Annuities are valued for their tax-deferred accumulation benefit, but they also provide an essential source of retirement income for many retirees.
Matt Drinkwater, assistant vice president, LIMRA Secure Retirement Institute in Windsor, Connecticut, reports the institute has conducted an ongoing study of variable annuity owners who purchased contracts in 2007. In 2013, 88 percent of owners above age 70 took guaranteed withdrawals from their annuities. That percentage drops off for those in their 50s and 60s, which is expected, but nonetheless, he points to the 88 percent as an impressive result that demonstrates the income benefit’s value to owners.
The focus on the income benefits of annuities continues with present-day sales. The institute categorized total retail annuity market sales for 2015 by investment objectives, and guaranteed income as a primary objective accounted for about $108 billion of the $207 billion total sales.
Peter Gourley, vice president with Ruark Consulting in Simsbury, Connecticut, says his firm’s research also finds high use rates of annuities’ income benefits among older contract holders. For example, among annuity owners over age 70, he estimates roughly three-quarters are taking withdrawals.
“Some of those are driven by the necessity to take a RMD on a qualified contract,” he notes. “But, even setting that aside, there’s a definite age effect where as people get older into retirement age, obviously they start using their retirement income feature.”
One reason for buyers’ interest is annuities’ ability to help retirees address multiple financial risks. John Homer, CLU and Million Dollar Round Table member with Oxford Financial Group in Salt Lake City, cites longevity, liquidity, inflation, health care costs, sequence of returns market risk and legacy risk as the major categories. Annuities can “deal with the market sequence risk because if I’m providing my income with annuities, I don’t have that risk,” he says. “If I’m concerned about longevity, outliving the income, my lifetime income benefit solves that. Inflation, if I’ve got the inflation type of rider in the annuity, it’s going to inflate. As time goes by, it takes care of that. And, so, three out of those six risks are handled by the annuity and there is no better way to handle those risks.”
Filling the Gap
Nonetheless, advisors shouldn’t view annuities as the ideal solution for every client, cautions Curtis Cloke, CLTC, LUTCF, RICP with Thrive Income Distribution Systems LLC in Burlington, Iowa. He suggests retirement income planning should initially identify the “gap” between clients’ income and expenses. The advisor’s role is to identify available resources, such as Social Security and pensions, and forecast how much additional asset-based income, if any, the client needs to sustain the desired lifestyle. That analysis should also consider inflation, he adds. If there is a current or projected income deficit, the question then becomes how much of that deficit the client wants to cover with a guaranteed income source in order to have a predictable income floor.
Every client, regardless of wealth, wants some level of income stability, Cloke says. Social Security is one source; pensions, when available, are another. If those two sources provide sufficient guaranteed income for the foreseeable future, the client might not need to draw on the portfolio for additional income, at least early in retirement.
Craig Lemoine, Ph.D., CFP and associate professor of financial planning at the American College of Financial Services in Bryn Mawr, Pennsylvania, suggests advisors and retirees also consider additional sources of wealth and liquidity, including home equity, in addition to annuities, for their potential to generate steady income. For example, the quality of available reverse mortgage options has improved and should be reviewed, he notes, despite the emotional attachment clients often have to leaving the family home to their children.
The Annuity Decision
When there is an income gap and the client wants to increase his or her guaranteed income, the amount and nature of the gap will indicate which type of annuity to consider, says Cloke. “If it’s an inflatable gap, then that narrows the scope even further because I can’t do inflation adjustment with guaranteed lifetime withdrawal benefit (GLWB) products; I can only do inflation with single premium immediate annuities (SPIAs) and deferred income annuities (DIAs). I can buy an inflation increase from a tenth of a point in 10 percent increments up to 6.5 percent. So, I can ladder these products starting at different times and subsets along the way, and I can buy them with different COLA adjustments based on what the math shows me,” he says.
SPIAs and DIAs are best suited for cases when there is a need for contractual inflation adjustments, Cloke believes. “Anytime you buy a GLWB with a fixed indexed annuity, any discussion of inflation is a projective, what-if, if such-and-such and so-and-so occurs kind of conversation,” he says. “Because when you buy a GLWB, things you cannot predict must happen in order for the possibility of inflation to be alive. You can’t guarantee it. You can only project it based on what-ifs. But, with an income annuity, you can buy it with absolute finality and certainty as a guarantee of the contractual obligations of that carrier.”
Income taxes are another factor, says Lemoine. Annuity withdrawals from qualified accounts will be fully taxed. But for nonqualified accounts, annuitization can offer an initial tax advantage over withdrawals because each annuitized payment will include a return of the annuitant’s cost basis. “If we take the income rider, we’re going to get a LIFO (last-in, first-out) treatment, and we’re going to wind up getting all gains at first,” he says “So, we need to consider the taxation element if it’s nonqualified.”
Pros and Cons
The drawback with annuitization is that only a few clients are likely to choose that option. Economists call this the annuity puzzle and advisors cite multiple reasons for clients’ reluctance to annuitize including, among others: exposure to inflation; risk of premature death and payments ending before recouping principal; and loss of control. Cloke has found he needs to offer installment or cash refund options with annuity proposals or clients won’t buy in. “You can’t just do life or joint-life only,” he says. “People won’t hurdle the risk that if I die tomorrow this insurance company keeps the dough, that my family loses my principal. So, I have to attach installment or cash refund. And when I do that I don’t have any risk of loss of anything but what I get is at [age] 65 a 6 percent distribution rate or 6.1, 6.2 depending on the day.”
Annuitization can provide an additional benefit, Cloke observes. The annuity’s relatively high distribution rate allows clients to take a longer-term view with their other assets. That perspective can allow them to take on additional risk with the remainder of their portfolio and increase the potential for earning higher returns.
Homer also reports that his firm doesn’t annuitize many contracts. That option can make sense when the client has limited assets but needs a relatively high income from those assets. In those cases, one strategy is to annuitize part of the assets with a SPIA to get the maximum payout, although he notes that adding an inflation option to SPIAs significantly reduces payouts in early years.
For most clients, the focus is on timing an annuity’s income benefits versus taking withdrawals, says Homer. Most of the annuities his firm has worked with have lifetime income benefits as part of the annuity and that feature is time-dependent. “The longer they wait to turn that income benefit on, the greater the payout will be so we’re measuring the timing,” he explains. “We’re measuring what they need against the timing of that growing payout factor to see when we want to move from just doing the free periodic withdrawals to where we want to move into the guaranteed lifetime income if indeed we want to move that way. There are some cases where we don’t, where we just are going to keep it on a periodic withdrawal basis and that’s where they’ve got large numbers of assets that allow them the freedom to do that.”
DOL Ruling’s Impact
The Labor Department’s recent fiduciary ruling has consumed advisors’ attention recently. The ruling will affect the placement of variable and indexed annuities’ distribution in retirement plans, but as of mid-April the insurance industry’s planned adaptations and implementation of the best interest contract requirements were still under wraps. My admittedly brief review of the ruling’s annuity- related sections did not find any proposed changes to the traditional annuitization options: life-only, joint-and-survivor, etc.
That lack of change makes sense because the options are essentially actuarial variations based on life expectancy tables and the prevailing discount factors. But it’s still unclear, at least to me, if or how variable annuities’ or indexed annuities’ guaranteed living benefit options might be affected. None of the annuity carriers I contacted were willing to be interviewed on this topic so at this point it’s wait and see.
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