How To Create Ways To Generate Lifetime Income In Retirement
The thinking in retirement in having the most net worth is a past way of thinking. As Dr. Robert C. Merton an American Economist said, "Our approach to saving is all wrong. We need to think about monthly income, not net worth." Annuities are a great financial tool to use to execute this goal for my clients. Whether it be a fixed- rate, income or fixed indexed annuity, all of them have their place in certain financial plans to generate a stream of income that will last during your retirement years.
Other than Social Security or pensions, an annuity is the only financial product that can guarantee lifetime income.
If you want to secure future income with an annuity, you have three main choices. Each can be appropriate for non qualified (taxable) accounts as well as IRAs and Roth IRAs. Each has its pros and cons.
Option 1: A deferred income annuity offers simplicity and predictability but little flexibility
A deferred income annuity (DIA) is a promise by an insurer guaranteeing to pay a stream of income starting on a set future date. You typically pay a single premium for this contract. You may choose to take the income for a set period, such as 15 years, but most people take the lifetime option. You can buy either a single-life annuity or a joint-life annuity to cover both spouses. The popular optional cash-refund feature guarantees that in the event of your early death prior to the income start date, your premium payment will be refunded to your beneficiaries.
This is a straightforward plan. You know exactly what your income is going to be starting on the date you’ve chosen. The downside is that there’s little or no flexibility. In exchange for the future income, you’ve turned over your money to the insurer. You’re committed.
Option 2: Fixed Indexed Annuity provides more flexibility and may even include income rider as added benefit
Fixed Indexed annuities offer buyers a chance to get a portion of the stock market’s gains while offering complete protection from loss. They credit interest based on the growth of a market index, such as the Dow Jones Industrial Average or S&P 500. But, uniquely, you lose nothing in down years.
By adding a lifetime-income guarantee rider, you can guarantee future income. Since the starting date for income is not set when you buy the annuity, you retain flexibility.
Normally, when you convert an annuity into an income stream,(“annuitization”), its cash surrender value becomes zero. That’s not the case here. You still own the full unused value of your annuity.
This makes it sound like this option is “have your cake and eat it too.” In a way it is, but there are downsides.
One of the biggest ones is cost. Most insurers charge around 1% annually of the assets in the annuity to add an income rider. So, your money will grow more slowly than without the rider.
The lifetime income amount is determined by the income account value and your gender and age at the time you start receiving payments. The income account value typically grows at a guaranteed annual compounded rate of 4% to 8%, so the longer you wait, the greater the income.
The income account value and cash value of your contract are separate. The income account value is used only to calculate your guaranteed income payments. It has no cash value and cannot be withdrawn. In contrast, the contract value can be withdrawn or passed to your heirs.
Another downside is fluctuating interest rates. If the market goes through a long bear cycle, you may earn nothing on your contract value for a number of years.
Option 3: Buying a fixed-rate annuity now and converting it to an immediate annuity later on offers flexibility and guaranteed growth, but future income varies.
This can be the best choice for people who want to keep control over their money for now, stay flexible and build more future income.
A fixed-rate deferred annuity (technically, a multi-year guarantee annuity, or MYGA (opens in new tab) acts much like a bank certificate of deposit. You deposit a lump sum and get a guaranteed interest rate for a set period, usually two to 10 years.
You’ll know to the penny what your annuity will be worth (assuming no withdrawals), at the end of the term. Interest is tax-deferred as long as you reinvest it in the annuity.
Here’s how this strategy works.
Let’s say you plan to retire in five years. You buy a five-year fixed-rate annuity. Near the end of the five-year term, you can shop the market for the best deal on an immediate-income annuity. If you hold your annuity in a non qualified account, you can swap it tax-free, via a 1035 exchange, for an immediate annuity.
An immediate annuity (opens in new tab) is pretty much identical to a DIA except that income payments begin right away. You won’t know exactly what your income will be because immediate annuity rates will have changed in the interim.
Here’s a scenario:
Joe Doe, age 60, deposits $150,000 in a five-year MYGA(opens in new tab) that pays an annual effective rate of 4.30%. Assuming he lets the interest accumulate, the annuity will be worth $185,145 at the end of the term.
He uses that sum to buy an immediate annuity. Based on today’s rates, with a joint-life policy for him and Mrs. Doe (also 60), the payout will be $964.50 per month for as long as either spouse is alive. (Of course, he might get a better or worse deal than what’s available today.)
If it’s a non qualified annuity, $464.89 will be taxable income and $499.61 will be nontaxable return of premium. If it’s a standard IRA annuity, payments will be fully taxable. With a Roth IRA annuity, all the income will be completely tax-free.
But suppose five years from now Joe decides to keep working for two more years. He can roll over the proceeds tax-free into a two-year MYGA and delay buying the income annuity.
Of course, he can do whatever he wants with the money in his annuity. If Joe decides to use some or all of it to sail around the world or give to charity, it’s his choice.
Different types of annuities are powerful tools for nailing down future lifetime income. None of these three options is always best for everyone. It depends on your situation and preferences.
The biggest question I ask my clients is, "how much income do you feel you'll need in retirement to maintain your lifestyle and be able to enjoy life?" Most of them haven't thought about it, and it's something we start planning for that day. Annuities aren't the answer to everything, but for someone who is looking for protection of principal of their money while also creating a lifetime income for them without the worry, they can be that tool for you!
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