Is an Annuity Right for You? A Deeper Look

In the second part of the series on annuities, Trevor Lawson uses a framework from a Morningstar article by Christine Benz to help listeners determine if an annuity is a suitable tool for their retirement plan. Trevor discusses key questions to consider, such as whether you need guaranteed lifetime income to hedge against longevity risk, especially since pensions are becoming less common. He also examines the appeal of annuities for their ability to provide protection against market losses, but notes that this often comes with a cap on potential growth. The episode also explores the tax benefits of annuities, which offer tax deferral similar to a 401k or IRA, but highlights the distinction that withdrawals are typically taxed as ordinary income rather than capital gains. Lastly, Trevor emphasizes that a key consideration is the lack of liquidity, as annuities often have surrender periods during which accessing funds incurs a penalty. He concludes by stating that annuities are great tools for income and protection, but not for those seeking maximum growth or frequent access to their money.

Reference: https://www.morningstar.com/retirement/is-an-annuity-right-you

Securities and investment advisory services offered through Osaic Wealth, Inc. member FINRA/SIPC. Osaic Wealth is separately owned and other entities and/or marketing names, products or services referenced here are independent of Osaic Wealth. Branch phone: [phone].

What is Retirement With/On Purpose?

A podcast designed to help retirees and those nearing retirement navigate finances and life planning with expert insights from financial advisor Trevor Lawson. Tune in for practical strategies and inspiring ideas to ensure your retirement years are purposeful, fulfilling, and truly your best chapter yet.

*Securities and investment advisory services offered through Osaic Wealth, Inc. member FINRA/SIPC. Osaic Wealth is separately owned and other entities and/or marketing names, products or services referenced here are independent of Osaic Wealth. Branch phone: [phone].

