What You Should Know About Using Fixed Annuities For Retirement Income

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Fixed deferred annuities often are used in the accumulation phase of a financial plan. They offer tax-deferred earnings, safety of principal and yields that are usually higher than comparable alternatives.

Perhaps most important, fixed annuities can be annuitized?i.e., converted to a series of payments to meet basic income needs in retirement.

Uniquely, these “income payments,” as they are often called, can be structured to last a lifetime. But timing maturities and selecting appropriate products can make a big difference in how well they meet investment objectives.

Consider the objective of preserving capital. Many clients seek to preserve capital and live on investment income during retirement. To achieve this, the client will often make a large investment in a deferred annuity that offers surrender charge-free withdrawals of interest. But the withdrawals will be taxable and the investor will lose flexibility.

Let?s say $100,000 is invested in a fixed deferred annuity paying 5%. If earnings are withdrawn annually, the investor will receive $5,000 each year before taxes or $3,750 after taxes assuming the person is in the 25% tax bracket.

A better solution would be to purchase a $50,000 fixed immediate annuity, and two $25,000 fixed deferred annuities. At current rates, the $50,000 will generate about $4,700 a year pre-tax for 15 years; 70% of these payments will be a tax-free return of capital, yielding $4,358 a year after tax. That is $607, or 16%, more than option one.

Assuming 5% interest, both $25,000 deferred annuities will have doubled by year 16. One can be annuitized to provide the same series of payments for another 15 years, 35% tax-free. In year 31, the third will be worth $100,000.

This approach preserves capital, too, but also maximizes income and minimizes taxes.

There are other options. For example, the third annuity could purchase a $100,000 single premium whole life policy providing income to our investor and a tax-free death benefit to heirs. The important point is that more contracts purchased initially will provide more flexibility later.

Even more flexibility is possible with careful selection of products. This is particularly important if the investor isn?t sure when he or she will need access to the investment.

There is a 10% Internal Revenue Service penalty on fixed annuity withdrawals made before age 59 1/2. This can be avoided if the series of payouts extends beyond that age. For maximum flexibility to take advantage of this, look for deferred annuities that waive surrender charges upon annuitization.

Annuitization waivers aren?t unusual. Almost half of the products in our database have them. But there can be significant differences between them. What?s the waiting/elimination period? Liberal waivers permit annuitization after 12 months. How about the minimum duration of payments? In some cases, it?s a lifetime. Look for term-certain options as well.

Some contracts offer an annuitization bonusa nice feature that boosts payouts. If the contract has a market value adjustment, make sure it doesn?t apply to annuitization. Finally, be sure to check for state variations and other restrictions.

When comparing products, also check the minimum guaranteed payments. For an initial review, look at the minimum guaranteed rate used to calculate payments and the mortality table date. The higher the rate, the higher the payment. Older tables generally mean larger lifetime payments.

As an example, let?s look at a summary of minimum payout information from a product profile in our database. This is shown in Table I.

The product shown in the Table has a reasonable 3% as the minimum guaranteed rate on payouts. The lifetime payouts are based on the 2000 mortality table. So it seems that there might be a better deal on lifetime payments but that year-certain payouts will be acceptable.

Looking more closely, let?s say the investor is age 60. What is the minimum this annuitant will receive per month for 15 years on $50,000? To find out, divide by 1,000 and then multiply by the 15-year certain factor: (50,000/1,000) x 6.87 = $343.50/month or $4,122/year before taxes.

If the currently available 15-year payout is $4,710/year pre-tax, the worst-case payout looks acceptable. This particular contract also offers two lifetime payment options, providing additional flexibility. Overall, this looks like a good fixed annuity, other choices being equal in terms of credited rate, company strength and so forth.

The message for financial advisors is, shop around. It?s just as important to shop around for the best fixed annuity when the time arrives for distribution as it is when the client is saving up for retirement. And remember that deferred annuities or lump sum distributions from employer-sponsored plans can be transferred/rolled over to a stand-alone immediate annuity. It?s always wise to compare payouts with those from a stand-alone immediate annuity.

is president and CEO of Beacon Research, Evanston, Ill. His e-mail address is jeremy@beaconresearch.net.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 3, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.