Retirement Focus - Pros & Cons of Annuity Payouts
FORECASTS & TRENDS E-LETTER
By Mike Posey
IN THIS ISSUE:
1. Overview Of Retirement Plan Distributions
2. Types Of Annuity Payouts
3. Advanced Annuity Payout Concepts
4. Retirement Tidbit – Minimum Distributions
As I noted in my last Retirement Focus feature back on June 5, one of the most requested topics we get from E-Letter readers is how to manage post-retirement income planning. As you might suspect, the answer to this question is as varied as the types of plans and distribution options available. Thus, retirement income planning will depend upon your unique personal situation.
A variety of factors affect how you might decide to take retirement income, including the type of retirement plan payout you expect to receive, personal savings outside of the plan, debt status, health issues, personal financial goals, post retirement employment, etc., etc. Thus, the best advice I can give you is to be sure to consult with a professional (Financial Planner, CPA, attorney) before making major retirement decisions.
That being said, there are some general guidelines I can share with you regarding taking income at retirement. This week, I’m going to kick off a series of Retirement Focus E-Letters discussing various ways to manage post-retirement income. I’m going to start out with annuity payment options offered by pension plans (usually “defined benefit” plans), and then move on in later issues to structuring income using lump-sum distributions from profit-sharing and 401(k) plans, IRAs, etc.
Please note that the information provided this week about the various forms of annuity payments will be worthwhile for you to review even if you are not covered by a traditional defined benefit plan. That’s because virtually anyone can elect to purchase an immediate annuity benefit with their IRA or 401(k) account balance at retirement. In fact, some large 401(k) plan providers are even offering access to competitive immediate annuity quotes to their clients. You can even buy a guaranteed monthly income with personal funds from savings, an inheritance, sale of a business, etc.
As you read through the various retirement payout options listed below, it is important to remember that these options are usually irrevocable once they are elected. Thus, it is extremely important that you carefully consider all of the pros and cons of each option before making a decision.
The Decision To Annuitize
When I talk about an “annuity” or “annuitizing your retirement benefit,” I mean a regular monthly income stream over a given time frame. For purposes of this article, most of the annuity payments I discuss below will be those that are paid over your lifetime. In other words, a payment stream that you cannot outlive.
Some employer retirement plans automatically offer benefits only in the form of an annuity, while others may just include it as an option upon retirement. However, as I noted above, virtually anyone can decide to buy an immediate annuity to gain the security of knowing they can’t outlive the income.
You might think that deciding on a payment option that insures you cannot outlive your money would be a “no-brainer,” but such is not the case. That’s because the decision to annuitize involves both advantages and disadvantages. The most obvious advantage of an annuity has already been covered – the promise of an income for life. Other advantages of lifetime annuities include:
1. Security – Annuity payments are guaranteed for life based either on the assets of the employer’s retirement plan or the claims-paying ability of the insurer;
2. Flexibility – There are a number of alternative guaranteed payment options that allow annuitants to customize their payouts (I’ll discuss these in more detail later on). In addition, annuitants may elect to receive either a fixed amount per month, or a payout that is based on the performance of the stock market in a variable contract. Space doesn’t permit me to discuss all of the differences between fixed and variable immediate annuities, but you will want to check out both options if they are available. Most comments in this article are directed at fixed contracts since they are the most common;
3. Inflation Protection – Some retirement plans, and now a few insurance companies, provide for monthly payments that can increase with inflation. However, this is not a common provision in private-sector retirement plans or in most annuity contracts; and
4. Simplicity – Once the decision to annuitize is made, it’s a “set it and forget it” option. Monthly payments are sent to you directly from the insurance company and you need take no further action other than just cashing the checks.
On the other side of the issue, critics of annuity payouts point to significant disadvantages associated with taking this form of retirement benefits:
1. Guarantees Are Limited – While monthly annuity payments from an insurance company are guaranteed for life, the value of the guarantee is only as strong as the company behind it (or the investments selected in the case of a variable contract). This is why it’s always important to check out the strength of any insurance company whose product is being offered to you. Ask for the company’s A.M. Best, Moody’s and Weiss ratings.
To be fair, should an insurance company become insolvent, state guaranty funds may pick up where the company left off. However, you may experience delays or an interruption in monthly payments while the state regulators sort out the situation, and the amount of annuity value covered may be less than the value of your contract, meaning that your monthly payment may be reduced.
