Annuities Have Changed, Offering More Flexibility and Customization

Key Takeaways:
  • Annuities continue to play an important role in retirement planning, but selecting the right one requires understanding your goals and if the product aligns with your needs.
  • Modern annuities have evolved significantly in the past five years, offering lower fees, more flexibility and simplified structures compared to older versions. Newer annuities may offer features like death benefits and long-term care riders, making them appealing for tax-deferred growth, guaranteed income and risk reduction.

Annuities can serve an important role in many investors’ portfolios as part of an overall retirement plan, but it’s important for an investor to understand what they want from an annuity and to make sure it is structured to fulfill their needs.

An annuity, fundamentally, is a contract between the investor and an insurance company. The investor pays a premium, either in the form of an upfront lump sum payment or monthly payments, and the insurance company pays out a fixed or variable stream of income, depending on the investor’s goals and the specific annuity product purchased.

Annuities are typically purchased for three reasons:

  • Tax deferral
  • Stream of income during retirement
  • Reduction of market risk

How Annuities Have Changed

If you purchased an annuity more than five to 10 years ago, you should review the contract annually to make sure it still fits your needs. Annuities have changed significantly in the past five years in terms of fees, expenses and how they work. Today’s annuities are generally more flexible and less complex than older annuities.

One of the most common types of annuities is an annuity with an income rider, designed to generate monthly income to supplement retirement income. These are often purchased five to 10 years before retirement to give them time to grow before any payouts start.

However, life events can happen during those years, such as loss of a spouse or receipt of an inheritance. You may no longer need the monthly income from the annuity you purchased earlier, but older annuities are not always flexible enough to make the change you may need.

Moreover, many annuities have “surrender periods” of five, seven or 10 years during which you will pay a steep penalty for terminating or withdrawing any money from the annuity.

If you are faced with this situation, it’s important to work with a financial advisor who can identify which of the following options may be best for you:

  • Fee-based Annuity — We typically recommend moving into a fee-based annuity that is fully liquid, so you avoid the surrender period. This requires payment of an annual fee instead of an up-front commission, and can help you get into an annuity that is more aligned with your current needs. Fee-based annuities are a fairly new type of annuity that has emerged in the marketplace.
  • 1035 Exchange — A 1035 exchange is a provision in the tax code that allows for the transfer of funds from one annuity policy to another. This means you can switch policies without incurring immediate tax liability, even if the original annuity has significant gains. The idea is to find a new annuity that fits your goals and objectives. The disadvantage of a 1035 exchange is that, if you switch into a commission-based annuity, you may start another surrender period during which your money is locked up. If you are within five years of retirement, this may be a significant disadvantage.
  • Surrender the Annuity — If you don’t want to keep an annuity in your portfolio, the third option is to surrender the annuity and pay the taxes on any gain that may have occurred. Bear in mind that gains from an annuity are taxed at ordinary income rates, not the more favorable capital gains rate. However, if you are already retired, you may be in a lower tax bracket, so this option may make sense.

What Makes Annuities Attractive Investments?

Investors still purchase annuities for the reasons noted above — tax deferral, retirement income and risk reduction — but today’s annuities come with lower costs and less complexity, making them attractive to investors who are structuring their retirement plans. Annuities also have no contribution limits, enabling investors to build a highly funded retirement income instrument.

Moreover, newer annuities offer such features as death benefits and long-term care riders. Given the high cost of long-term care insurance policies, having the option to tack this benefit onto an annuity has made annuities very attractive to certain investors.

There are many annuities available that align with investors’ varying goals. One of the most well-known is the Registered Index-Linked Annuity, or RILA.

RILAs give investors potentially full participation in the market with protection against market volatility. As the name suggests, RILAs are linked to stock market indexes and active managed mutual funds.

For example, a RILA that is linked to the S&P 500 gives the investor exposure to that well-known index, but with less risk. If there is a significant dip in the market, the RILA can protect you from 10% to 30% to even 100%, depending on how much protection you have built into your RILA. More protection on the downside is offset by less upside potential for the most conservative investors.

RILAs are good for deferring taxes and providing an income stream at a later date, and they can be customized to your risk tolerance.

Questions?

Annuities have changed significantly in recent years, making them more attractive and easier to customize to an investor’s individual goals. If you are over 50 and are interested in adding an annuity to your retirement portfolio, or if you own an older annuity that you would like to review, contact an Adams Brown investment advisor.