When it comes to funding your retirement dreams, it’s important to look at all available investment options and then structure a portfolio that provides regular income for as long as you’ll need it. An annuity is a good option, but how do you know how much to allocate to annuities as compared with other investments?
Many people planning for retirement know little about annuities, and for good reason. There are many kinds with a variety of features. Let’s review the basics.
When you invest in an annuity, you enter into a contract with an insurance company.
In return for your investment, the insurance company promises you – and sometimes your heirs – a stream of payments starting now or at some point in the future.
Annuities can be subdivided by when they begin paying an income stream.
With an immediate annuity, you start receiving payments soon after the contract is signed.
With a deferred annuity, payments are postponed until a later date, such as when you retire.
Annuities can also be fixed or variable. Fixed annuities invest primarily in bonds or bond funds. Variable annuities invest primarily in stocks, stock funds or stock index funds.
So you select the type of annuity you want.
The insurer invests the money you give it. Then, at the designated time, the insurance company starts paying you an income stream.
Many different payout options are generally available.
You can get payments for the rest of your life, as long as you or your spouse is alive or for a set period such as 15 years.
As long as the money remains in the annuity, the earnings aren’t taxed – but money paid out by an annuity is taxed at your ordinary income level, not your capital gains tax level.
There are two main advantages to an annuity. First, money invested in the annuity grows tax-deferred, so the earnings aren’t taxed until they are withdrawn. Second, the annuity provides a regular income stream.
As you know, creating a portfolio usually involves allocating assets to a mix of stocks (so your assets can keep pace with inflation) and bonds (so you’ll have a steady income stream). You’ll probably also want to have some cash on hand, and you may want to consider an investment in annuities.
To decide how much to allocate to an annuity, you could consider it a part of your bond allocation. That’s because allocating some of your nest egg to an immediate annuity creates a stream of income you can’t outlive, helping you overcome “longevity risk” – the risk that you’ll run out of money before you die.
Ask yourself what you think the stock market will do, and decide what your tolerance is for investment risk. Also consider whether you’re likely to burn through your assets earlier than you’d planned.
A significant allocation to an immediate annuity might be a good option under the following conditions:
· When the stock market appears to be peaking or in the early stages of a decline
· When your tolerance for investment risk is low
· When there’s a high probability you’ll exhaust your assets earlier than you wish.
It’s easy to understand why annuities are so puzzling, given the number of different types. If you’re considering an annuity on the recommendation of your financial advisor, a good place to start is by asking your advisor the following questions:
· What type of annuity are you recommending? Is it variable or fixed? Is it an immediate or a deferred annuity? Is it an equity indexed annuity?
· What other options are available? While there is certainly choice among annuity types, there is also a choice between annuities and other investment options.
· If you’re looking for tax-deferred growth, annuities offer that, but so do IRAs and 401(k) plans; in this situation, an annuity might not be ideal until you have maxed out your other options.
· If you’re looking for a guaranteed income stream, however, an annuity might be the best choice for you, as IRAs and 401(k) plans don’t offer that.
· What are your liquidity needs? When your money is in an annuity, it’s not as accessible as it is when it is invested in other accounts, such as Roth IRAs.
Ask yourself if you’ll have any near-term requirements for the money or even if it’s possible you might need it at some point in the near future. If the timing isn’t right, you may want to delay your investment.
· How much does the annuity cost? Different annuities have different costs. There are also riders you can add to an annuity that will increase your cost or affect your payout in some way. It’s a good idea to ask for a breakdown of costs before investing.
· How strong is the insurance company offering the annuity? It’s always a good idea to research the insurer. Ask how it is rated by the big rating agencies: A.M. Best Company, Standard & Poor’s, Moody’s Investors Service and Fitch Ratings.