Many large pension plans pay benefits directly from plan assets rather than purchasing an annuity contract from an insurance company. Thus, the ability for the plan to continue to pay may depend upon the funding status of the plan and/or the financial condition of the employer. While defined benefit plan benefits are covered by the Pension Benefit Guaranty Corporation (PBGC), it does not necessarily guarantee 100% of benefits, even if they are in post-retirement pay status;
2. Inflexible – Critics of annuity payouts point out that the limited flexibility they offer (see above) is more than offset by restrictions they contain. For example, the decision to annuitize is usually irrevocable. Thus, you can’t change your mind should family or health issues make an annuity less desirable. As a general rule, you also cannot change the form of the original payout option once monthly payments begin;
3. Illiquidity – Once annuity payments begin, lump sum withdrawals generally cannot be made from immediate annuity contracts. Thus, emergency medical or home repair expenses cannot be met from this source, unless the contract has a cancellation provision. (Some annuity proponents actually see this as an advantage, in that it keeps individuals with poor spending habits from raiding their retirement security.)
Related to illiquidity is the fact that annuity contracts, by definition, draw down your retirement assets. In other words, you are receiving a combination of principal and income each month. This precludes living off of the income from investments and then passing on the principal to heirs;
4. Loss of Purchasing Power – One of the most common criticisms of immediate annuities with fixed payouts is that the monthly benefit remains unchanged for the remainder of the annuitant’s lifetime. While this isn’t necessarily true for variable immediate annuities, retirement plans with cost of living increases or some of the new annuity programs with inflation protection, I’d dare say that it describes the lion’s share of annuity payments being received today.
Critics say that what sounds like an adequate monthly benefit upon initial retirement may become inadequate over time. With life expectancies increasing, inflation can eat away at the purchasing power of a fixed annuity payment to the point where it is no longer sufficient to meet the annuitant’s needs. For example, an inflation rate of 3% would cut the purchasing power of a dollar in half over a period of 25 years; and
5. Low Fixed Returns – A final criticism frequently leveled at fixed annuity payouts is that they are based on very conservative returns. Variable contracts attempt to address this issue by allowing payments to fluctuate based on an investment account, but this can actually result in a lower monthly payment if markets decline.
While the above advantages and disadvantages are not meant to be exhaustive, they do represent the major pros and cons of annuity payments. Because retirees’ individual circumstances will determine the extent to which these advantages and disadvantages affect them, there is considerable debate among financial planning professionals as to whether or not retirees should elect to annuitize all or part of their benefits.
On one side, some professionals (usually insurance agents) suggest that a substantial portion of a retiree’s nestegg should be placed into an annuity contract in order to take advantage of the security of a lifetime income. On the opposite end of the spectrum, other professionals fail to see any circumstances in which an annuity contract would be beneficial, other than when an employer’s retirement plan offers no suitable alternative.
As with most issues, the truth about whether or not to use an annuity contract is probably somewhere in between these two extremes. There are some retirees for whom an annuity may be ideal, such as those who want the security of a joint lifetime income, or others who can’t control their spending and may “borrow” from their nest egg until it is depleted. For others, however, the protection and security offered by an annuity contract may not be desired or even advisable, or may be suitable for only a portion of the money.
As with most retirement issues, there are no “one-size-fits-all” solutions. The decision of whether or not to annuitize should be based on your own special situation, risk tolerance, need for a secure source of income and many other relevant factors. That’s why it’s imperative to seek out the counsel of a qualified professional before making this important decision.
Types Of Annuity Payouts
For those investors who either must take an annuity payout from their employer’s plan or who decide that an immediate annuity contract is their best option, additional decisions must be made. A number of flexible payout options exist, but each carries with it a cost. The following is a discussion of each of these payout options, the probable costs involved, and under what conditions each option may be advisable.
Also known as a “straight-life” or “life-only” annuity, single-life annuities pay benefits over the lifetime of a single annuitant. This form of benefit is required to be the normal form of payment in employer defined benefit plans, but can also be found as an option in other types of plans and immediate annuity contracts.
