Paclean & Sweep Investment

For the 80 million Baby Boomers who are just now beginning to cross the retirement threshold, at a rate of 10,000 per day for the next 20 years, the concept of retirement planning has taken on a whole new meaning.  Under the “new normal” retirement planning includes delaying the retirement date, planning for work after retirement, or lowering standard-of-living expectations. Retirement savers have had to endure two steep market declines (2000 and 2008), essentially flat returns during the decade of 2000, and, now a stymied economy that has shattered their confidence.  No longer can anyone simply rely on the simple strategy of socking a part of their paycheck into a 401(k) and let it ride. Today’s retirement portfolio needs to be constructed in way that addresses all of the risks while keeping the door open for growth.

Annuities as a retirement savings vehicle have had their critics.  Often labeled as too inflexible, or too expensive, or too illiquid, annuities have emerged as a critical component of a larger, more balanced retirement portfolio.  When considered on their own, one might be able to make an argument as to their inflexibility or their expenses as being unsuitable for many investors. However, when considered in the context of a complete portfolio, they make much more sense than some of the alternatives.  Let’s explore the features of annuity in the context of a retirement portfolio:

Tax Deferred Growth

When saving for retirement, or any long term objective, minimizing taxes on earnings is essential in order to maximize growth. The tax deferral component of annuities makes them attractive for anyone in the higher tax brackets who can benefit from minimizing taxes.  As with qualified plans, taxes are paid on the earnings as they are withdrawn, and there are penalties for withdrawals made prior to age 59 ½. As part of a retirement portfolio, annuities should be considered when allowable contributions to qualified plans, such as 401(k)s, have been maximized as they do provide current tax savings that annuity contributions don’t.

Safety of Principal

Fixed annuities are considered to among the safest of all investment vehicles. With the principal backed by the assets of life insurance companies, the most stable of financial institutions, investors have the peace-of-mind assurance that a portion of their retirement portfolio will  be secure no matter the economic or market conditions. A properly balanced portfolio should always have a portion of assets allocated to investments that are free of market risk.  The amount of the allocation will depend largely on the risk tolerance and the growth objectives of the individual investor.

No Required Minimum Withdrawals

One of the problems with relying solely on a qualified plan for a retirement portfolio is that they require a minimum level of withdrawals to be taken at the age of 70 ½. With annuities, there is no such requirement, so they can be left intact, continuing to accumulate on a tax deferred basis much later into retirement.

No Impact on Social Security Taxation

Many retirees are finding that, in order to maintain their standard of living, they need to continue to work in retirement. The potential problem that creates is that a portion of their Social Security income may then become includable in their income tax calculations. A married couple in retirement can only earn $32,000 from all sources before taxes are also owed on Social Security income.  One of the advantages of annuities is that their income is not includable as part of the Social Security tax calculation.

Guaranteed Death Benefit

Millions of investors lost as much as 40% of their retirement plan account values in the last market crash.  For those who were brave enough to keep their money invested in the markets, they recouped their losses and more.  It’s an unfortunate fact, that many investors didn’t keep their money invested and have yet to fully recover their losses. Throughout that whole ordeal these investors and their families were suddenly very vulnerable in the event of a premature death of the investor.  The family would be left with only a fraction of what was accumulated, and, in many cases, a loss of principal.  Annuities provide a unique layer of protection with their guaranteed death benefit which pays out, at a minimum the original principal to the beneficiaries. With some annuities, such as an indexed annuity or a variable annuity with special riders, even the gains can be protected against loss and includable in the guaranteed death benefit.

Annuities Explained

Guaranteed Lifetime Income

Since the demise of defined benefit, or pension plans, investors have had to rely on their own ability to accumulate enough funds that would generate an income they couldn’t outlive. Most studies have sadly shown that as much as 60% of people reaching retirement age have not saved nearly enough money to last a lifetime, at least without some major downgrade in their lifestyle. The “new normal” today will see most people delaying their retirement or working well into it. This is, perhaps, the biggest reason why pre-retirees are adding annuities to their retirement portfolios, because, as they are coming to realize, annuities are the only investment vehicle that can guarantee a stream of income that cannot be outlived.  When combined with the income generated from other savings vehicles, annuity income can provide the added safety net and stability for a retirement portfolio that needs to include other growth or risk oriented investments.

