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Written by: Thomas M. Geier, CPA, CFP®, PFS

One of today’s greatest challenges for many people is planning for retirement. They wonder how much they need to save, how long they will need to work, and if they will outlive their nest egg once they do retire. Concerns about Social Security and the changes in employer-sponsored pensions add to the worries. And to top it all off, many baby-boomers that are near retirement had a significant set back as a result of the stock market collapse of 2008.

As we work with our clients through financial planning exercises to answer their questions, address their concerns, and construct a solid retirement plan, one of the areas we stress is proper allocation of retirement assets. We discuss the risk attached to each investment opportunity and determine the “comfort level” the client has for that approach. Inevitably, the desire for a certain level of secured or guaranteed lifetime income is expressed.

case for annuitiesOne solution for proper asset allocation that actually does provide guaranteed lifetime income is an annuity. An annuity is a contract with an insurance company that provides a series of income payments at regular intervals, usually for the remaining life of the client. Many people find this attractive because the amount of the premium is known up front, the amount of the future income payment can be calculated, and the duration of the payments can be guaranteed. Insurance companies are able to make these guarantees through their use of mortality tables, premium investment history, and assumed risks.

Benefits of Annuities

In addition to providing clients with an income that they cannot outlive, a huge advantage of an annuity is tax deferred growth of the investment. Similar to IRA’s and 401(k)’s, the money in the annuity grows over time without being subject to capital gains taxes. Taxes on the gains are not assessed until the money is paid out, usually in retirement when the client’s tax bracket should be lower than while employed. Annuities also allow the client to name a beneficiary so that, if the contract allows, benefits may be paid to someone other than the contract owner without going through the probate process. Some annuities also provide for flexibility of the income stream, whereby the client may be able to increase or decrease the income amount to best manage taxes, social security maximums, and other considerations once retired.

Some Drawbacks of Annuities

Our biggest concern with annuities is whether the insurance company is investing our client’s premiums safely so that the insurance company is still around many years into the future. For example, prior to 2008, a few insurance companies offering annuities invested in way too many structured products, most with bizarre sounding names. We wondered at the time how these companies would fare in a market downturn, and if their insured’s would really see the promised benefits. Our concerns proved valid when many structured investments crashed when the real estate and stock market bubble popped. In fact, one of the world’s largest insurance companies, AIG, needed to be taken over by the US government at the cost of $85 billion to US taxpayers. Read more: U.S. To Take Over AIG.

Fortunately, after the problems of 2008, insurance companies have made enormous improvements to their ratings, reserves, and balance sheets. The strong companies have become even stronger. Dodd-Frank legislation also helps restrict investments to better quality ones.

Another drawback of annuities is their expenses. Because of the mortality component, the insurance companies absorb much higher administrative costs than alternative investment opportunities such as a mutual fund. With this in mind, the insurance companies have tailored their annuity products with increased options, flexibility, and guarantees. By running a cost/benefit analysis, a client can determine if the added benefits outweigh the higher expenses.

Because of their tax deferred status, distributions to a client out of the annuity before the age of 59 ½ are subject to a ten percent penalty, just like IRA’s and 401(k) distributions. Annuities are also very illiquid. It is hard to take any premiums paid into an annuity back out again without consequences.  Most have surrender charges and do not reach their best tax deferred gains until after many years of compounding.

Indexed Annuities

Most people are well aware of the benefits of investing in the stock market. However, they are equally concerned about the volatility and possible loss of their savings that could occur during a financial downturn. At retirement, a client is no longer concerned about accumulating assets, and is now focused on capital preservation and income. However, no one knows what the market environment will be like at retirement age. Will we be entering a new bull market where the capital saved continues to grow, or will we be in the midst of a bear market where investments seems to decline in value faster than the income produced? Indexed annuities are offered as a stabilizing solution to this dilemma.

Indexed annuities are fixed annuities that provide an interest rate return on most of the accumulated premiums. However, the insurance company will take a small piece of the premium and buy call options on a major stock market index, such as the S&P 500. Call options go up in value as the stock market increases. However, if the stock market goes down, the most money lost is the amount of the price of the option. The use of this strategy allows the client to benefit when the stock market goes up, but also avoid the losses when the market goes down. Although this is not the same as a direct investment in the equities market, clients can gain some of the added potential of stock market gains without the stress of market losses.

Are They For You?

Annuities are not suitable for everyone. Careful consideration must be given to the client’s goals, risk tolerance, and tax bracket now and in the future. Clients must be able to understand what annuities are, how they work, and what other options are available. For those clients who are interested in a guaranteed lifetime income, an annuity may be very appropriate for a portion of their retirement asset allocation. Our firm would be very happy to discuss annuities with you and help you determine if they are a good fit for your retirement future.

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© Geier Asset Management, Inc. January 2015.  Thomas M. Geier is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor.  The above blog reflects the opinions of Mr. Geier and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance.