Retirement

You Can Customize Annuities To Meet Your Goals, Reduce Their Disadvantages

Higher interest rates are making annuities more popular than ever. But despite rising annuities sales, misunderstandings keep many people from taking advantage of annuities.

Insurers have been dealing with waves of applications in 2023 as yields on multi-year guaranteed annuities (MYGAs) leapt to 3%, 4%, and then above 5%.

Let’s look at the misunderstandings that keep people from adding annuities to their financial plans and consider the ways annuities can be customized to meet different goals.

There are several types of annuities. In this post, I focus on the more conservative, low-cost annuities that should be considered in many retirement and pre-retirement portfolios in lieu of bonds.

In a MYGA, the consumer deposits a lump sum with an insurer for a fixed period. The insurer guarantees the principal value won’t fluctuate and the account will earn a fixed rate of interest.

MYGAs are like bank CDs, except tax on interest earned by a MYGA is deferred until the interest is distributed. Also, as a general rule, MYGAs of three years and longer duration usually pay higher yields than CDs. The yield differential between MYGAs and CDs fluctuates over time, so always check the market before making a decision.

Some MYGAs guarantee the yield will be paid each year for the full term while others guaranteed the stated yield for only the first year and adjust the interest rate each subsequent year based on market conditions. You can decide when choosing a annuity either to lock in a yield when buying the annuity or have it fluctuate annually with the market.

Some people don’t buy MYGAs because they don’t want their money locked up for the annuity term. There are options for them.

Many MYGAs allow you to receive or withdraw the interest as it is earned or when you want without a penalty. Your principal stays in the MYGA to earn more interest.

Most MYGAs also allow you to withdraw some of your principal penalty-free after one year. The rest of the principal stays in the account to earn interest. Typically, the maximum penalty-free annual principal withdrawal after the first year is 5% or 10%.

MYGAs don’t have extra fees or commissions. The insurance agent’s commission is built in the yield the account earns. The insurer pays the agent, so the full amount you deposit is in the account earning the guaranteed yield.

Another type of annuity to consider is the single-premium immediate annuity (SPIA), the classic annuity that guarantees a fixed periodic income for life no matter how long you live. You deposit money with an insurer and decide when you want the guaranteed payments to begin. The insurer tells you how much those payments will be.

There’s a lot more flexibility in SPIAs than many people realize.

A concern for some people is they might not live to life expectancy. If that happens, the insurer keeps the deposit, and the annuity owner’s heirs receive nothing. In that scenario, the insurer “wins.”

There are solutions when that’s your concern.

Some annuities let you select income that lasts for the longer of either a term of years or for life. Suppose you select an income period of 10 years or life. If you die within 10 years after the annuity payments begin, the payments will continue to your beneficiary until income was paid to you and your beneficiary for a total of 10 years.

An alternative is known generally as a return of premium rider. There are many variations, but in general if you die before life expectancy a prorated portion of your initial deposit is paid to your beneficiary.

Or you can elect payments to be made for the joint life of you and a beneficiary. Payments don’t stop until both you and the beneficiary have passed away. This is a good choice for many married people.

An insurer might offer other options and variations. The point is you shouldn’t forego the guaranteed lifetime income of a SPIA out of fear you might not live long enough (unless you have good reason to believe you won’t live until at least average life expecntacy). Keep in mind, though, that each of these options reduces the monthly guaranteed lifetime income.

Also, I don’t recommend putting all your retirement funds in a SPIA. Let a SPIA plus Social Security pay your basic living expenses. The remainder of your assets can be invested and left to heirs.

Another criticism of the standard SPIA is that the regular income payment is fixed for life. It loses purchasing power to inflation over time.

One way to protect your purchasing power is with assets outside the annuity. Invest those for growth so they can be used to supplement the SPIA income.

Some SPIAs also offer inflation protection known generally as an income growth factor. No insurer in the U.S. offers true inflation protection in which the income payment increases each year with the change in the Consumer Price Index.

But many SPIAs allow you to select a percentage, usually from 1% to 5%, by which the income payment will automatically increase each year.

The cost of the income growth factor is your first-year income payment is reduced. The reduction varies between insurers but tends to be from 20% to 33% of the what the first-year payment would be without the growth factor. You can use a spreadsheet to estimate how long it would take you to receive more from a SPIA with the income growth factor than from one without it.

Another concern some have about SPIAs is the annuity owner receives only the fixed periodic payments. When a large, unexpected expense arises, you can’t dip into an annuity account for extra cash.

Some insurers respond to this concern by offering an option allowing an additional withdrawal after the first year. Typically, up to 10% of the initial deposit can be withdrawn during a year.

Electing this provision usually means the initial income payments are reduced. In addition, if the option is exercised by withdrawing some of the deposit, future income payments usually are reduced accordingly.

The better strategy usually is to put only a portion of your nest egg into SPIAs and have other funds available for unexpected spending.

Annuities are more flexible than many people realize. The standard annuity, whether it is a MYGA or SPIA, can be customized to satisfy many goals and concerns.

For many people, the best plan is to deposit a portion of your assets in the appropriate annuity and look to the rest of your assets to meet other goals such as inflation protection, paying for unexpected expenses, and benefitting heirs.

Another reason people give for avoiding both MYGAs and SPIAs is interest rates. They don’t want to lock in current interest rates and will reconsider annuities when rates are higher.

This reason was more valid before 2022. Now, it isn’t a good reason to avoid having some MYGAs in your holdings. You can lock in the highest yields in a long time, and those yields often are higher than those on comparable CDs and treasury bonds.

If you anticipate rates will go higher, then consider dollar-cost averaging into MYGAs over time. Or you can establish an annuity ladder, depositing equal amounts in annuities that mature at different times over the next five years. You can buy MYGAs that mature in one year, two years, three years, and five years. After the one-year annuity matures, roll over the balance to a new five-year annuity.

With SPIAs, the wait for higher rates never made much sense. SPIAs are long-term contracts, and insurers don’t give primary weight to current short-term rates when setting the income payments. They focus more on your age and life expectancy.

To the extent the insurers consider interest rates, they look at the earnings they expect from their investment portfolios over the rest of your life expectancy instead of current interest rates.

There are a lot of choices with annuities, whether you want a MYGA or SPIA or a little of both. Don’t take a do-it-yourself approach. Work with a consumer-friendly expert who works with a number of different insurers to find the annuities that fit your needs and goals.

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