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Annuities 101: How Fixed Annuities Can Stretch Retirement Savings

Annuities 101: How Fixed Annuities Can Stretch Retirement Savings

Managing investments and wealth for retirement is a daunting challenge. Long-term market performance is difficult to measure, and the time horizon for retirement is shorter than during the accumulation years, further increasing risk. While you work, you can offset your losses with new capital from wages and employer compensation. In retirement, it is harder to save when you should be spending your savings.

The result: retirees are caught between the fear of running out of savings too soon and the fear of outliving it.

As with all phases of the investor life cycle, diversity is essential to managing risk and protecting against market volatility. A fixed income annuity can alleviate the uncertainty inherent in retirement planning by providing a guaranteed, steady stream of income no matter where the market goes during your golden years and how long they last.

According to a McKinsey analysis, annuities are growing in popularity both in absolute dollars and as a percentage of the total life insurance business. (Annuities are issued and regulated as insurance products, not investments.) In the five years ending in 2017, annuities accounted for nearly $115 billion of all life insurance business in the Americas, compared to nearly $60 billion over the five years ending in 2007.

How it works

In exchange for paying premiums, which can be spread over months or years or paid in a single payment, retirees receive a guaranteed and predictable payment, usually monthly. Simply put, a fixed income annuity is much like a salary, but it's paid by a financial institution rather than an employer. It is the financial institution's responsibility to manage the investment behind the scenes to make this payment; all the recipient has to do is spend the proceeds.

Therefore, the advantages against volatility and in favor of peace of mind are obvious. Instead of relying on the market to reward your investment intuition in a defined contribution plan like an IRA or 401(k), the annuity issuer pays out a fixed amount, much like a paycheck. And even if you outlive your life expectancy, you will continue to receive a regular income. Annuities are available in a variety of configurations. Here is a quick overview of some that standouts:

  • Single Premium Immediate Annuities: This is the easiest type of annuity to explain. In exchange for a one-time lump sum paid by the purchaser (usually at least $100,000, usually much more), the annuity begins paying benefits the same month.

  • Fixed indexed annuities: This is linked to a guaranteed minimum interest rate and a broad stock market index such as the S&P 500 or equivalent. So, when this index performs well, holders earn more interest. But when the index falls, interest cannot be incurred below the guaranteed rate. This allows investors to seek higher returns when purchasing an annuity without negative volatility.

  • Deferred Annuities: Also called longevity annuities, this property typically does not pay benefits until several years after premiums have been paid in full. The benefit to the buyer is a lower premium cost than an immediate annuity with the same benefit. The advantage for insurers is the ability to spread risk over a longer time horizon before paying monthly benefits to an insured.

The Biggest Obstacle to Planning: Time

Fixed annuities reduce uncertainty by protecting beneficiaries from market fluctuations and ensuring a steady stream of payments until death. Rather than predicting the amount of capital to withdraw in any given year, they provide income throughout retirement.

During these advanced years, many begin to wonder if their mix of retirement assets and expenses is adequate and if they will be rewarded enough for taking risks in the market. 

For this reason, longevity annuities are the best. Longevity annuities allow you to deal with the potential risk of living to 80 or 90 and running out of resources. They allow people to take an impossible planning situation and turn it into a reasonable planning situation.

A study by the Employee Benefits Research Institute found that, on average, committing up to 20% of a 401(k) balance to a 20-year deferred annuity at age 65 improves retirement asset outcomes. High earners fare better with higher percentages committed to an annuity, at levels up to 30% of the 401(k) balance, because Social Security is relatively more generous to lower incomes.

Don't forget to spend your money.

Fixed annuities can also help investors combat a less obvious risk: not spending enough in retirement. Some of the costliest mistakes people make in retirement aren't about lack of resources but involuntary expenses. Essentially, every monthly decision to withdraw or keep more retirement assets is a battle, and crippling fears of volatility and longevity win many of those battles. Some retirees are afraid to spend their savings and don't know what to do.

The commitment to buy a fixed income annuity can provide the psychological green light to spend without fear of running out of resources prematurely. Paying the [premium] to buy the annuity is a big decision. But once you do that, many of your fears and worries are gone because you have a guaranteed monthly income.

Buying a fixed income annuity is a complicated decision, and investors will have different priorities and goals regarding retirement expenses and benefits for surviving spouses or other beneficiaries. For these reasons, few investors devote all their savings to these products, but they can help smooth out many edges at a time when many prefer to focus on comfort, convenience, and certainty. And it insulates day-to-day spending and retirement spending from the day-to-day fluctuations of an ever-unpredictable market.



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