It is worth mentioning a few other annuities that could play a role in a retirement income plan, before digging into the discussion of deferred variable and fixed index annuities.
Deferred Fixed Annuities
Deferred fixed annuities (DFAs), or multiyear guaranteed annuities (MYGAs) may be used as an accumulation tool in the years leading up to retirement. They are the annuity equivalent of holding CDs or other shorter-term fixed-income investments to a targeted maturity date. These annuities are deferred because they do not require immediate annuitization. Though all annuities offer an ability to annuitize the assets into a stream of payments, this may not be the priority for most DFA purchases. Rather, the objective is to seek competitive after-tax fixed-income returns for assets.
When choosing between bonds, CDs, and deferred fixed annuities, there are several differences to emphasize. First, deferred fixed annuities provide protection from interest rate risk. Unlike a bond fund or individual bonds not held to maturity, deferred fixed annuities do not experience losses if interest rates rise. Principal is protected and secured, providing a way to take risk off the table in the pivotal years before retirement.
Second, deferred fixed annuities offer the ability to seek corporate bond yields held in the insurance company’s general account, relative to treasuries, without being unduly exposed to the credit risk of individual companies. Insurance company general accounts provide similar diversification to a bond fund.
Finally, a deferred fixed annuity offers tax deferral, unlike bonds held in taxable accounts that face ongoing taxes on their interest. Tax deferral is only relevant when the annuity is purchased outside of a qualified retirement plan. With this combination of volatility protection, higher yields, and tax deferral, deferred fixed annuities may provide a higher net return than households could achieve with other fixed-income choices. As for disadvantages, deferred fixed annuities may have penalties or withdrawal charges due on distributions taken before the end of the annuity’s withdrawal charge period, which can mean that they offer less flexibility than bonds for covering unplanned expenses requiring liquidation before maturity.
Investment-Only Deferred Variable Annuities
Deferred variable annuities were originally created in the 1950s in the United States as a tax-deferred vehicle for accumulating assets. They grew in popularity after the Tax Reform Act of 1986 limited the opportunities for tax-deferred savings in qualified retirement plans. Though every annuity, by definition, must include a means to convert into a guaranteed income stream, the attractiveness of early variable annuities related to their ability to defer taxes rather than to generate income.
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This may be the reason that annuities and pensions evolved as two distinct words in American English. If not for the tax code, the terms should be indistinguishable. Both were meant to serve as sources of lifetime income with the only practical distinction being perhaps that annuities were sold through commercial providers rather than being a benefit offered by employers or the government.
In the 1990s, the emergence of income guarantee riders for deferred variable annuities brought their income-generating potential back to the forefront.
Nonetheless, even more recently there has been a movement to bring back the traditional deferred variable annuity with low costs and de-emphasized guarantees as a way to provide tax deferral for those investors who have already filled the tax-deferred space in their qualified retirement plans and still seek to invest further in tax-inefficient asset classes that may generate ordinary income and short-term capital gains, such as bonds, actively managed stock funds, alternative assets, and real estate investment trusts. To benefit from tax deferral, it is vital that the annuity costs are less than the tax deferral benefits.
Regarding lifetime income, if it is later desired, the owner might investigate exchanging the annuity assets into a new annuity with better guaranteed income provisions. This can be done as a 1035 exchange in the tax code. Assets are exchanged into a new annuity without triggering a taxable event at that time.
Though these investment-only variable annuities are liquid, investors must remember that the tax deferral advantages provided by the government for certain tax-qualified investments like these may be accompanied by the need to pay taxes and an additional 10 percent penalty on distributions taken before the age of 59.5. The government provides tax benefits to encourage retirement savings and will take back these benefits and penalize those using the tools for different purposes.
There are exceptions that can allow earlier distributions without penalties. When penalties are not applied, gains are still taxed at income tax rates. This includes long-term capital gains or other qualified dividends that would have been taxed at a lower rate inside of a taxable account. It would generally be unwise to hold stock index funds and other tax-efficient investments inside variable annuities. Tax-inefficient investments are taxed at income tax rates anyway.
When considering an investment-only variable annuity, be sure to consider the investment options available, the explicit costs for the annuity, and whether 12b-1 fees are included to increase the expense ratios on the offered underlying funds. These 12b-1 fees are marketing and distribution fees from the fund that can be incorporated into the expense ratio. If the variable annuity includes 12b-1 fees, this would represent an additional cost to weigh for those with other investment opportunities that do not include such fees.
Immediate Variable Annuities
The main variable annuity discussion in this chapter will be about deferred variable annuities. Immediate variable annuities do also exist, and they do work differently. They do provide lifetime income protections. However, while academics tend to like the concept of immediate variable annuities, they are quite rare in practice. This rarity is why they are not featured more heavily here.
Briefly, immediate variable annuities provide a guaranteed income for life, but the amount of income provided over time varies based on the returns to an underlying portfolio of assets and how these returns compare to an assumed interest rate for the contract. Owners buy annuity units with the premium, and these annuity units generate a variable amount of income over time. They provide a way for someone to have a lifetime income, but to accept some risk about the level of this income. If markets underperform relative to the assumed interest rate, the amount of guaranteed income decreases. But market outperformance relative to the assumed interest rate will increase guaranteed income.
Each annuity unit provides a guaranteed lifetime income, it is just unclear what this income amount will be per annuity unit until market performance for the underlying annuity subaccounts is realized.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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