Investors Are Revisiting Annuities

08/18/2011 8:30 am EST

Focus: MARKETS

Bob Carlson

Vice President and Regional Manager, Northern Trust Investments

Fed up with the volatility and uncertainty of the stock market, and wanting to preserve what they saved for retirement, retirees and near-retirees are taking a fresh look at vehicles that were shunned during the bull market, writes Bob Carlson of Retirement Watch.

Industry sources say investors are allocating more to annuities, and sales are rising. The more conservative annuities are drawing the most attention.

At the same time, some insurers are withdrawing from some annuity sectors, and others are changing the terms of annuities they offer. The problems for insurers are persistent low interest rates and increasing life expectancies.

The problem for investors seeking safety is that annuities are difficult to compare. There are many types of annuities, and within each type insurers offer vastly different features and options.

Also, many people begin the annuity investment process the wrong way. They begin by examining a specific annuity that’s been presented to them and try to decide whether or not to buy it.

First, you need to set your goals and then decide the risks you are willing to take. Also note the risks you want to avoid. Then, look for the investments, including annuities, that fit your profile.

Finally, after you select a type of annuity, shop among several insurers. As I’ve shown in my studies in Retirement Watch, the payouts among insurers vary even for annuities with similar terms.

Annuities can help meet several goals. Foremost, annuities protect against the happy outcome of living a long time. (Some wags suggest that annuities should be called life insurance, and life insurance should be called death insurance.)

You receive income for life, no matter how long it is. Most annuities also insulate you from some or all market volatility.

Annuities are not without risks. In good investment markets, you risk missing the high returns of a diversified portfolio. You also take the risk the insurer will fail.

Another risk for some types of annuities is locking in a low payout rate because interest rates are low when you purchase the annuity.

Those are the general risks and rewards. Specific types of annuities have their own tradeoffs. Here’s an overview of the annuity world:

Immediate Annuities
These are the traditional, plain, vanilla annuities. You deposit an amount with the insurer, and the insurer begins making regular payments. Payments can be monthly, quarterly, or annually.

Most immediate annuities make fixed payments, but some offer variable payments. The payments can vary with inflation or a portfolio of investments selected by the annuity owner.

You can receive payments for your life, the joint life of you and a beneficiary (such as your spouse), a period of years, or the longer of your life and a period of years. The highest payout is for your life or a period of years shorter than your life expectancy. The other options result in lower initial payouts.

Studies show that having a portion of your retirement portfolio in immediate annuities reduces the risk of running out of money during retirement. Annuities help stabilize a portfolio’s value and returns. They also can allow you to take more risk with the rest of your portfolio.

Index Annuities
These used to be called equity-index annuities, but the term preferred by the insurance industry now is fixed index annuity or index annuity.

These are deferred annuities. The returns compound tax-deferred until distributions begin. The returns of these annuities are tied to the performance of one or more stock market indexes using a formula.

Usually there is an annual floor, or guaranteed return, of 1% to 3%. They also have an annual cap, or maximum return, which recently averaged around 6%.

The difficulty when evaluating IAs is understanding the formula for computing the annual return. The insurer uses a formula of its own creation to calculate the return, and the account is credited with returns that often are dramatically different from those of the market index.

The account also is credited only with a portion of the calculated return, known as a participation rate, up to the annual cap. The important point is you should have a general understanding of how your return will be calculated, and how it is likely to differ from the index’s returns.

IAs usually guarantee the account against losses. Sometimes 100% of the principal is guaranteed, sometimes only 90% or so is guaranteed.

IAs generally are for conservative investors who want a chance at higher returns than traditional conservative investments, but want to avoid the risks of stock markets or other growth investments.

NEXT: Variable Annuities

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Variable Annuities
These are mutual funds combined with annuities. The investor selects investments from those offered by the insurer, and the returns from the investments compound tax-deferred in the account, after subtracting fees and expenses.

Most variable annuities are deferred. But some immediate annuities are variable; the annual payouts vary with the returns of investments selected by the insured.

VAs were very popular until the bear market that began in 2000, when investors suffered large losses in their annuity accounts. Insurers are trying to bring investors back to VAs with new features. Many of the VAs now have guaranteed death benefit guarantees and lifetime withdrawal benefits.

A guaranteed death benefit guarantees the policy beneficiary will receive at least a minimum amount when the original owner dies. Some policies guarantee the initial amount invested in the policy. Others guarantee the policy’s highest value on the anniversaries of its purchase.

A guaranteed lifetime withdrawal allows the insured, after a certain age, to make annual withdrawals for life of a percentage of the original investment or some other amount. The guarantee usually is around 4%.

The trade-off in VAs is these features cost money. The basic VA’s fees on average are 2% or so of the account’s value each year. As these other features are added, the costs increase.

There are low-cost variable annuities from Vanguard, Ameritas, and some other financial-services firms, but for all of them you have to determine if the benefits are worth the costs.

Fixed Annuities
These are traditional, plain vanilla deferred annuities. You give the insurer a lump sum today, or make a series of payments.

The money is put in an account and credited with earnings each year. The earnings are determined by the insurer each year, and usually are similar to the interest rate on intermediate-term bonds.

These annuities are alternatives to bonds or other safe investments in a portfolio. You want to know how the annual interest rate is determined, what the insurer’s yield history is for its annuities, which expenses will be subtracted before your earnings are credited (gross earnings versus net earnings), and how safe the insurer is.

Longevity Annuities
These are relatively new. You give the insurer a lump sum, and the insurer promises to pay you annual income beginning at age 80 or 85, should you live that long.

The annuity ensures you will have income if you live a long life. If you don’t make it that long, the insurer keeps the money. A typical offering today is that $25,000 invested by a 65-year-old female will generate monthly payouts of $1,169 at age 85.

Hybrid Policies
Some fixed deferred annuities can be used to pay for long-term care if it is needed, via a rider or supplement to the annuity. A typical combo policy will pay up to two or three times the account’s value for long-term care over a period of about six years.

For example, an annuity’s value is $150,000 when the owner needs long-term care. The policy will pay up to $300,000 to $450,000 for long-term care after a claim is filed. The annuity does not earn income after a claim is filed, and the account’s value for other purposes is reduced.

Consider carefully before choosing an annuity, because it is a long-term investment. Most annuities charge surrender fees if you want to withdraw your investment within a fixed period of seven years or longer. Some have much longer lock-in periods.

There are many annuity features to choose from. You need to remember that each of these features and protections costs money. It will reduce either your earnings or your payout.

The reasons to buy an annuity usually are to create a stream of guaranteed retirement income, to achieve a safer return than is available in other investments, or to take advantage of an annuity’s tax deferral. Adding other goals, such as ensuring something remains for your heirs, reduces your income.

Inflation protection is the feature most likely to be worth the cost in an immediate annuity. Another buying tip: The longer you wait to purchase an immediate annuity and begin income payouts, the higher your lifetime income will be.
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