Retirement Income Strategies: Using Annuities
If you have an investment strategy or a retirement strategy, there better be an income strategy as well. In a pension-less world, too many people are relying too much on their Social Security payments. Social Security is the best inflation annuity on the planet, but it was never put in place to be the primary source of retirement income.
Because annuities are the only financial product that contractually guarantees an income stream that you can’t outlive. For that fact alone, any retirement income strategies have to include annuities. For all of you annuity haters out there, that’s the brutal truth.
How Annuity Income Works
First of all, annuities are transfer of risk contracts issued by life insurance companies. Regardless of the type of annuity used for lifetime income, the payment is primarily priced and based on your life expectancy (or life expectancies if “joint”) at the time income starts. Interest rates play a secondary pricing role.
The income generated from any annuity income strategy is really just a life expectancy play. You are taking the bet from the annuity company that you are going to live longer than their actuaries project you to live. And if you do, that annuity carrier is on the hook to pay. That’s the benefit proposition in a nutshell.
Even if you draw your account down to zero, the annuity company has to contractually pay. There’s no ROI or total return calculation until you die. Up until that point, it’s a pure transfer of risk. The income withdrawal rate is a reflection of your life expectancy(s) at the time the payments start. The bottom line is that you need to consider annuities as the personal pension part of your retirement plan.
More Income Floor
Your retirement income strategy is really how you are going to build your income floor. This secure income floor is the guaranteed amount of income, interest, or dividends that hit your account every month, every quarter, or once a year. Your RMD (Required Minimum Distribution) is part of your fixed income floor as well as interest on your CDs (Certificates of Deposit), dividends from your investment portfolio, and Social Security payments.
Investment returns from mutual funds, ETFs, stocks, options, etc., are not part of the overall income floor calculation.
An efficient way to use annuities with your income floor is to add up your current income sources, and then determine what gap or dollar amount needs to be filled. Because annuities are contracts, you can reverse engineer the customized quote to find the lowest contractual amount needed to fill that income gap.
If you need income to start as soon as 30 days and as far out as 1 year, then a Single Premium Immediate Annuity (SPIA) is the best annuity types that provides the highest contractual guarantees. SPIAs are commodity products (like all annuity types), and should be quoted with all carriers to find the highest number for your specific situation.
Before you place your retirement savings into a guaranteed income annuity, ask and answer the following 3 questions:
- Do you want to structure the policy “Single” or “Joint” Life?
- When do you want the income to start?
- What type of account do you want to use?
From those specific answers, you can then use an objective retirement income calculator that quotes all carriers for the highest guarantees available for your situation.
All account types (IRA, Roth IRA, Non-IRA) can house a SPIA. The contractual guarantees are the same regardless of the account type, the only difference is how the income stream is taxed.
It’s also important to understand that a “Single Life” payout will be higher than a “Joint Life” payout. Common sense will tell you that guaranteeing 2 life expectancies will provide a lower income stream than than one life expectancy.
When income is needed to start from 13 months to as far out as 20 or 30 years, then there are 3 annuity products that can provide that contractual future payment guarantee.
*Deferred Income Annuities (DIAs): No annual fees. No moving parts. No market attachments. The same structure as a SPIA, but with income starting as soon as 13 months from the policy issue date and as far out as 20-30-40 years depending on the carrier.
*Qualified Longevity Annuity Contracts (QLACs): No annual fees. No moving parts. No market attachments. This is a DIA that can only be used in Traditional IRAs and some employer sponsored plans. The premium dollar limit for 2020 is the lesser of 25% of your total IRA (qualified) assets or $135,000.
*Income Riders: These are attached benefits to Fixed Index Annuities (FIAs) or Variable Annuities (VAs). Income Riders are a separate calculation from the accumulation value that guarantees a future income stream where you determine the start date.
DIAs and Income Riders can be used with any account type, and QLACs can only be used in Traditional IRAs and some employer sponsored plans. The contractual guarantees are the same regardless of where the money is coming from, but the taxation of the income stream will depend on the specific type of account.
Don’t Drink The COLA
Annuity companies have the big buildings and the large logos on the corporate jets for a reason. They don’t give anything away. Life insurance companies know when we are going to die, and price their product offerings accordingly. It’s all about life expectancy when it comes to annuity income guarantees.
A common question that I receive concerns future inflation. There is no perfect annuity product that efficiently addresses the moving target called inflation. Annuity companies do offer you the choice of adding a COLA (Cost of Living Adjustment) rider to some of their annuity types. COLAs are a contractually guaranteed percentage increase to the income stream on the policy anniversary date. That sounds fantastic in theory, but the annuity companies don’t give that COLA away. If you add a COLA to your guaranteed income annuity, the starting payment level is significantly lower than the same annuity without a COLA.
Can’t Time It
So what is the answer to the million dollar question, “What is the best investment for retirement income?” The answer is contractually guaranteed annuity contracts. There is no debating this fact.
Any retirement income planning strategy is not a short term play. You need to set up the payments so that you can never outlive that income stream. For most investors, you have been trained to try and time any financial purchase. Unfortunately, that’s a tough one when it comes to annuity contracts.
Because interest rates play a secondary pricing role to life expectancy when it comes to lifetime income annuities, the focus should be on the transferring of the risk to the annuity company to pay you for life. For example, if you wait to buy a SPIA...then you have to factor in the missed payments while you are trying to “time it.”
The reality is that you can’t beat the annuity companies when they are playing the life expectancy game. Don’t try. As you put together your personal retirement income strategy, when the annuity contractual guarantees meet your goals…then it might be the right time to transfer that risk.