Dismantling The Myths Of Annuities - Part 1
Annuities have a bad reputation among some people — but not necessarily a well-deserved one. A variable annuity with broad investment choice, valuable product features and low fees can help you achieve your retirement income goals.
The two primary types of annuities are “fixed” (or guaranteed) and “variable.” In fixed or guaranteed annuities, the funds are invested in the insurance company’s general account, which typically contains fixed-income securities like bonds. The issuer, not the contract owner, assumes all investment risk. Fixed annuities offer a guaranteed payment, with the payout amount based on the assumed future returns of the investments and the annuitant’s life expectancy. The payment can be fixed for life, or can allow for future increases. Variable annuities provide the contract owner with the ability to invest in both fixed-income and stock-based accounts whose values change depending on the performance of these underlying investments. While variable annuities offer the potential for higher long-term returns than fixed annuities, generally their payouts will fluctuate (sometimes dramatically) from year to year. Unlike with a fixed annuity, the contract owner of a variable annuity assumes all investment risk.
When planning your financial future, one of your biggest concerns is “longevity risk,” or the risk of being unable to fund your retirement if you live much longer than expected. Consider a product that offers one of the best ways to finance a long life expectancy — the life annuity. While variable annuities are often criticized for having high fees (a criticism of some fixed annuities as well), being difficult to understand and lacking flexibility on receiving income in retirement, life annuities offer one advantage that other investment options do not — a guaranteed stream of income that will last as long as you live. (Note that these guarantees are based upon the issuing company’s claims-paying ability.) A variable annuity that provides a range of investment options among various asset classes, has relatively low costs and includes product features that are well-suited to your needs can play an important role in helping you fund your retirement.
What Are Annuities, and How Do They Work?
To appreciate the advantages that annuities can offer, it’s important to understand how annuities work. Annuities are contracts sold by insurance companies that are designed to provide regular payments to the contract holder (also known as the annuitant) and his or her annuity partner (if there is one). The basic principle behind life annuities is simple: A number of different annuity purchasers provide funds, either in a lump sum or through regular premium payments, to the insurance company that issues the annuity. This creates a pool of assets that the insurance company manages. From this pool, at least some portion of the assets of those whose lives are shorter than expected are used to support income payments for those whose lives become longer than expected. With any annuity, all payments are based on the claims-paying ability of the insurance company.
Annuities also have accumulation phases, the time from the date when an annuity contract is issued until the start of income payments, during which the owner of annuity makes payments into the contract and accumulates assets.
What company is offering the annuity is also important to consider. Fees, surrender charges, investment options and the performance track-record1 of the various variable annuities available in the market can vary significantly. Don’t pay more than necessary. Shop carefully for a low-cost variable annuity that has features which are tailored to your goals.
And don’t overlook the financial strength of the insurance company issuing the annuity; look for a company with top ratings from the major insurance company rating agencies, which include A.M. Best Company, Standard & Poor’s, Moody’s Investors Service and Fitch. Ratings do not apply to the performance of variable annuities.
Unless you choose a “period certain” or fixed period annuity option, where payments stop after a specified time period, you will receive regular income payments from an annuity for as long as you live. For many people, this guarantee of lifetime income is the annuity’s major advantage when compared with other retirement income options.
Although annuities in the payout stage can be an effective vehicle for receiving income in retirement, many people have a negative impression of them, often based on misconceptions about what annuities are and the role they can play in retirement planning. Below, we list some of the most common myths about payout annuities, and then counter the myths with the facts.
Myth: "I don’t need an annuity — I can figure out how to take withdrawals from my retirement accounts to meet my income needs."
Reality: When you retire, you can try to develop a strategy for taking withdrawals from your various retirement accounts and assets, which might include defined contribution plans like 401(k)s or 403(b)s, IRAs, individual investments like stocks and bonds, and personal savings. However, crafting an income strategy from investment and savings vehicles such as these by living off your interest and earnings, or by drawing down principal gradually, can be tricky; while you may be successful in meeting your income needs, there’s always a danger that you’ll either live longer than your income lasts or that your investments won’t achieve the earnings you thought they would. If this happens, you’d either have to cut back on spending or, in a worse-case scenario, run out of money altogether.
Through an annuity, you can help avoid the danger of exhausting your retirement assets since the annuity provides you with regular payments for as long as you live. For example, Annuities: Now, Later, Never? (PDF), a research paper published by the TIAA-CREF Institute (October 2006), demonstrates that a life annuity can provide the highest level of income available to a retired individual.
There are different ways you can choose to receive income from an annuity for yourself and, if applicable, your annuity partner. For example, if you only need income for yourself, you can select what’s known as a “single life annuity.” If you also want to provide benefits to your annuity partner, the “full benefit to survivor option” provides full payments to both you and your partner until both of you die. Other alternatives allow your annuity partner to keep receiving benefits after your death.
Myth: "If I own an annuity and I die, the insurance company will keep all my money."
Reality: This is a common misconception about annuities — and one that scares away many investors who might actually benefit from owning an annuity. Certainly, it’s true that annuities are contractual arrangements that provide annuitants with payments until death, and if an annuitant dies soon after the payments begin, all payments from the annuity cease.
However, virtually all annuities offer an option called a guaranteed period that reduces the annuitant’s risk of receiving too few payments. With a guaranteed period, if both you and your annuity partner die within the guaranteed period, payments continue to your beneficiary(ies) until the end of the period. If you die after the guaranteed period ends, no further payments are made to the beneficiary(ies). Insurance companies offer guaranteed periods that cover varying lengths of time, such as 10, 15 and 20 years.
Selecting a guaranteed period is an effective way to remove the risk of losing all your money to the insurance company due to an early death. Note that while selecting a guaranteed period will reduce the amount of your payments, the overall cost may not necessarily reduce your payments by a large margin. Talk to your financial advisor and consult the annuity’s prospectus for further information.
Learn more about annuities at TIAA-CREF or other retirement planning topics in our Learning Center. Or you can contact us to learn more.
Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk, including possible loss of principal. Withdrawals prior to age 59½ may be subject to a 10% federal tax penalty on earnings, and surrender charges may apply in the early years of some contracts.
Payments from the variable annuity accounts [and mutual funds] are not guaranteed and will rise or fall based on investment performance. Mutual funds do not offer the range of income options available through annuities.
Annuity contracts and certificates are issued by Teachers Insurance and Annuity Association (TIAA) and College Retirement Equities Fund (CREF), New York, NY.
1 Past performance cannot guarantee future results.