“Should I buy a retirement annuity” is a question people often ask themselves when they are concerned about the state of their retirement finances. Some people say that if you feel the need to ask the question then the answer is probably “yes”. I believe that the definitive and absolutely correct answer to this question is… Maybe. It depends.
If you think that a retirement annuity might be right for you, the real question you should be asking yourself is what problem are you trying to resolve? What concern and source of stress are you trying to eliminate? This requires you to have a clear understanding of what you want to achieve with your purchase.
Most retirement annuities are no better or worse than any other financial instrument out there when used for what it was actually designed.
I say most because certain retirement annuities should indeed be avoided like the plague
(I explain which in my book)
On the other hand, the right annuity can be a valuable tool if used correctly, but let me emphasize “right” and “correctly”.
Just as you wouldn’t want to hammer a nail with a screwdriver…
Try tightening a screw with a hammer.
Not going to get the job done !
So, be weary of any financial professionals who tell you “I hate annuities and so should you” as they group all annuities into one category to prove their point, or others who tell you that fixed indexed annuities are the only solution to all your worries.
Since fixed annuities are as different from variable annuity as stocks are to CD’s, and especially because annuities are long-term financial instruments with high penalties for early withdrawals in excess of the yearly free withdrawal provision (usually 10%) …
You should never purchase a retirement annuity without first having a good understanding of its features, what you give up (drawbacks) and what you gain (advantages)!
So the first thing you need to do is to learn enough about retirement annuities to know how they work and how they are different from one another.
What Is a Retirement Annuity?
Too often, I meet people who bought a variable annuity thinking that their principal was protected and that they would not lose any money during market downturns while others bought a fixed indexed annuity with an income rider when what they really wanted was the maximum growth potential possible.
For a quick and easy to understand overview of the three main categories of annuities, how they are different from each other, what are their pros and cons, and who each one may be right for…
Once you have a general understanding of the different kinds of retirement annuities available and how they work and what are their advantages and disadvantages, the question to ask yourself is…
Do I Need a Retirement Annuity?
There are several reasons why you might want to purchase one. In a previous article, I identify eight reasons why a fixed indexed annuity might be right for you. Several of those reasons are directly related to “need” (the others are related to “wants”). You may still want to ad one to your retirement plan even if you don’t “need” one; for now, let’s focus on the three of most importance…
The most obvious reason to purchase a retirement annuity is income, since this is what they were originally designed to do.
Doesn’t it make sense to have enough guaranteed income to cover your basic living expenses so no matter what happens in the market or in the economy, you don’t have to worry about the things you absolutely must have and that you cannot do without (mortgage, healthcare, car expenses, food…)?
“Life expectancies are getting longer. With that comes an increased risk of outliving one’s retirement savings … Annuities can help to prevent that from happening by providing lifetime income for retirees. An annuity is basically an insurance contract in which you pay a financial institution a specific amount of money—either in a lump sum or a series of payments—and the company then invests your money and promises to pay you a regular income right away or in the future. ” CNN, October 24,2014
Since Social Security and pensions often do not cover one’s living expenses in their entirety, retirement savings become the source of the income needed to bridge this income gap.
Using a portion of your retirement savings to purchase a retirement annuity that will provide the additional guaranteed income you need can eliminate the stress that comes from worrying about outliving your savings.
Living free from financial stress has proven health benefits
that contribute to good health and longevity.
Another benefit that comes from making sure that your basic living expenses are covered with guaranteed income is that you can use the remainder of your savings more aggressively to try to capture greater returns and stretch your savings even further.
You may also decide, as many people do, that you want to protect more than just your basic living expenses; you may also want to protect the portion of your savings that you have earmarked for leisure activities, vacations, emergencies, or those extras that give you the lifestyle you enjoy.
Long Term Care
The rapidly rising costs of assisted living and long term care facilities are the biggest threat to your savings. With the costs for these services growing at double and triple the current rate of inflation, certain annuities can give you:
- Increased payout of your guaranteed lifetime income to help cover the costs
- Preserve your savings
- Guarantee that your spouse will continue to benefit from lifetime income even after you’re gone and even if the cash value of your savings account goes to zero.
Protection of principal
Many people I talk to knowingly take on more risk in the market than they feel comfortable with because they don’t know how to safely get the returns they need or worse, they don’t even realize how much risk they are actually exposed to. If the income needed comes from retirement savings at risk in the market, protecting your principal is a must.
A fixed indexed annuity designed for growth can protect your savings from market losses and provide returns ranging from 4-7%.
If it turns out that you likely are going to need the guaranteed income or protection of principal an annuity can provide, the next question is….
How Much Retirement Annuity Do I Need?
If your objective is preservation of principal, the answer is fairly straightforward. You should place whatever savings you want to protect from market risk into a retirement annuity (remember, variable annuities do not protect your principal). The other main consideration is how much of that money do you need and when do you need it. Most annuities will allow you to make withdrawals of up to 10% per year without any penalties.
If your objective is income, than figuring out how much income you need and when you need it are the two main factors that will tell you how much annuity you need.
If you’re still working, here are some questions you should start asking yourself:
- How many years do I have until I retire?
- What do I expect my expenses to be when I retire and how will these expenses change over the 20 to 30 years of retirement?
- It is important to account for inflation and the fact that some expenses will go away, others will stay constant, others will increase, and others will appear only later (Long Term Care).
- How much do I expect to have saved by the time I retire?
- How much guaranteed income do I expect to receive at retirement and how will this income change?
- Social Security benefits will have increases (COLA)
- If married, the loss of your spouse will affect your benefits. The lesser of the two payments will go away. If both spouses receive approximately the same amount in Social Security benefits, this amounts to a 50% decrease in income.
- For pensions, there may or may not be survivor benefits depending on how you elected to receive payments.
- Will there be an income gap between my guaranteed income and my expenses?
- Figuring out how much annuity you need comes down to a simple calculation:
- Expenses – After Tax Guaranteed Income (i.e.: Social Security, pensions, annuity payments) = Annuity Income Needed.
- Figuring out how much annuity you need comes down to a simple calculation:
- Will 2.5 to 3% of the savings I expect to have generate the after-tax income I need to bridge the income gap, especially during the first 10 to 20 years of retirement?
If you’re retired (and if you’re still working), here are some other questions:
- How much guaranteed income will you or your spouse lose when one outlives the other?
- How will the costs of Long Term Care, both in-home and nursing home, impact your savings and how will this impact your spouse’s lifestyle and quality of life?
- How much growth do you need/want?
- How much liquidity do you need?
- Do I need additional tax-deferral?
At this point, you should have determined if an annuity is right for you. The next question then is…