Part 1: Understanding How Your Specific Annuity Works

Understanding How Your Specific Annuity Works

Understanding How Your Specific Annuity Works

At FAI, clients often ask us whether annuities make sense, especially when they see big market swings like we’ve seen over the last few quarters.  The short answer is that annuities are definitely useful tools in certain cases, but it’s important to understand how your specific annuity works.  It’s easy to pick one that is not a good fit for your situation.  Since annuities are often hard or expensive to get out of, you may get stuck long-term with a product you don’t want.

Much of the complexity of discussing annuities comes down to what they are: contracts with an insurance company.  If that seems poorly defined, that’s because insurance companies have very broad latitude regarding how to structure those contracts.  It’s very common to find two annuities that don’t even remotely resemble each other.  While there are some common patterns among annuities, there is even relatively little standardization regarding the terminology for those common patterns.  Because of this extreme variability, it’s better to think of annuities as a family of related products than as a single product with many variations.

Let’s start by taking a look at one of the simplest types of annuities.  With a “single premium immediate annuity,” you pay the insurance company a single lump sum (the premium) and they immediately begin making regular payments to you over a period of time.  You can choose how often to be paid and for how long.  The most common choices are to be paid monthly for your life (possibly including your spouse’s), using this to turn your initial premium into an income stream.

Note that you can already get income from a liquid investment portfolio simply by withdrawing from it.  However, you would be exposed to the risk of either running out of money or needing to reduce your withdrawal rate at some point.  This risk is particularly pronounced if you live longer than expected.  What the annuity can do that the investment portfolio can’t is guarantee a minimum level of income indefinitely, regardless of market conditions or how long you live.

There are a couple of big caveats to consider here.

The most significant is that the original lump sum is not yours anymore.  Unlike with an investment portfolio, you do not have access to the original amount for opportunities or emergencies.  Because of this, it’s usually best to err on the side of committing too little to an annuity rather than too much.  (Remember that you can always buy more later.)  A reasonable rule of thumb is to limit the annuity income to no more than your essential fixed expenses (such as mortgage payments/rent, groceries, prescriptions, etc.), using your investment portfolio to fund entertainment, travel, and other expenses.  Remember to reduce the target annuity amount by your estimated Social Security income when making plans.

The other caveat is that many of these annuities do not adjust their payments based on inflation.  Your investment portfolio will need to make up the difference, either by increasing withdrawals from your investments over time or by using those assets to purchase another annuity later.

As part of this, you should also review the risk level of your remaining investment portfolio.  You will not need to withdraw as much from your portfolio because the annuity payments cover some of your expenses.  Moreover, a greater proportion of your withdrawals will be discretionary in nature, meaning you have much more flexibility to delay or reduce your withdrawals based on market movements.  Therefore, purchasing an annuity with part of your portfolio may give you more capacity to accept risk with what you have left.

In most cases, you have another way of dealing with inflation.  You typically have the option to accept a lower initial payout from the insurance company and have the payment amount automatically increase over time.  You will be better off with this option if you live longer than expected, but worse off if you die earlier.  In effect, you are paying more—in lower payments early—to buy more insurance against the risk of outliving your assets.

Some clients dislike the idea that they may not receive back what they paid in the initial premium if they die early.  Most companies will offer a return of principal option where the company guarantees that they will pay out at least as much as the initial premium (ignoring inflation).  If you die early, the difference between the initial premium and the amount already paid out over time is paid to designated beneficiaries.  There are other variations where the company guarantees payments for at least a certain number of years, but the concept is similar.  In each of these cases, the regular payment will be (permanently) less than if you did not have the additional option.  You are therefore buying less longevity insurance for the same initial premium.

As you can see, even with this relatively simple type of annuity, there are already a lot of factors to consider.  Their interactions are often very complex.  For example, while how much guaranteed income to purchase and whether to include an inflation adjustment are mostly judgment calls, it’s usually not such a good idea to opt for return of principal guarantees.  To understand where that conclusion comes from, we’ll need to understand how annuities and investment portfolios compare to each other.  We’ll dive into that next time, along with looking at some more complicated types of annuities.


About FAI Wealth Management, Inc.: Located in Columbia, Maryland, FAI focuses on helping clients create the financial future they desire by protecting their wealth, making the most of their assets, and planning for life's uncertainties. The firm combines fee-only, fiduciary-driven guidance with highly personalized, consultative financial planning and investment services that enable individuals, families, and businesses to navigate complex life transitions. Founded in 1987, FAI currently manages more than $350 million in client assets nationwide. For more information about FAI Wealth Management, please visit the website at https://www.faiwealth.com or call 410.715.9200.

 

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