In employer retirement plans, the amount of the single life annuity payment is determined by the plan’s benefit formula. In insurance contracts, the amount of monthly payment depends upon the age and sex of the individual, as well as the amount of money available for the premium. As a general rule, the older one is upon annuitizing, the greater the monthly benefit, and men tend to receive higher payments than women because of their lower actuarial life expectancy.
Because the basic single-life annuity pays out only over the life span of one individual, payments are generally greater than found in any other form of annuity benefit. However, the tradeoff is that, should the annuitant die prematurely, the insurance company keeps the entire premium paid for the contract and pays nothing to the annuitant’s survivors.
While the single-life payout option provides the greatest amount of income, it is not often selected because of the fact that early death would mean a windfall to the insurance company or retirement plan. Variations of the single-life annuity, however, can fix this problem.
Most retirement plans and insurance companies offer a “period-certain” option for a single-life annuity that will guarantee payments to the annuitant or a beneficiary for a specified period of time, usually anywhere from 5 to 20 years. Thus, under a single-life annuity with 10 years certain, the specified monthly benefit will continue as long as the annuitant lives, but no less than 10 years should the annuitant die prematurely.
Using this option, you would know that payments would continue to your beneficiary for a specified period of time, even if you didn’t live that long. However, because of the potential for payments to be continued beyond the lifetime of the annuitant, and possibly add up to far more than the initial premium, a “single-life with period certain” annuity will generally provide a lower monthly benefit per dollar of premium than the single-life annuity alone.
Another similar payout option is a single-life annuity with a cash refund feature. This option is usually only found in insurance contracts, and provides that should you die prior to receiving cumulative payments equal to your initial premium, your named beneficiary will receive an amount equal to the remaining premium amount. This option is usually not as expensive as the period-certain feature, since the insurance company knows that the refund will only equal the remaining premium.
While the single-life annuity may be a good option for a single individual who wishes to maximize monthly income, use of the period-certain option adds the security of knowing payments will continue to a beneficiary for at least some period of time upon a premature death. The “single-life annuity with period certain” option may also be attractive to married individuals where both spouses have their own pension benefits. It is generally not a good option for annuitants who want to provide benefits for the life of a surviving spouse, since it is possible that a surviving spouse could outlive the period of time payments are guaranteed.
Also known as a “joint and survivor” annuity, this type of contract pays a monthly benefit over the lives of two individuals, usually spouses. Thus, it addresses the need for a monthly income for the life of a surviving spouse, no matter how long he or she may live. After the death of the first annuitant, the survivor receives a percentage of the prior monthly payment, which can range from 50% to 100%. This type of annuity payout is required for married individuals in defined benefit plans, and can only be waived by the written consent of both spouses.
As you might suspect, the joint-life annuity payout results in a lower monthly payment than the single-life option since it promises to pay over the longer of two lifetimes. Plus, the monthly payout adjustment is greater for a 100% survivor annuity than for a 50% survivor payout. The amount of monthly benefit received under a joint-life annuity is equal to the actuarial equivalent of a single-life annuity on the retiree. For the annuitant, this means a reduction in monthly income to offset the greater economic value of the joint-life payout option.
As with a single-life annuity, the basic joint-life option pays monthly income only until the death of the second annuitant. However, if both annuitants were to die prematurely, all payments would cease and the insurance company might again reap a windfall, depending upon how long payments had been made prior to death.
For this reason, the period-certain option is also available on joint-life annuities to insure that payments continue to a named beneficiary even if both spouses die prematurely. As discussed above, the period-certain option results in a lower monthly payment than a basic joint-life payout.
It’s fairly obvious that joint-life annuities are tailor-made for married individuals. This option assures married annuitants that a guaranteed monthly income will continue should they predecease their spouses. It is also significant that waiving a joint-life annuity in an employer retirement plan requires the consent of both spouses. This helps to assure the decision is made with the input of both marriage partners. The purchase of an insurance company annuity contract, however, has no such spousal consent requirement, but it’s still a good idea to involve both in this important decision.
A 2003 study by the Urban Institute reported that 72% of married men elect a joint life payout, but only 31% of married women do so. The study concluded that this result is largely due to men having the only (or largest) retirement coverage, while women seek to maximize lifetime benefits since they usually outlive their husbands.