Welcome back to part two of this series on annuities. And so last episode, we talked about what is an annuity Today we're gonna take that a step further and start to evaluate whether or not an annuity is right for you. And there's a framework we're gonna use offered up by Morningstar again, and Christine Bins again.
Uh, she, she's really done a good job over the past couple of weeks coming up, coming out with content on the Morningstar website, talking about [00:01:00] these vehicles. Um, so I'm using her article as an annuity right for you. As a guide, and we'll link to that in the show notes. But to kick things off is an annuity right for you.
So I equip my spins here. It starts with the fact that these are insurance products. Even when they are combined with mutual funds, they range from low cost, very simple annuities that can deliver on a promise for a guaranteed stream of income. And really strengthen a retirement income plan to expensive, highly complicated packages offering uncertain results for, for, for some that critics often rightly do ride as not much more than a way for an advisor or insurance salesman to earn a commission.
A combination of potential benefits from some features, significant pitfalls from others, wide variations of complexity. Opacity of fees and high commissions and advisor incentives makes it incredibly difficult for consumers to figure out if an [00:02:00] annuity is simply right for them in the first place, let alone conduct due diligence on various products.
So to. That kind of in itself gives you a sense of why, um, annuities are all across the spectrum in terms of whether or not they're right for the, the investor. They're, sometimes they're the perfect solution. Sometimes they're offered, um, to an investor who was. Sold a product from a insurance salesman or advisor who was more after a commission than the right outcome for the client.
So it's very important to understand the type of annuity and whether or not it makes sense for you before entering into that contract with the insurance company. So here's some questions to determine whether or not an annuity makes sense for you. One, and I would argue this is one of the more important questions, uh, especially for income driven annuities.
Income annuities. Do you [00:03:00] need guaranteed lifetime income? So, Ms. Ben's notes, I'd argue that the ability to earn guaranteed lifetime income is the biggest attraction to an annu. In contrast with your portfolio, which can run out of money if you overspend or make poor investment decisions. Most annuities, once you annuitize, will pay you income for the rest of your life.
Much like social security. So I mentioned last time, but again, as pensions are becoming a thing of the past for retirees. Annuities are a tool for potentially filling that gap and providing a source of guaranteed income for retirees. And so again, a lot of retirement researchers are very optimistic about the future of annuities for their ability to pay a guaranteed income.
And I think, you know, as, as a retiree, one of the things that a lot of clients with annuities find very attractive is just the peace of mind that [00:04:00] comes with that guaranteed income stream every month or every year, regardless of how the market is performing. Again, much like a pension. Provided nonetheless, I'm quoting again here nonetheless.
The combination of lifetime income plus a higher payout means that basic income annuities can be a sensible addition to retirees toolkits. That's particularly true today, given low yields on safe investments, think CDs, treasuries, things that are very safe. The as interest rates have come down, the yields on these investments have also come down.
The ebbing away of pensions, which I just talked about, and longer life expectancies, especially for wealthier individuals. If you're part of a married couple, there's a one in four chance that you or your partner will live to age 95, and if your higher income, the odds are even higher, that one of you will make it to 95.
So these income annuities especially can serve as a great hedge against longevity risk. When you give, you know, or loan give, [00:05:00] however you wanna frame it, the insurance company, your money, an income annuity is contractually obligated to pay you out over the rest of your life. And so for those that really outlive their, you know, the, the average longevity for the average age for men or women, an annuity can, can really be a hedge against this, this longevity risk, and outliving your money because that insurance company is on the hook to pay you out for the rest of your life no matter how long you live.
Just like pensions used to. Another question to frame whether or not annuity is right for you. Are you seeking guarantees against losses? Protection against outliving your assets. The ability to receive an income stream until you die is arguably the most compelling selling point for annuities. That's the key reason that so many retire.
Retirement Researchers believe that annuities, especially immediate income annuities or deferred income annuities are [00:06:00] utilized in retiree portfolios, yet annuities are often sold because of the other guarantees, namely protection against big stock market losses. Indeed a common type of annuity and equity indexed annuity has that as its main selling point.
These products use options to provide returns that are based on the performance of an equity index, but also put a floor underneath losses. So guaranteed income, uh, you know, is, is one factor to, to consider if you need, um, for determining whether or not an annuity is right for you. The other is, do you need some protection?
So. Other types of annuities. Fixed indexed annuities, fixed annuities, equity indexed annuities. These, these, I put in another camp, and they're not designed necessarily for guaranteed income. They're more designed for protection. So if an investor's looking for a way to [00:07:00] protect a portion of their monies.
These other types of annuities that I mentioned could be a worthwhile consideration. Just keep in mind that usually when the annuity company is providing you downside protection, what they're doing in exchange is capping you on the upside. So you're giving up some growth potential for protection, but in some cases, that could be the right trade off.
Particularly for clients who are entering their retirement years and are more concerned about preserving their nest egg than they are about continuing to to grow and build it. Piggybacking on that is growth. Your main objective, so another. I'm quoting Ms. Bens here for income annuities, either immediate or deferred.
