Annuities Can Play an Important Role in Your Retirement Plan

Many people view their retirement plans as one-dimensional portfolios but that couldn't be further from the truth. You can have include several components in your retirement plan - including annuities.

Let's discuss the role annuities play in your retirement BIG PICTURE. Names and personal information are excluded to protect privacy. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Q: Is it a good idea to invest in fixed annuities as a retirement plan strategy? Will I lose money on an annuity in the long run?

A: An annuity is another way to get tax-deferred growth outside of IRAs or other employer-sponsored retirement plans. It's a useful tool that provides additional income upon retirement – but only one of many. Let's talk annuities.

Fixed Annuities

Fixed annuities are life insurance company products that provide minimal insurance protection during what is called the "accumulation phase." During this phase, they earn interest which compounds until it reaches the annuity's "cash value." If the owner dies, the cash value will be paid to beneficiaries. In retirement, the annuity owner selects a life income option that is paid as long as the owner lives…a guaranteed income benefit for life.

Annuities have no upfront sales charges or commission. However, annuities do have early withdrawal fees that the insurance company keeps if money is withdrawn during a certain period, usually 5-7 years after the annuity is purchased. These withdrawal fees are in addition to any taxes or tax penalties that may be due when money is taken out of an annuity prematurely. Of note, if the interest rate paid after the guarantee period is no longer competitive, the annuity can be exchanged for another fixed annuity from a different insurance company.

Interest earned by fixed annuities is income tax deferred until payments are received from the annuity. Each payment includes a partial return of principal, thus, only the interest portion of the payment is taxable income. But like IRAs, if withdrawals are made before age 59 1/2, extra tax penalties may apply.

Variable Annuities

I’ve had a personal experience with a variable annuity, which is also a contract with an insurance provider but includes both a self-directed investment component and an insurance component. Its intended purpose is for retirement. Unlike the earlier mentioned fixed annuity in which the insurance company invests your funds and provides you with a specific guaranteed return, a variable annuity lets you decide how the money is invested. Obviously, the return on avariable annuity will vary depending on the performance of the investments you choose.

During the accumulation phase of the variable annuity, investment money goes into various pre-selected investment choices, ranging from aggressive to conservative. I chose three mutual funds: a total stock index fund (50%), an REIT index fund (25%) and a balanced fund (25%)…heavily weighted to equities (I was younger then). Because the annuity qualifies as an insurance contract, all investment earnings are tax-deferred until you start taking withdrawals.

Death Clause

To qualify as an insurance contract, the annuity must also provide some form of insurance; thus, most annuity contracts guarantee that your initial investment will be paid out as a death benefit (e.g., that upon your death, even if your investments incur a loss, your named beneficiary will receive the original amount you invested…less any withdrawals you may have taken). And because the annuity qualifies as an insurance contract, all investment earnings are tax-deferred until you start taking withdrawals.

Financial Outlook

The safety of all annuities – fixed or variable – is based on the financial stability of the issuing insurance company. And with specific regard to variable annuities, your return will vary based on the performance of the investments you choose. Admittedly, in my case, dumb luck prevailed. First, I chose Vanguard to deal with. Second, I chose Vanguard mutual funds to invest in. And third, I chose to remain invested in those three funds during a 33-year period of extraordinary market appreciation. My original investment grew by a factor of 12 during those 33 years, largely thanks to Vanguard’s financial management skills… and maybe a little bit to my patience as an investor (remember those PDQ Principles).

As to the question about losing money in the long run, fixed annuities earn tax-deferred interest on the initial principal investment without the risk of market value loss. Some caveats: Annuities are available with the interest rate guaranteed for 1 - several years. After the guarantee period ends, the insurance company will pay interest based on the company's own investment results.

Part of a Whole

Despite my own good luck with a variable annuity, I would not recommend a wholesale devotion to annuity contracts. To me, their greatest value is to serve as one of several components designed to replace your paycheck when you retire. Bills don’t stop coming after retirement.

Cash flow sufficient to cover those ordinary expenses is very comforting, and a bucket of liquid assets providing those funds often includes (1) for the lucky few, a company pension fund, (2) for most, an inflation-adjusted social security check or two, (3) for many, a monthly distribution from a 401(k), 403(b), or IRA account, and (4) a gap-filling monthly annuity check.

Use annuities wisely. They aren’t a panacea.