Someone once told me the CD didn’t stand for certificate of deposit anymore, it stood for certificate of disappointment. For the past 7 years, the United States has been in a historically low interest rate environment. For many retirees, who are accustomed to supplementing their income with their certificate of deposit interest, the lower interest rates made it necessary to look elsewhere for safe income while protecting principal.
As of April 22, 2016, the most competitive 5-year CD rates were around 2.1% to 2.2%. Currently, the highest 5-year fixed annuities are paying 3.1%. While this doesn’t seem like much, the difference adds up to a 47% increase over the 2.1% rate that is offered by CDs (3.1/2.1= 47%).
Additionally, fixed indexed annuity interest can remain in the annuity instead of being paid out to the contract holder, which allows for the deferral of income taxes. This isn’t the case with a CD.
Let’s say an investor didn’t need the interest from their CD. As a result, the CD remained untouched and continued to earn interest. However, they would still pay income tax on the CD, regardless of whether or not it was distributed.
Alternatively, the interest in a fixed annuity is only taxable if the investor decides to receive the pay out. Otherwise, the interest remains in the annuity and is taxed at a later time.
Now, take a moment to consider the impact of letting a 2.1% CD grow vs. allowing the same amount to grow in the fixed annuity:
Due to the tax deferral and fixed indexed annuity’s higher interest rate, the account value is substantially different after 5 years. Considering these statistics, a fixed indexed annuity might be appropriate for retirees looking for an alternative to certificates of disappointment.
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What role do index annuities play in financial planning? Can they provide growth or just income?
First, let’s address index annuity growth versus market growth. Since 1995, some of the better index annuities have historically averaged 4 to 5%.1 Many would dismiss this growth, compared to the stock market’s “higher returns.” The disconnect is that we often focus solely on actual market returns, pointing to the S&P or Dow during good market performance periods only, rather than focusing on actual return performance in an investor’s portfolio during good and bad times.
Dalbar’s QAIB study of 2013 tells us that over the last 20 or 30 years, the average 50/50 stock/bond investor has averaged only 2.87% and 2.20% respectively. 2
Why so little? It’s unrealistic for the average investor to match the indexes we follow — indexes like the S&P 500 or The Dow Jones Industrial Average (DJIA). Why?
First, you can’t invest in the S&P 500 or the Dow. These indexes are merely averages of the prices of the stocks in the index. They are calculated without fees, expenses, or taxes. Second, if we try to emulate an index’s performance with a index fund meant to mirror those indexes, we have to deal with the realities that the financial industry wants to get paid for its services, and the IRS wants to collect taxes on our realized earnings — capital gains, bond interest, and stock dividends, etc.
Third, people often make illogical comparisons. For example, they may expect to do as well as stock indexes like the S&P 500 and the Dow, but are invested more in cash and bonds than in stocks. Realizing that we have to factor in the reality of these additional fees and taxes, improper comparisons, plus the measured observation that consumer behavior does not always guide us to the best decisions, typically leaves investors with performance well below market indexes.
Purchasing an index fund, meant to mirror indexes like the S&P 500 or Dow, might be a suitable investment for your retirement portfolio if you have many years to allow for market volatility, but that is not the only way to achieve growth in a portfolio. There are some insurance carriers that offer annuity contracts with guaranteed rates of return that are worth including in a retirement portfolio. These annuity contracts can offer growth based on the market, without being in the market.
Secondly, how do index annuities compare with the market in providing income?
While index annuities, by design, are not created to match a bull run like the 1990s, some can produce and even outpace the market during turbulent times. But indexed annuities are purchased primarily for their safety of principal and income. An index annuity can guarantee lifetime income through a rider.
Can the stock market guarantee lifetime income? No! Can the market even provide any confidence that you can receive income payments for 25 to 30 years? A recent study by Blanchett, Finke, & Pfau tells us that a safe withdrawal rate from the market is 2.8%.3 Why so low? Because withdrawing money in down years accelerates your account’s fall to zero.
Can insurance annuities provide a greater income than 2.8%?2 Absolutely! And the insurance company guarantees it. Here is an example of how an insurance annuity provides more guaranteed income than the market can be expected to provide in good and bad conditions.
