have the highest ratings for safety and stability. There are plenty of annuities to choose from among the top 20 life insurers.
I’m concerned about paying too much in taxes from my savings and earnings:
Although tax rates have come down quite a bit in the last few decades, people are still heavily taxed, especially when you combine federal taxes with state and local taxes. The effective tax rate for many people can still reach as high as 50%. When that happens, 50 cents of every dollar of interest earned is lost, forever, to taxes. By keeping that 50 cents working in your investment account, compounding over many years, you can more than double your accumulation, and that will make a huge difference for people who are concerned with accumulating enough for a secure retirement.
Annuities are one of the very few individual financial instruments that allow your funds to accumulate without having to pay taxes on them. Your funds will eventually be taxed as ordinary income when they are withdrawn, however, for most people, the tax rate in retirement will be lower than during their working years. It is important to be aware of the penalty for withdrawing funds too early (prior to age 59 ½), however, if you are saving for retirement that may not be a concern.
I’m concerned with the low yields that my money is earning right now:
Current interest rates are still at historic lows. While that may be an advantage if you’re borrowing money, it makes accumulating money very difficult. Fixed annuities do offer yields that are higher than other safe savings vehicles, such as CDSs; however, if you want your money to work harder without much additional risk, then you could consider an indexed annuity or a variable annuity with optional guarantees. With an indexed annuity, your yield is linked to a stock market index, so if the market rises, your yield can rise. Although there is an upper cap on the yield (in the range of 5% to 8%), there is also a minimum rate guarantee, so, even if the market index declines, you will still earn a positive return. The funds in variable annuities are invested in stock and bond accounts, so there is market risk involved; however, many variable annuities offer an option that will guarantee a minimum rate or a minimum withdrawal amount based on your principal. These options do cost extra but they enable you to enjoy the upside without concern for the downside.
There’s much more to annuities that you will need to know – there are expenses, withdrawal provisions, different savings options, as well as the fact that there are hundreds from which to choose. However, your most important consideration in determining why you should buy one is how it will help you address your needs and concerns. If you share one or more of the concerns listed here, an annuity may be right for you.
Retirement savers are starting to get serious. After years of saving at anemic levels, and then suffering through one of the worst economic downturns in our history, people of all generations are gearing up, and, as evidence, last year saw a record number of variable annuity purchases. The resurgence can be attributed to some of the new features that have been introduced over the last several years which make variable annuities extremely attractive to risk-oriented and risk-adverse investors alike. With new options available that can guarantee income, withdrawals and even principal, variable annuities are as close as any investment to becoming the “best of all worlds”.
Even with that, variable annuities are not for everyone. It is recommended that only those people with an understanding of how investments work and are familiar with market risk consider them. As with any investment tied to the fluctuations of the markets, variable annuities are not the type of vehicle that you can set and then forget. In order to maximize the long term return opportunities, and to optimize the product to best fit your needs, the investments within a variable annuity contract require at least a moderate level of management. Establishing the proper diversification and balance to match your investment profile is the first, critical step. But, once the investment accounts go to work, they will almost certainly require ongoing management to maintain the proper level of diversification and balance.
Let’s consider an example of a variable annuity investment allocation. The investor is in his late forties. With 20 years on his time horizon, he is able to accept a moderate level of risk in order to increase his potential return, so he creates a balance that is heavily tilted towards equities, but only 20% is allocated toward higher risk stocks. With his initial deposit of $100,000, he allocates the funds among five different investment accounts: $30,000 in a large cap growth account; $20,000 in an international stock account; $20,000 in a balanced growth and income account; $20,000 in a corporate bond account; $10,000 in a fixed income account. It is well-balanced between growth potential investments and more stable income oriented investments – about 70/30 which is appropriate for his age.
During the course of the next year, the international markets flourish and the international stock account increases by 20% . The large cap fund also increased by 12%. Because the stock and bond markets don’t always move in the same direction, his income oriented accounts, the balance account and the corporate bond account decreased by 6%. So, at the end the year, his allocation now looks like this: International stock account – $24,000; large cap growth account – $33, 600; balanced account – $18,800; corporate bond account – $18,800; fixed account – $10,400. The balance between growth and income has changed to about 75/25.
While the increase in his growth accounts is a positive thing, the fact that his portfolio balance is more tilted towards growth means it no longer matched his investment profile. If the same trend were to continue for the next couple of years, the portfolio can get further out of balance. As long as the markets are working in his favor, there may be a temptation to leave well enough alone. However, should they turn against him, his portfolio has greater risk exposure than he may be willing to tolerate. In order to ensure the portfolio matched his risk tolerance, he needs to re-balance his accounts by moving funds from his growth accounts into his income accounts to achieve the 70/30 balance. It is also important to keep in mind that, as he gets older, he may want to adjust his balance for greater emphasis on the stable, income accounts, which may require more re-balancing.
The other reason to balance your accounts is to ensure that you lock in any gains. If, after that first year of gains in the growth accounts, the markets turned and declined by 20%, the prior year’s gains would be wiped out. By adjusting the accounts, moving some of the gains into the stable accounts, he could minimize the losses or even achieve more gains if the stable accounts performed well.
