Taking the Mystery Out of Annuities
Ensuring a guarantee of lifetime income during retirement is an essential element of any sound retirement strategy. And guaranteed lifetime income is the fundamental principle of an annuity. So why don't annuities show up in more peoples' retirement portfolios? It's largely a matter of misunderstanding and confusion about the true value an annuity can deliver.
Determining How Much to Allocate to Build an Income Floor
Although the needs of individual participants vary, the following steps can be used to determine the allocation within a diversified portfolio to provide for your basic income needs:
Determine the guaranteed income floor required to meet basic living expenses in retirement. While this amount varies, research suggests that most people need roughly $30,000 to $50,000 per year (or $2,500 to $4,200 per month).
Estimate monthly Social Security income.
Calculate the resulting income gap.
Direct savings to a fixed annuity that will generate the income needed to close the gap.
Allocate remaining plan contributions among a diversified mix of variable assets to help meet other investment and spending goals in retirement.
Choosing the Right Annuity
In choosing an annuity that delivers a guarantee of lifetime income, there is a wide range of options. Some of the key criteria to look for, and questions to ask, include:
Low costs. Are the company's annuity offerings low-cost? Or do they have sales charges, commissions, surrender fees or other expenses that can reduce financial benefits for plan participants? Also, are you able to buy a retirement annuity and thus receive lower "institutional pricing" versus paying retail price for an annuity outside your retirement plan?
Strength and stability. Does the company have sufficient capital strength to meet its current and future financial obligations? (The financial crisis heightened concerns about the solvency of insurance companies that issue annuity contracts.) Similarly, does the company have expertise and experience in providing lifetime income through various market and economic cycles? How long has the company offered annuities?
Transparency. Are the company's annuity contracts and income benefits clearly stated and based on reasonable assumptions? Is the annuity option suitable for the company's active and retired work force?
Trusted advice. Does the company offer a robust education program to help you understand the appropriate use of annuities as a long-term retirement savings vehicle - not a source of short-term liquidity?
There's Never Been a Better Time for Annuities
America's workers face an uncertain future in retirement. Savings rates are low, the long-term solvency of Social Security remains in doubt, and life expectancy is rising. With the baby boom generation entering retirement age, amid challenging economic conditions, there is a clear need for Americans to find additional, dependable ways to fund their retirement.
One retirement planning tool that has been largely overlooked is the annuity. Often misunderstood, owing to misleading and frequently outdated criticism, annuities have not gained wide acceptance in individual retirement portfolios. Yet a recent review of studies by a Wharton School economist found a consensus that "lifetime income annuities should definitely play a substantial role in the retirement arrangements of most people." The economist concluded that annuities should comprise 40 to 80% of an individual's retirement income, and those who are highly risk-averse or who do not plan to leave funds to heirs should consider being at the higher end of this range.1
While every individual has a unique financial profile, a low-cost annuity can make the difference between outliving your money and being able to afford life's essential expenses throughout your retirement. Indeed, most retirement accounts emphasize wealth accumulation, with little thought given to how that wealth will translate into retirement income.2 Annuities are focused on the income side of the equation, providing retirees with a guaranteed stream of payments that will help them build lifetime financial security.
Guaranteed Income — Why You Want it and Why It's Important
One of the lessons of the past few years has been that most Americans can't depend on their savings alone to ensure a secure retirement. Volatile investment returns and extreme events like the financial crisis of 2008 can quickly erode the value of a nest egg — particularly for older workers who have most of their assets at risk and less time to recover from steep losses.
While many retirees continue to have some regular sources of guaranteed income, this income is rarely sufficient to maintain their desired standard of living. For the average retiree, Social Security replaces only two out of every five dollars of pre-retirement income. For many middle- and upper-income individuals, the replacement ratio is even lower.
On top of that, many retirees don't have a retirement plan from their employer, and even those who do rarely get enough income from it to cover all their basic needs in retirement. As a result, most retirees face a gap between their guaranteed monthly income and what they perceive to be their necessary expenses. The seriousness of the retirement challenge is underscored by several recent research findings:
- A 2009 study from McKinsey & Company showed that the average U.S. household faces a retirement savings shortfall of $250,000.3
- The Employee Benefits Research Institute (EBRI) reports that 47.2% of Americans approaching retirement are at risk of running out of money.4
- TIAA-CREF research reveals that about 40% of American adults report they aren't saving enough for retirement.
- Most people would like to increase their savings, but more than three-quarters of those believe they won't succeed in doing so.
- Most people report that they have little idea how to change their behavior. More than 80% of those who believe they aren't saving enough for retirement report that they don't know how to get started.5
What's more, the dominant retirement savings model – building wealth – doesn't address the most basic risks and uncertainties associated with achieving lifetime financial security: how to assure that individuals can plan and act over the long term to support themselves adequately in retirement.
To address these shortcomings, TIAA-CREF is placing renewed focus on the concept of "guaranteed income" as a linchpin of retirement planning. We see this income as the reservoir of savings that you cannot deplete – providing security amid the uncertainty of not knowing how long you will need a steady income stream.
Guaranteed income also serves as a hedge against changes to your health and employment status. By establishing the means to realize guaranteed income and create an income floor — the absolute minimum you need to survive — the payouts from the guaranteed resource will pay for essential expenses such as food, home and taxes throughout old age.
About Annuities — Minus the Mystery
Annuities are uniquely designed to deliver a guaranteed income. But they are one of the most misunderstood investment products and are often the target of unfair criticism. Let's clear up some of the confusion and start with a basic explanation of how annuities work.
