Over the past month, we have been looking at some of the basic principles of that often misunderstood investment vehicle known as the annuity. We have seen that there are some unique tax considerations, as well as multiple categories of annuities.
Not all annuities are created the same, so sweeping generalizations can be dangerous. How do you know which type is for you?
This week, we are going to take a quick look at two ends of the purpose spectrum. In other words, what purpose is the annuity you are looking at going to accomplish?
Let’s get started.
There are two big options investors should consider: income and growth.
Income vs. Growth
Imagine a seesaw. On one end is seated growth. On the other, income. As one side gets higher, the other gets lower. So, if you’re looking for better growth in your account, you’ll likely give up some of the future lifetime income benefits associated with the account. Conversely, if you’re looking for better lifetime income, you’ll likely lose out on growth in the account.
7% Guaranteed… Seriously?
One thing that gets pitched by financial professionals is the prospect of high guaranteed rates of return, often in the ballpark of 7-10% per year.
Let’s stop here and ask ourselves a question: in our day and age, does a 7% guaranteed annual rate of return sound realistic?
So, what is going on and how does this relate to the seesaw analogy?
With most annuities, you have several values listed on your statement. While their names can vary from company to company, these values often include:
- Accumulated value
- Death benefit
- Surrender value
- Income value
When investors look at any of their financial statements, it isn’t unusual for them to look for the highest figure and assume that is the actual value of their account. When it comes to income-focused annuities, the largest value on the page is typically the income value.
This is why the income value on most annuities is commonly misinterpreted as the lump sum value the client could withdraw at the end of their term, be it five, seven, ten, or even twenty years.
The income value is honestly nothing more than an accounting figure that grows at a predetermined “roll-up rate.” As this value grows, the insurance company who issued your annuity contract will use that figure (plus actuarial figures and other data) to determine what your monthly income stream will be when you begin taking it. All the while, the actual value of your account may, due to additional account fees and market fluctuation, only be growing by 1-2% per year.
Using our example above, while the income value at the end of a 7-year term might be $160,578.15, the actual value (assuming you earned 2% per year) would only be $114,868.57. That is a MASSIVE difference in expectations, especially if you don’t really understand the type/purpose of the annuity you’re getting and what the values mean.
Truth be told, the “guaranteed income growth rate” is not the number that matters. The number that matters is what the actual monthly payout will be. It is possible that some income annuities with a 6% guaranteed income growth rate will provide a higher monthly income benefit than one that offers a 10% guaranteed income growth rate. If you are considering an annuity for income purposes, look primarily at the monthly income payout, not the roll-up rate.
Why Choose an Income Annuity?
Income annuities can have a purpose within an individual’s retirement plan. These can be a great solution for a person looking for a steady stream of income that they can never outlive. These benefits, if correctly understood and implemented, can provide some individuals with more confidence in their longevity planning. However, it is important to note that if individuals are looking for better growth in their actual/accumulated value, they should not look primarily at annuities with good income benefits.
Safe Growth and “Wiggly” Growth
If income is not your primary goal with your annuity, growth probably is.
In the previous post, we looked briefly at variable annuities. These vehicles utilize what are known as subaccounts, the insurance industry equivalent of a mutual fund. As with most mutual fund accounts, the actual value can have some positive and some negative wiggle, as I like to call it.
Variable annuities might be used by individuals who desire long term capital appreciation of their taxable accounts, but want the accounts to grow tax-deferred. The drawback comes in the form of generally higher fees than a typical mutual fund brokerage account. These are, after all, held by insurance companies and will include things like mortality and expense fees, administrative fees, etc.
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Fixed and fixed-indexed annuities can offer principal protection and the possibility of safe actual accumulation in the account.
Depending on the details of the fixed annuity you’re looking at, a Multi-Year Guaranteed Annuity (MYGA) might yield you 4% per year for 5 years. That would take your $100,000 deposit up to $121,665.29 — a bit more of realistic return in our day and age.
Depending on the details of your fixed-indexed annuity, you might be fortunate enough to average 5% over a 5 year period. If you averaged 5% during that period, you’d be looking at $127,628.16, which would beat the MYGA. However, if the indexes your account were tied to only averaged 3.5% over the 5 year period, your $100,000 deposit would grow to $118,768.63 at the end of the term.
It is totally possible that, again depending on the interest crediting method and the performance of indexes you are tied to, you could average 7% per year during a 5 year period. Note that I said possible, not probable.
The growth risk of not utilizing a fixed rate is that, due to market conditions, you might not see any growth. On a positive note, a fixed-indexed annuity with no annual fees will keep your principal in place, even if there is only negative market movement.
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Whether you are utilizing a variable, fixed or fixed-indexed annuity, if the purpose is better growth, your opportunity cost will be a better income benefit. The growth vs income question can only be answered by you once you go through the retirement planning process and address that all-important aspect known as income planning.
If you have general questions about annuities or questions about a specific annuity you’re being offered, don’t hesitate to comment below!
In our next annuity installment, we’ll shed some light on those various account values mentioned earlier in this post.
-Written by Ryan Gilmore, Investment Advisor at Oakmont Advisory Group.