Variable annuities are ideal, because they do allow you to transfer funds between the accounts several times a year without charge, and better yet, with no tax consequences which is not the case when transferring between mutual fund accounts.
It’s a Balancing Act
One of the main criticisms of variable annuities are their high expenses, sometimes averaging as much as 1.5% more than a mutual fund. And, if you add any of the guarantee options, it can add another .05% to 1%. Investors who have been ravaged in the markets probably won’t mind paying the extra cost for the peace-of-mind of those guarantees. But, it makes it all the more important to ensure that you are maximizing your investment returns while maintaining the proper balance in your portfolio. The race to retirement is not a sprint, it is a marathon which requires thoughtful pacing and steady progress. There is no need to take big risk if you are able to achieve consistent, stable returns. And that is best achieved through a well-balanced portfolio.
In the wake of the recent financial crisis, retirement concerns are mounting for all generations. As people’s focus turn to shoring up their retirement future, all savings options are, once again, on the table, and the one option that is garnering the most attention, by savers of all ages, are annuities. Anxious savers are discovering, or re-discovering, the advantages of annuities for savings flexibility, tax benefits, safety of principal, growth guarantees, and income guarantees. To their chagrin, they are also discovering that the choice of annuity products is not that simple based purely on the number of different annuity products that have proliferated in the last decade. As with any critical purchase, determining the best annuity product for you should come down to what’s most important to you.
Narrowing Your Choices
Getting past massive confusion of the myriad of annuity products on the market, the one thing the annuity providers have done right is to create an annuity product for just about everyone. Those seeking absolute safety can select fixed annuities with guaranteed rates and safety of principal. Those who understand market risk and want to make their money work as hard as possible can allocate their funds among several different types of investment accounts within a variable annuity. And, for those who have a low tolerance for risk, but want to do better than low fixed yields, an indexed annuity is an ideal choice. For those seeking the ultimate balance in risk and growth, the best solution may be some combination of the three.
Before you begin your search for the best annuity product, it is vitally important to spend the time to fully understand your situation and objectives. All deferred annuity products offer tax deferral, guaranteed death benefits, guaranteed minimum growth (this may only be offered as an option in some variable annuities), and, ultimately guaranteed income. Beyond that, the different products vary greatly in their savings options, withdrawal flexibility, expenses, and their level of safety. The only way to quickly narrow down your choices is to conduct a thorough assessment of your needs, your concerns, your risk tolerance and your priorities. While your particular situation will vary from the next person, this investment profile guide can give you an idea of how to go about narrowing your selection.
Zero risk tolerance:
If you can’t stomach the possibility of getting back one dime less of your principal, and you are willing to except lower returns on your investment, then a fixed annuity with guaranteed rates is your best bet. Fixed annuities are considered to be among the safest of all savings vehicles, but it couldn’t hurt to look at products from only the strongest and most financially stable life insurance companies. Stick with an A+ rated company and you’ll have the ultimate peace-of-mind.
Moderate risk tolerance/Need for higher returns:
With the introduction of indexed annuities, life insurers have provided one of the best solutions for people who don’t mind some fluctuation in their account balance if it comes with the potential for higher returns. Indexed annuities actually, go one step better by locking in your principal while applying rates that are tied to a stock market index. Because they cap the maximum rate you can earn, you won’t capture the total return of the index. But, you also won’t incur any losses in years when the index declines. Essentially, index annuities are all gain with no pain. You can expect moderately higher yields than those on fixed annuities. Again, the guarantees available in indexed annuities are as secure as the company that backs them – stay with highly rated insurance companies.
Moderate to high risk tolerance/Seeking high returns:
If you are a stock or mutual fund investor, and you understand the risk-reward equation, variable annuities can give you the same opportunity for growth with the added benefit of tax deferral. As with any mutual fund, performance varies from one annuity provider to the next as do the investment choices that are available. Variable annuities offer the same opportunity for achieving portfolio diversification and balance among different asset classes for optimizing long term growth potential.
Some variable annuities also offer options (at an additional cost) that provide principal guarantees, minimum growth guarantees and even minimum income guarantees, any of which virtually eliminates the risk of investing in the markets. Expenses can be somewhat higher than other types of investments, as much as 2% annually over mutual funds depending on how many guarantee options you add, but, for many investors who suffered through two steep market declines within 10 years, the peace-of-mind could be priceless.
The one certainty in life is change. Through time, needs change, risk tolerance changes, priorities change. While annuities are long term investments, they do offer some flexibility. All annuities offer investors the opportunity to access their funds through withdrawal provisions. If the annuity is held long enough, this can be done without incurring any charges (not including a possible IRS penalty of 10% for withdrawal prior to 59 ½). In the early years of the contract, a fee may be applied if the withdrawal exceeds 10% of the account balance during the surrender period which can last as many as 10 to 12 years.
The highest level of flexibility can be achieved by taking a portfolio approach to annuity selection. By combining annuities with different investment characteristics, you can more achieve a closer match to your investment profile. A combination of fixed, indexed and variable annuities can be arranged to match your risk tolerance while optimizing your opportunities for growth. The only way to truly counter all of the risks, including market risk, inflation risk, and interest rate risk, is to achieve optimal diversification and balance with all of your assets.
At no other time in our history has the need for retirement planning been more critical. Tens of millions of Baby Boomers will be crossing the retirement threshold unprepared and underfunded, and the generations that follow are not on track. It’s beginning to hit home for people that , if a comfortable, secure retirement is to be, then it is up to thee. And, this is why it is vitally important to have a thorough understanding of all of the tools in the arsenal. There is no “one size fits all” for retirement solutions, and there is no one single vehicle that will get the job done. The option should no longer be framed as Annuities vs IRAs vs 401(k), but rather, Annuities + IRAs + 401(k)s as a more complete solution for retirement.
Combining the three may not be an appropriate strategy for everyone. Not everyone has access to a 401(k) plans, and for those who do, not everyone may be eligible to make a tax qualified IRA contribution. While, anyone can own an annuity, it may not always fit their financial situation. But, where the strategy can fit, creating a retirement portfolio using some combination of these vehicles could produce the best long term results. Let’s examine them separately, then together as a multi-pronged strategy:
The Annuity Component
Annuities are non-qualified retirement vehicles, which means that contributions are not currently tax deductible. They do, however, allow for funds to accumulate tax-deferred. Unlike qualified plans, there are no limits to how much can be contributed to annuities, and, on the other end, there is no required minimum withdrawal (RMD). Like their qualified plan cousins, annuities do have some restrictions on early withdrawals, prior to age 59 ½, in which the IRS will apply a 10% penalty. Additionally, annuities also have surrender penalties that are applied by the annuity provider if funds are accessed early in the accumulation phase, generally the first seven to 10 years. The penalty, which can begin as high as 10% is reduced each year of the surrender period until it is reduced to zero.
From a retirement planning standpoint, annuities provide two primary advantages. First, the tax deferred component works to the advantage of younger people with time to accumulate. If the retirement horizon if 15 years or more, tax deferral can give savers in higher tax brackets an edge. Secondly, annuities have an income component that can guarantee that a retiree will not outlive their income. The amount of the income is based on the accumulated capital, the age of the retiree and his or her life expectancy. Payments can be guaranteed for a specified period of time, or a lifetime.
The IRA Component
There are two types of IRAs – traditional and Roth. Both are tax qualified retirement plans, but each has a different tax treatment. Both IRAs allow eligible people to make tax deductible contributions up to $5,000. In a traditional IRA, the contribution is tax deductible, while in a Roth it is not. In a Roth, withdrawals are exempt from taxes, while in a traditional IRA, the withdrawals are taxed as ordinary income. The decision as to whether to invest in a traditional or Roth IRA should come down to your tax situation. If you are in a higher bracket currently, and expect to be in lower bracket in retirement, a traditional IRA could be more advantageous. Otherwise, a Roth would be more favorable for people if they expect their retirement tax bracket to be about the same as it is today. Plus, a Roth IRA has greater flexibility for people who want to make early withdrawals as contributions are the first to come out and are, therefore, not taxed, nor penalized.
Not everyone can qualify for an IRA. If you participate in an employer sponsored plan, you may not be eligible depending on your adjusted gross income. If your income is below $56,000 you can still invest in an IRA with full tax benefits. If your income is above$66,000 (as a single filer) your contributions will not be tax deductible. Roth eligibility is a little more flexible for 401(k) participants but there are still income eligibility requirements.
The 401(k) Component
Participants in a 401(k) plan benefit from easy payroll contributions, current tax savings, tax deferred earnings, investment choices, and, in many plans, an employer matching contribution. Between the tax savings and the employer match, participants receive an instant return on their contributions, so it is always advisable to participate in a 401(k) plan. You can contribute up to $16,500 from your earnings.
Putting them Together
When putting together your retirement portfolio, your initial focus shouldn’t be on specific products or vehicles; rather it should be on what it is you really want to have happen in retirement. People looking for the highest degree of security and flexibility need to consider how different retirement components can work together.
For 401(k) participants, it is advisable to contribute the maximum eligible amount. This increases your current tax savings while boosting your ability to stay on track to your accumulation goal. The same advice applies to those who are eligible for an IRA. In either case, these vehicles provide the best opportunity for maximum accumulation which is the most important aspect of retirement planning.
For those people who are concerned with the possibility of outliving their retirement income sources, serious consideration should be given to contributing, in addition, to an annuity, especially if you have reached the maximum level of contributions to your qualified plans. While annuities can also be advantageous as accumulation vehicles, they provide a critical retirement planning element the qualified plans don’t – absolute future security. The guarantees that are built into annuities, such as guaranteed principal, guaranteed growth, guaranteed income, can create the essential safety net everyone needs and may have to rely upon if there is any disruption in your accumulation.
A sound retirement plan should be thought of as an overall strategy built around your specific needs, concerns, and priorities. For most people, no one vehicle can address all of their needs, but a well-conceived strategy employing multiple vehicles can almost always do so.