An annuity is best thought of as a contract between an individual and a financial services firm that is also registered as an insurance company. Under this contract, you commit funds to a firm that manages the annuity, and it invests your funds as well as those of other investors. When you decide you want to start receiving annuity distributions (typically when you are 59½ or older, in order to avoid tax penalties), the firm is obligated to make payments to you.
Many annuities, including those offered by TIAA-CREF, offer a broad range of accumulation and payout options, serving people of different ages, incomes and financial situations. And annuities offer a flexibility not found in many other investment products. In some cases, you have the freedom to reallocate your assets if there is a change in your financial status or in market conditions. For example, as you grow older, you might decide you'd like a steadier income stream. With variable annuities, you can take some of the annuity income you are receiving from more volatile investments such as stock (equity) accounts and transfer it to more conservative investment choices such as fixed-income accounts.6 And annuities differ from individual retirement accounts in that individuals who are still working are not required to begin making withdrawals at the age of 70½.
There are two different kinds of annuities: "fixed" and "variable."
Fixed annuities provide both tax-deferred asset accumulation and lifetime income. This makes them particularly well-suited to serve as the foundation of a complete retirement plan.
Safety and Stability
A fixed annuity guarantees safety of principal and a specified interest rate. Unlike stocks, bonds and other variable investments, the annuity provides some upside return potential with no downside risk. As a result, your annuity account balance never declines — even during periods of extreme market volatility and negative returns for other types of investments.
U.S. stocks plummeted nearly 45% between December 2007, when the "Great Recession" began, and March 9, 2009, the recent bottom for most equity markets. A fixed annuity, however, would have held its value and increased by the amount of guaranteed interest paid under the terms of the annuity contract.
Fixed annuities are excellent portfolio diversifiers because their returns historically have had low correlations with those of other asset classes, such as stocks and bonds. Diversification can help reduce overall volatility and enhance long-term return potential, which may make it easier for you to maintain an appropriate asset allocation during periods of market volatility.
Potentially Higher Retirement Income
When you contribute to a low-cost, fixed annuity over the course of a working career and convert the accumulated savings into a guaranteed stream of lifetime income, you may benefit from the fact that your contributions were applied during different interest rate environments. Individuals who wait until retirement to purchase a fixed life annuity may run the risk of investing funds during a low interest rate environment, with consequently lower income payments.
Like fixed annuities, variable annuities can also provide tax-deferred asset accumulation and lifetime income. But they differ in important ways. While a fixed annuity provides a minimum level of guaranteed income, the income under a variable annuity is based on the performance of various investment sub-accounts (thus "variable" and not "fixed"), and the amount of the payout typically resets monthly or annually. Moreover, while income is guaranteed for the duration of the investor's life, the amount of such income can vary significantly over time.
Potentially Higher Growth
Variable annuities invest your capital in both stocks and bonds. This means you can potentially realize higher long-term returns than if you had invested in a fixed annuity, though there is also greater downside risk. For this reason variable annuities are often used to help mitigate inflation risk.
The extreme volatility of the stock market spanning 2008 and 2009 provided a potent reminder of the risks associated with investing. For individuals entering retirement, the steep market decline had the potential to disrupt years – or even decades – worth of financial planning.
But annuities, which provide a guaranteed income as individuals enter retirement, can play an important part in helping to strengthen your financial security and achieve other long-term financial goals.
All Annuities Are High Cost
Annuities are frequently portrayed as a bad deal for investors, and the most common complaint is that they are riddled with high fees and hidden expenses. While some annuities fit this description, with a little bit of shopping around you’ll find annuities that are low cost and free of expenses such as sales loads and surrender charges. And expenses associated with lifetime income annuities have been steadily declining. Research by a University of Pennsylvania professor reveals that the average load (or sales charge) on an annuity was 50% lower in 2006 than in 1995. And the expenses can be reasonable when compared to what’s found with many mutual funds that carry sales loads and annual expenses of 1% or more.
Annuities Don’t Provide for Beneficiaries7
One of the common misconceptions about annuities is that if the owner of the annuity dies earlier than expected, the firm offering the annuity will not make any further payments. While this can be true of some annuity options, virtually all annuities offer an option called a guaranteed period, during which time payments are guaranteed (these periods can cover varying lengths of time, such as 10, 15 and 20 years). This reduces the annuitant’s risk of receiving too few payments, and ensures that the beneficiary(ies) will continue to receive payments. Under joint-life annuities, income is paid as long as one of the two owners of the annuity is still living.
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. 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.
3 See McKinsey & Company (2009). Restoring Americans’ Retirement Security – A Shared Responsibility
4 www.ebri.org/pdf/briefspdf/EBRI_IB_07-2010_No344_RRR-RSPM.pdf (PDF)
Guaranteed Lifetime Income is provided by Insurance companies and based on their claims-paying ability.
Fixed Annuities may carry liquidity and withdrawal restrictions.
Annuity account options are available through contracts issued by TIAA or CREF. These contracts are designed for retirement or other long-term goals, and offer a variety of income options, including lifetime income. Payments from the variable annuity accounts [and mutual funds] are not guaranteed and will rise or fall based on investment performance.
There are costs associated with annuities, including surrender fees, early withdrawal penalties and mortality risk expenses. Also, depending on the financial company you choose, the availability of specific types of annuities and annuity features may vary by state. So always read the prospectus before investing.
Withdrawals of earnings are subject to ordinary income tax and a Federal 10% penalty may apply prior to age 59½.
TIAA-CREF Individual & Institutional Services, LLC and Teachers Personal Investors Services, Inc., members FINRA, distribute securities products.
Annuity contracts and certificates are issued by Teachers Insurance and Annuity Association (TIAA) and College Retirement Equities Fund (CREF), New York, NY.