While I have generally restricted the discussion to annuity payouts that extend over the lifetime of the retiree, it’s worth mentioning that there are annuity contracts that make guaranteed monthly payments only over a specified period of time. These “period-certain” annuities, like the add-on period-certain options mentioned above, guarantee payments for a limited period of time and then all payments cease.
The amount of monthly income provided in a period-certain annuity depends upon the period of time selected for payment, the amount of premium, and the earnings assumptions made by the insurance company or retirement plan. The longer the guaranteed payout period selected, the lower the resulting monthly payment.
Some annuitants might be tempted to select a period-certain annuity over a single life or joint life annuity because it could pay a higher monthly benefit in certain situations. However, doing so subjects the annuitant to the risk of outliving the monthly payouts, and is generally not recommended.
Period-certain annuities may have a place, however, where the monthly income is intended to serve as a “bridge” to a subsequent income event. For example, a couple that wants to retire early may have one spouse take a period-certain annuity payout from his or her retirement plan to maximize monthly income until Social Security eligibility or the subsequent start date of other retirement plans. It may also be used in conjunction with a traditional IRA, where distributions must begin after age 70½.
As with many types of financial instruments, annuity payouts can be tailored to meet the needs of individuals in a variety of situations. Plus, defined benefit retirement plan sponsors and insurance companies are working hard to overcome some of the limitations and criticisms aimed at annuity payouts. The following are very brief descriptions of just a few creative ways annuities may be utilized:
Half And Half – In order to overcome the liquidity issue, some retirees elect to use only a portion of their retirement nest egg to purchase an annuity contract. This way, at least part of their retirement benefits will be in the form of a guaranteed payment for life, with the remainder available for liquidity, if needed. It’s not necessary to do a 50/50 split, so you can invest whatever percentage in the immediate annuity that best suits your individual needs. Also note that this option may not be available in an employer retirement plan.
Married Couples – In situations where both spouses are covered by retirement plans, each may elect to take single-life annuity payouts (with spousal consent, of course) rather than the joint life options. This option maximizes monthly income until the first death, but after that the income from the deceased spouse goes away. Thus, it’s important to determine that each spouse’s single-life annuity is sufficient to meet future needs, especially in light of increasing life expectancies.
Save the Difference – Another option available to couples who receive only a single retirement benefit is to take the single-life annuity and methodically save (or invest) the difference between that option and the joint-life option each month. That way, there’s an additional “cushion” available if it’s needed for emergencies. If not, the savings will hopefully grow to be enough to provide a survivor benefit at the death of the annuitant.
The big problem with this scenario is what happens if the annuitant dies early. Very little savings would be accumulated to fund the survivor’s income needs. You could address this by taking a single-life annuity with a period certain, but this would reduce the amount of difference available for saving each month.
Finally, this option depends upon the discipline of the couple to actually save the differential and not spend it, which not all couples can (or will) do.
Insured Survivor Benefits – One solution from the life insurance industry is to take a single-life payout without a period certain to maximize income, while also purchasing a life insurance policy on the life of the annuitant. The amount of life insurance coverage is calculated to be the sum necessary to continue lifetime income for the survivor, since the annuity benefit will cease upon the death of the annuitant. The tax effect of the insurance benefit is also factored in, since life insurance proceeds would be paid tax-free to the surviving spouse.
In an ideal scenario, the cost of the insurance coverage is less than the differential in monthly income between the single-life and joint-life annuity options. Thus, the couple gets a higher income during retirement than under a joint-life option, while the survivor is still provided for upon the death of the annuitant. Of course, it doesn’t always work out this way since the life insurance premium could actually be more than the monthly income differential, resulting in a lower monthly income than under the joint-life option.
As you might suspect, this option is very dependent upon the right combination of circumstances, including insurability. If the annuitant’s health is such that he or she cannot obtain life insurance, then this option is simply not available. Some of the literature I have read regarding this option says that cash surrender values may be available inside the life insurance contract for emergency expenditures. However, it might also be true that these cash values would be too small to be helpful.
There are other disadvantages to this option, including the possibility that a surviving spouse could lose medical or other employer-provided benefits if they no longer receive benefits from the retirement plan. Plus, if the couple allows the insurance policy to lapse after retirement, the survivor benefit ceases to exist.
