Lifetime Income -- Build Your Own Pension
- Author Thomas Swenson
- Published December 16, 2022
- Word count 1,915
Build Your Own “Pension Plan” with a Guaranteed Lifetime Annuity
At the age of 65, an individual can expect to live about 25 years in retirement (a bit longer if married).
Annuities generally provide at least several of the following benefits:
• A guaranteed income for life you can never outlive
• 100% principal protection (0% floor, i.e., your money will never go backwards due to negative returns in the stock market)
• Positive, tax-deferred gains (often pegged to one or more stock indices) are locked in every year (but no stock dividends) (in deferred annuities)
• A guaranteed return in the form of a “bonus” credited to the accumulation value, in a range of 5% to 10%, depending on the product
• Inflation protection
• Peace of mind
• Certainty of covering basic needs (or more), allowing riskier investing with greater potential upside
• Guaranteed minimum death benefit for heirs
• Long-term care and/or chronic illness benefits
Does a wealth-building wealth-preservation tool with some of the above-mentioned features interest you? It should if you want a safe, happy, secure retirement.
Retirement presents numerous financial risks:
Market Risk – As one approaches retirement age, whether that is age 50, 65 or 75, the risks associated with significant downturns in the stock market become greater and more critical. Think about the dot-com crash 2000-2002, the financial crisis 2007-08, the market “corrections” occurring now in 2022, and today’s general economic uncertainties. When one is younger and still earning money in the “accumulation” phase of retirement planning, one may be relatively confident that the markets will bounce back or crawl back over the long term (i.e., over a 10-15 year time span). When one is approaching or has already reached retirement, however, there is no time for a portfolio to recover.
Sequence of Returns Risk – Sequence of returns risk is related to market risk, but it is more insidious. A market downturn and corresponding decrease in portfolio value during initial retirement years can have a devastating effect on the durability of retirement savings. A market downturn in early retirement years, means the retiree must consume principal to pay retirement expenses. As a result, there is less principal for growth when the market finally picks up again. In contrast, upside growth in a bull market during early retirement years means portfolio gains can fund initial retirement and the portfolio can actually grow. Thus, even if the market grows an average of 10% over a 20-year retirement period, a retirement portfolio might run out of money (or not) depending on what the market was doing in the initial years.
Withdrawal Rate Risk – Years ago, when bonds were paying higher interest rates, the conventional wisdom said a retiree could safely withdraw 4% a year from a typical conservative retirement portfolio over the long run. Because safe, fixed income investments (e.g., bonds) now pay low interest, 3% might now be considered safe, but more realistically only 2% withdrawal of portfolio value can be recommended.
Inflation Risk – Official government data say inflation is currently (June 2022) about 9%, the highest in 40 years. Honest economists say the real number is closer to 15%. In any case, a conventional, conservative retirement portfolio containing fixed income vehicles can hardly keep pace with inflation.
Longevity Risk, a risk multiplier – Longevity risk is the risk of outliving your retirement income. The longer you live, the longer your retirement savings need to go to support you. Problem is, nobody (except the terminally ill and the suicidal) knows how long he/she will live. Do you spend down your retirement savings as if you will live 10 more years, or 30 more years? Furthermore, longevity risk is a risk multiplier – the longer one lives, the graver are the other risks mentioned above.
Two Types of Annuities
Basically, there are two types of annuity policies, (i) immediate, and (ii) deferred.
An immediate annuity’s primary purpose is to provide guaranteed income. Typically, a lump sum policy premium is paid, and then annuity payments begin immediately or within 12 months (although some companies allow deferral of income up to 40 years). Income is guaranteed for a fixed time period (e.g., 10 or 20 years) or for a lifetime (or a couple’s lifetime).
A deferred annuity is used primarily for saving and investing. A deferred annuity does not begin payments immediately; instead, it allows money to grow over time while avoiding exposure to market downturns. Importantly, taxation on gains is deferred until distributions are taken. A deferred annuity can be “annuitized”, that is, a lifetime income stream can be turned on, or income can be turned on and off (called “systemic withdrawal”). Although a deferred annuity can be annuitized, depending on various factors, it often makes more financial sense to exchange a deferred annuity for an immediate lifetime annuity to get higher payout rates.
As with most annuity products, withdrawals or annuity payments made before age 59-1/2 are generally subject to a 10% penalty in addition to income tax, unless one of certain exceptions apply.
Building Wealth with Fixed Index Annuities (FIAs)
A fixed index annuity (FIA) is a type of deferred annuity for building and preserving wealth. It provides pretty good growth potential, no downside risk (e.g., "0% floor"), and various features that make it an excellent tool for retirement planning.
Account growth of an FIA is tied to the performance of one or more market indices and credited periodically (e.g., annually).