Guaranteed income is the main objective, so growth will be modest. So if growth is your main objective and income annuity is, is likely not the best solution for. Your, your investment in [00:08:00] intention, and even like I mentioned, these other types of annuities, fixed indexed, fixed equity index. These, these annuities that can provide, uh, protection.
What you're giving up for that protection is growth potential. So if growth is all you're after, most of the time, the investors better served looking outside of an annuity for, for maximum growth potential. Annuities are great ways for providing income and protection, but in turn for that income and protection that you're getting from the annuity, the growth is oftentimes not what it would be in another traditional investment like a stock or you know, mutual fund.
Do you need additional sources of tax deferral? So another of the main selling points for annuities is the potential tax benefit annuities are tax deferred, and we [00:09:00] talked about this in the last episode, similar to funds in a traditional IRA or 401k. This means that as long as your assets stay inside the annuity wrapper.
They're not subject to taxation because contributions to annuities aren't subject to the same income or contribution limits as IRAs and 4 0 1 ks. These products are often sold as an additional source of tax deferred funds for retirement. So that's an interesting, um, point here. So for many high income earners during their accumulation years that are maxing out their 401k and are looking for additional ways to, to put money away for retirement purposes, but do so in a, in a manner that's tax deferred.
Annuity can be, um, a way to go about doing that because again, once it's in the annuity, all the earnings are taxed. Deferred. And then when the, you know, when the, when the investor takes the money out in retirement, they'll pay, they'll pay taxes. Ms. Ben's notes though, and I fully agree, it's also important to understand the tax treatment of the [00:10:00] funds on the way out.
If the annuity consists of assets that have never been taxed. So think money from your IRA or 401k that was already pre-taxed, it's considered qualified and any payments you receive from it are fully taxable at your ordinary income tax rate. If on the other hand, you steered after-tax funds into the annuity, the tax due upon any payments from it are subject to what's called the exclusion ratio.
Meaning that any funds you've already paid taxes on aren't subject to taxes, but amounts over and above that level are subject to ordinary income tax. So for that, for that higher income earner or that, that just, that individual approaching retirement, that's looking for another source of, of tax deferral.
Especially with monies that have already been taxed. It's important to evaluate the short term tax benefit that the annuity provides in the way of tax deferral versus the, [00:11:00] you know, the, the long term ordinary income tax consequences that you'll get in return. So the opportunity for tax deferral, Ms.
Ben's notes means that annuities have some tax benefits relative to saving in a plain vanilla brokerage account, but they're not necessarily better. While a brokerage account doesn't supply tax deferral in the same way as an annuity does, the appreciation on assets and a taxable account is tax at your capital gains tax rate.
So that's one of the key differences between. An annuity and, uh, just a, a traditional brokerage account is an annuity. All the gains are gonna be taxed at ordinary income tax rates, a brokerage account. Those gains are oftentimes taxed at capital gains tax rates, which is oftentimes much more favorable than the ordinary income tax rate assessed on an annuity.
Lastly, one, one final thing to think about is do you need ongoing access to your money? [00:12:00] So. Quoting again, finally, your need for liquidity should be a key consideration before venturing too far down the path of an annuity purchase. Annuities are contracts with insurance companies and while different annuities have different rules about withdrawals, they typically carry charges if you need access to your funds within the first several years of purchase.
So most, if not all annuities, the money is, is tied up for a period of time. So in order for the insurance company to be able to. Offer you the benefits of tax deferral and, and protection and or income. What you, you give up is access to your money. So most annuities will come with what they call a surrender period, and that can.
That can range in in years depending on the type of annuity, but generally there's a surrender period. So if you, the investor needed full access to your money, while that annuity is still within its surrender period, you're gonna pay an early withdrawal penalty for accessing your money [00:13:00] during that time.
So if you need ongoing access to your money, usually an annuity is, is not the right solution because they are not liquid. During that, those initial years when you're in that surrender period. So in summary, annuities are without question great tools for those needing another source of guaranteed income.
I think income annuities that I've mentioned are a, are a way for people who no longer have a pension or are desiring a pension type benefit to create guaranteed income in retirement. They're also a potential, uh, tool for those that are looking for an investment with protection features and tax deferral.
So protection features, like I mentioned, come with fixed and fixed index annuities and other. Index typed annuities and the, the, the earnings and [00:14:00] those annuity annuities are all tax deferred. So for investors that are looking for protection while also capturing some growth potential, um, there are annuities out there that may be a good solution, but for those that are simply looking to maximize growth potential and are wanting to have access to their money.
Are generally not the right tool for that investor. I hope you found this series on annuities. Educational and at least it inspires you to start thinking about whether or not an annuity is a tool that's right for your retirement toolkit. As always, if you've got any questions about this topic or any other retirement topics, feel comfortable reaching out to my team and I, as we can always help you further evaluate any retirement related concept and the pros and cons of applying it to your.
Retirement pitcher. [00:15:00] Thank you for your time and I'll look forward to being with you again soon. Take care.