I include this option because it may work in some limited situations. I haven’t run any numbers on it, but some of the insurance industry literature suggests that this idea works best if the insurance policy is purchased in the years prior to retirement, when premiums per dollar of coverage are less. As with any other retirement payout option, it pays to consult a professional before opting out of a joint-life annuity payout option in favor of a life insurance purchase.
New Types of Insurance Contracts – Perhaps the greatest promise on the insurance front, in my opinion, is in the form of new types of annuity contracts designed to address some of the more common disadvantages of traditional annuities. I mentioned above how some insurance companies are beginning to introduce annuity contracts that allow the monthly income to be adjusted for inflation as time goes by. Obviously, these contracts will pay a lower initial monthly income than a comparable annuity without inflation protection, but the inflation-adjusted monthly payout may eventually grow to be greater than a fixed-payment alternative.
Another new type of variable annuity insurance contract offers a lifetime paycheck in the form of a guaranteed withdrawal benefit rather than an annuity payout. The withdrawal benefit works like this - as long as ongoing withdrawals stay within a pre-determined amount selected by the annuitant, the insurance company will guarantee to continue these withdrawals for life, even if the annuity value drops to zero. The real benefit, however, is that the account value is available if needed for emergency expenses, though this would decrease future guaranteed withdrawals. Plus, unlike an immediate annuity, any value remaining in the contract upon death of the annuitant is paid to the named beneficiary.
There are many other strategies for annuitizing all or part of retirement benefits, but I think you get the picture. The ability to annuitize offers retirees a stable income option for life, which is very important to some individuals. However, it’s important that retirees do their homework and consider all of the options before making an irrevocable decision to annuitize.
This week’s Retirement Tidbit will be short and sweet – if you are age 70½ or older and are required to take a Required Minimum Distribution (RMD) from your traditional IRA by December 31, 2007, start planning for that distribution NOW. RMDs must be received by December 31st each year, but waiting too late to start the process could mean missing that deadline.
Each year, many investors wait until October or November to begin the process of taking their RMD. In some cases, especially in those investments where distributions are paid only once per month, a request for an RMD may be turned in before the deadline, but the actual payment might not be made until after December 31st. Since the law requires the distribution to be received by the deadline, any payment after December 31st is too late.
Note that if you are just turning 70 ½ in 2007, the law gives you a one-time opportunity to wait until April 1, 2008 to receive your first RMD. However, this will result in two taxable IRA distributions in 2008 since your next RMD will have to be paid out by December 31st of next year. If you are now eligible for your first RMD, consult with your tax professional to see if it might be wise to go ahead and take your 2007 RMD this year.
If you have multiple traditional IRA accounts at various custodians, it is not necessary that you take a pro-rata RMD from each. You can take your entire RMD from one or any combination of the accounts, but it’s always a good idea to contact all of your custodians to let them know whether or not you plan to take your RMD from the IRA account they hold on your behalf.
Failure to take your RMD by the required deadline results in a penalty tax of 50% of the amount that should have been distributed. With a penalty that severe, it pays to make every effort to ensure your IRA RMD is paid out on time.
The number of options and different types of annuity payout provisions are often bewildering to many retirees. Perhaps this complexity is the reason that very few retirees who have a choice elect an annuity payout.
From a personal perspective, I tend to think that annuity payouts are best reserved for those who have no other choice in their employer’s retirement plan, cannot tolerate investment risk or do not want to have to worry about market volatility in regard to all or part of their investment income. Since annuity payments are a way to systematically draw down on your principal, they may also work well for someone who has not accumulated a sufficient amount of retirement assets for investment income alone to provide a meaningful amount of annual income.
For those of you who may want the stability of an annuity payout, or who are covered by a defined benefit plan that requires benefits to be distributed as monthly income, I hope the above information will be helpful to you when you retire.
There’s an old saying in carpentry that goes “measure twice and cut once.” The same is true in regard to retirement planning, especially when it comes to selecting an annuity payout. Since the decision is usually irrevocable once made, it’s important to check all of your options – twice – (or more) before making any decisions. Also remember that what appears to be a nice monthly income when you retire may not meet your needs many years in the future.
As always, I recommend that you consult with a qualified professional prior to making this very important decision. If you would like to talk to us about your retirement options, feel free to give us a call at 800-348-3601 or e-mail us at firstname.lastname@example.org.
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