Hypothetically, let’s assume that you have $1,000,000 you want to use to pay the bills for the rest of your life, beginning in 10 years. What could that $1,000,000 have grown to in 10 years? Let’s consider three market possibilities: 1) 10% growth, 2) no growth, and 3) a 50% loss.
Hypothetical Example One:
Index Annuity Income
So how might an index annuity compare? The older you are and the longer you delay income, the more income you’ll get. Let’s assume a married couple, each person 60 years of age, purchases an index annuity to guarantee a joint-life income starting in 10 years, at age 70. How much income might they count on from an annuity?
A fixed indexed annuity with an income for life rider that I currently offer to some of my clients can hypothetically guarantee this couple a joint lifetime income of $86,607 per year! That is if the market does nothing. What if the market has some good years and bad years? If the market were to repeat its last 12 years (which includes the terrible 07 and 08), at that point, our couple could be guaranteed a joint lifetime income of $119,624!
So the range of possibilities for their hypothetical index annuity is a worst case of $86,607 (assuming no growth) to a more likely $119,624! Note that the insurance company’s illustrated “worst case” income is higher than the market’s likely “best case.” Note too, that $119,624 is way too large a withdrawal from most any market holdings to have a reasonable chance of lasting 30 years, but the annuity company guarantees it to last for the longer of either life, with the balance of the account going to your beneficiaries.
That means the index annuity allows you to spend less of your money to acquire the income you need, allowing more of your money to now seek unfettered growth in the market, where it is available to access!
Index annuities can be very powerful in providing realistic growth, with limited Market risk; they are uniquely capable of providing lifetime income while still allowing the owner control over the asset.
If you’re interested in using an annuity to help provide an income for life, contact Ernie Dorado at firstname.lastname@example.org
Despite all of the negative talk often surrounding variable annuities, they are still the highest selling annuity product in the industry. There are good variable annuity products out there, and bad ones as well, so it’s important to be able to tell the difference. The best way to determine if a certain annuity product is right for you is by speaking with an annuity expert and comparing your needs and goals with the potential benefits.
Annuity products are the opposite of life insurance. You pay a lump sum of money up front and then receive monthly income for a specified time frame or for the rest of your life. Annuities protect your money and offer some type of growth as well, depending on the product. Variable annuities allow you to invest your money in sub accounts, which function in a similar manner to mutual funds. Your specific product and terms will determine how much growth you can receive and when you are able to access your money.
Variable annuities provide tax deferral for your money. Your earnings are tax deferred until you start receiving payments from your annuity, often when you are retired and in a lower tax bracket. This is especially helpful for people who have maxed out contributions to 401k’s and IRA’s. Variable annuities also allow you to convert your money into a lifetime stream of income. This is helpful to anyone who is worried about outliving their savings, which is the majority of Americans. Many states allow variable annuity funds protection from court judgements, which is a little known benefit helpful to those in deep debt or in professions that are frequently sued. There are other benefits to variable annuity products as well.
Variable annuities also have some drawbacks though. The products can be complex and their prospectus’s can be hundreds of pages long. It’s crucial to understand exactly what you are getting with your product. Along that line, some variable annuities have high fees for the added benefits they offer. Do an analysis to see if the fees are worth the benefits you are receiving. Most variable annuities have a surrender period where your money is illiquid. Don’t put money into a variable annuity that you might need to access in an emergency. There are attractive growth guarantees for many variable annuity products, but they will cost you more. You have to decide if investing in the markets directly with no guarantees or investing in variable annuities that offer guarantees but lock up your money for a time is better for you.
There are a few other things to consider in regards to variable annuities. Death benefits are important to many consumers, so determine what kind of benefits your annuity offers. Some are enhanced, some are based on account value and others are based on your initial investments. This can make a big difference in the payout to your heirs. Ask the person selling you the variable annuity to visibly demonstrate why this product is right for your individual plan, especially with the fees you will pay. If you determine that a variable annuity is right for you after all of your research, limit your purchase to no more than 25% of your total savings. That will leave you flexibility with the rest of your money.
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