Summary

Very few financial advisors would advise anyone to own an annuity unless it was in the context of a complete retirement strategy that included a well diversified, balanced portfolio.  When the unique attributes of an annuity – its tax deferral, its safety, its guarantees, and it flexibility – are combined with a larger portfolio, it can greatly enhance its stability, reduce risk exposure, and provide long term security.

Over the years the debate over the relative safety of mutual funds versus variable annuities has come and gone with nothing in the way of any real consensus winner. They both came on the scene at roughly the same time, surged in popularity together during the raging stock markets of the 80’ and 90’s, and proliferated to the point of saturation well into the early 2000’s. All things being equal, they both offer investors the opportunity to participate in the markets with relative safety and equal potential for upside growth. In either case, investors can achieve a level of diversification within professionally managed portfolios that can reduce the risk of stock market investing. In that regard, can one actually be safer than another?  In a word, yes.

If, by “safer”, we are referring to the possibility of principal loss, both types of investments entail market risk. Both invest in portfolios of securities that can either appreciate or decline in value. But, if you consider a standard variable annuity contract, there is at least one safety feature that you won’t find in a mutual fund and that is the guaranteed death benefit.  The death benefit affords the variable annuity investor one layer of protection that the mutual fund doesn’t offer and that is the guaranteed return of the investor’s principal investment.  While some variable annuity critics may try to belittle that benefit as inconsequential, they might ask those mutual fund investors who were unfortunate enough to die during the worst of the market decline in 2008.  At the very least, variable annuity investors can assure their surviving families of greater financial security even in the face severe market declines.

It has only been in recent years that variable annuity providers have upped the ante for investment safety by adding rider options that go even further to protect the principal as well as the gains in the account value.  And, for the increasing number of people who are concerned with outliving their income sources, the riders will also guarantee their income from a variable annuity.  Practically speaking, it doesn’t get much safer than that. While they do come at a cost, these riders provide the ultimate peace-of-mind that one doesn’t usually find in investments that also allow for unlimited upside growth.

All Gain and No Pain

The guaranteed account value rider (GAV) enables variable annuity investors to enjoy the gains in their account values while riding out the market swings.  Essentially, the rider guarantees a minimum amount of growth of the principal amount regardless of market declines. And, if the account values do appreciate over time, the rider provides a “step-up” that enables the investor to reset the principal amount to the higher account value.

No Account Gain? No Problem

The guaranteed minimum income benefit (GMIB) addresses any concern an investor might have over the possibility of having to take a smaller income as a result of declining market values.  The rider ensures that, during the accumulation phase, the account values will achieve a minimum amount of growth. And, at the time of annuitization, the income payment will be based on the greater of the minimum accumulation amount, the actual account value, or the highest account value level at previous anniversary date.

No Account Balance? No Problem

The living withdrawal benefit (LWB) essentially turns a variable annuity into a bottomless pit of withdrawals regardless of whether or not there are funds left in the account. When the rider is exercised, the withdrawal rate is set based on a percentage of the account value which can be the actual value or a guaranteed account value based on a minimum growth, whichever is higher.  Even after withdrawals begin, the account value can be “stepped up” if, as a result of market growth, it increases above the base account value. This would result in an upward adjustment of the withdrawal amount based on the same percentage applied to the higher account value.

Summary

The addition of these variable annuity riders essentially shuts the door on the “safer” debate. It’s not even a fair fight. However, they don’t come without a cost.  To add one of these riders an additional fee in the range of .5% to 1.2% will be deducted annually from the account values.  This on top of the average annual fees of 1.5% to 2% for standard variable annuity contracts. So, for the absolute peace-of-mind that can be attained alongside the upside growth potential, an investor will pay as much 3% of account values each year.  With over 60% of Baby Boomers lying awake wondering if they will outlive their income, these types of guarantees may be priceless.

One important caveat: Guarantees are only as solid as the companies that back them. If you are guaranteed a minimum income for a lifetime that may last 30 years, it would be extremely important to make sure you are working with a company that will be around at least as long. Life insurance companies are considered to be the strongest and most stable of financial institutions, but, with so much at stake, why not work with the strongest? Companies that have earned the highest ratings (A+ or better from A.M. Best or AAA from Standard & Poor’s) are deemed to have the capability of weathering even the most treacherous economic storms. If you really want peace-of-mind, stick with quality.