With proper asset allocation using FIAs as a wealth-building tool, the pain of recent stock market crashes and corrections could have been significantly mitigated. Unfortunately, the vast majority of advisors giving stock and mutual fund advice do not use FIAs to help their clients. As a result, stock market downturns take a heavy toll, financially and mentally, on most US investors. FIAs can also offer more liquidity and higher lifetime income rates than some immediate annuity policies.
A traditional fixed annuity account grows at a set, guaranteed rate (e.g., 3.5%) and provides certainty and security by paying a regular (e.g., monthly) distribution to the annuitant(s) for the lifetime of the annuitant(s). This type of annuity still exists and is still useful. Fixed annuity policies have various payout features and options, such as a guaranteed minimum payout to beneficiaries if the annuitant dies early.
A variable annuity is deferred annuity that is both an insurance product and a security, and Shoreview LLC is currently not qualified to sell or give advice on specific variable products. In a variable annuity policy, the account funds are invested directly in the market (typically in “insurance dedicated funds”, IDFs). As such, the policy account is subject to the ups and downs of the market. A variable policy provides potential for considerable upside growth, but with considerable downside risk. With the advent of risk-free fixed index annuities (FIAs), described above, the allure of variable annuities has faded.
As mentioned above, an annuity can also be owned inside an IRA or a qualified employee retirement plan (e.g., 401(k) and 403(b) plans) to protect account values against market downturns.
Some lifetime-income annuities provide a limited degree of inflation protection through riders that increase payouts each year, for example, by 1%, 3% or even 5%. Another available approach is to schedule annual payments to be low initially and to increase gradually over time. Additionally, FIAs (as well as other annuities) can provide the financial security and peace of mind to make other portfolio investments that would otherwise be too risky closely before or during retirement. Such “portfolio optimization” using riskier, inflation-sensitive investments (e.g., commodities, real estate, stocks) can then match or outpace inflation. (Of course, some of the profits can then be used to purchase more guaranteed income annuities!) Similarly, since the periodic crediting rate of an FIA is based on the overall change of one or more market indices (e.g., S&P 500) over the crediting term (e.g., one year), and because market prices usually track inflation, the policy crediting rates will generally rise with inflation, although usually with a lag. Also, the fixed, guaranteed crediting rates in deferred annuity policies also track the prevailing bond rates. Bond/interest rates and inflation often correlate. As interest rates increase, the yields of bonds held by an annuity carrier also increase (with a lag), allowing the carrier to increase the periodic policy crediting rate. Any retirement planning should also address potential long term care needs (LTC costs are always inflating), which can quickly destroy an individual’s or couple’s retirement, as well as any legacy intended for children.
Different variations of annuities can provide guaranteed lifetime income; for example, Single Premium Immediate Annuity (SPIA), Deferred Income Annuity (DIA), some FIAs.
Taxation of Annuities
The account balance in an annuity grows tax deferred. If the annuity was funded with post-tax money, then the earnings portion of every distribution corresponding to growth is taxed as regular income when distributed, while the basis portion corresponding to paid-in premium is not taxed. If the annuity is owned inside a qualified retirement plan funded entirely with pre-tax money (e.g., 401(k) or IRA plan), then all distributions are taxed as income.
Access to Funds – Random Withdrawals
Immediate lifetime income annuities are not illiquid, as some people claim; rather, an owner of a lifetime annuity could generally request a lump sum payment from the policy. A deferred annuity policy typically allows withdrawal of up to 10% of account value annually, without “surrender” charges. Usually after seven to 10 years, withdrawal (surrender) charges no longer apply. Tax penalties may apply, however, when an individual makes a withdrawal before age 59½ (except in special cases, such as death or disability, first-time purchase of a home, or as part of a life-income option plan with fixed payouts). Taxation of withdrawals is done under LIFO (last in, first out) rules, which mean that earnings are presumed to be the last monies to enter the account. Therefore, earnings are considered to be withdrawn from the account balance first and taxed as ordinary income. After all earnings have been withdrawn, additional withdrawals are treated as basis and are not taxed. (In contrast, annuitized payments are taxed as explained above).
Buying Annuities within an IRA or 401(k) or other qualified retirement plans. Money grows tax-free in retirement saving plans, but it can still be exposed to the market. A big, sustained drop in the markets close to or during retirement could cause irreparable harm. Why not buy an annuity inside a retirement plan to protect principal (with a “0% floor”) and to guarantee income? Payments from a guaranteed lifetime income annuity can actually exceed the required minimum distributions (RMDs) otherwise paid from an IRA or a qualified plan.
If you would like to learn more about annuities and other insurance products for building and protecting wealth, contact Shoreview LLC or call 303-442-3100.
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