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Is an Annuity the Best Way to Guarantee Income in Retirement?

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If you’re approaching retirement (which is the critical phase of transitioning from accumulating a lifetime of wealth to distributing that wealth back to yourself in order to provide income for the rest of your life), you may be wondering “am I at risk of outliving what I’ve saved?”

Investor concerns about depleting their retirement resources often translate to additional risk aversion during the years leading up to retirement — as well as during retirement — while going through possible portfolio declines, resulting in investors seeking products that seem to provide it all: guaranteed1 income, market participation and “no risk” of loss. This is why some investors choose to buy annuity products — but do they really improve a strategic income plan?

Let’s start with some background on annuities.

What is an annuity?

Annuities are financial contracts offered by insurance companies that are designed to provide income immediately or at a future date. There are two basic types: immediate and deferred.

  • Immediate annuities – With an immediate annuity, the contract holder makes a lump-sum payment to the insurance company in exchange for fixed or variable income payments beginning on a specified date. The payout period can be for a fixed number of years or for the rest of the contract owner’s life. The lump-sum payment is foregone in exchange for the income stream, and the contract owner usually incurs penalty fees if additional withdrawals are needed. These types of annuities are uncommon for investors to purchase, as the internal rates of return have been undesirable for more than a decade, and there’s been a decline in investor willingness to give up access to a large lump sum of their savings.
  • Deferred annuities – Deferred simply means the income phase of the annuity will start at a later date. These annuities allow for flexible premiums (contributions/deposits) during the deferral period (which can last as long as age 90 in some contracts). They can be fixed, equity-indexed or variable, and gains accumulate on a tax-deferred basis. Any gains on the contract are subject to ordinary income tax rates upon withdrawal, and an additional 10% penalty applies to the growth if withdrawn prior to age 59 ½. Variable and equity-indexed annuities are often sold with riders, of which the most common is a guaranteed income rider.

Annuity fees

Let’s dive further into the fees for the most common types of deferred annuities sold to investors: variable annuities and equity-indexed annuities.

  • Mortality & expense ratio (M/E ratio) – This fee is charged by the insurance company to hedge its risk (i.e., the death of the policyholder). The industry average for this charge is 1.25% annually, which is taken directly from the annuity.
  • Surrender fees – A declining scale fee that reduces to 0% after a specified number of years. Withdrawals from the account prior to the end of a surrender period are subject to penalties. A typical surrender period is seven years, with first-year fees that could be as high as 10%. Contracts often allow for a partial withdrawal of 10% of contract value without being subject to fees.
  • Sub-account fees – The investment products offered within the annuity are also subject to investment management expenses. This is very similar to the expense ratio of a mutual fund or ETF. As with mutual funds and ETFs, these fees can vary greatly, but most are under 2.0%.
  • Rider fees – These are additional fees for features chosen by the investor to add to the product. The most common are income guarantee riders and death benefit riders. These fees typically range from 0.50% to 1.50% for each type of rider.

The bottom line is that most annuities that have at least one rider, meaning an investor is paying an insurance company (either directly or indirectly) 2.5% to 3.5% on average. They’re also locked into the product for a number of years.

Alternatives to annuities

At Creative Planning, we believe there’s a more efficient solution for the majority of investors. We believe investors should work with a qualified fiduciary advisor who can help maximize their retirement income. We help clients implement the following strategies as we work with them to establish a reliable plan for retirement income.

  • A financial plan – The first step in ensuring an adequate retirement income stream is developing a custom financial plan to help guide your decision-making. A comprehensive plan puts you in control of all aspects of your finances and can help you identify strategies for generating income in retirement.
  • Diversification – Regardless of the current market environment, it’s always wise to maintain a diversified portfolio. Investing in different types of assets can help spread out your risk, because when one sector or investment type is performing poorly, another investment type that’s performing better can help smooth out volatility within your portfolio. Diversification won’t prevent losses, but it can reduce the risk of being too heavily invested in the worst-performing part of the market.
  • Short- and long-term investment accounts – One of the best ways to avoid market volatility and ensure you’ll have adequate funds to cover your daily living expenses is by maintaining three to five years of living expenses in a short-term, liquid investment account. A mix of bond funds typically works well, as it provides capital for opportunistic rebalancing as well as income. Having a short-term allocation to bonds can prevent you from being forced to sell out to equities at a loss when markets are low.

On the flip side, it’s important to continue growing your assets in order to offset inflation and ensure you have enough income to last throughout retirement. That’s why we recommend investing any assets not needed to fund your short-term needs in a diversified portfolio that focuses on growth and inflation protection. While this portfolio should be in line with your overall risk tolerance and investment objectives, it can be invested in riskier assets than your short-term account. Throughout retirement, your wealth manager will help you identify opportune times to rebalance and adjust your portfolio in a tax-efficient manner.

  • A tax-efficient withdrawal strategy – Another way to maximize your retirement income is by following a disciplined spend-down strategy. Your wealth manager can help you establish an appropriate strategy that takes into consideration your current financial situation and retirement goals. This strategy should incorporate all potential sources of retirement income, including Social Security.

At Creative Planning, we strongly believe there are more efficient and more cost-effective ways to an income stream than investing in annuities. To learn more about how we help clients plan for a successful retirement, please schedule a call with a member of our team.

  1. Guaranteed by the claims paying ability of the insurance company.

This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.


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