Annuities Deferred Income Annuities Retirement Income Planning

Annuitization Payment Option: The Financial Decision You Will Live With for the Rest of Your Life

Using Fixed Income Annuities to Build Your Portfolio Ladder, in addition to introducing the fixed income annuity strategy, was intended to be a primer on annuities in general. Although, as we learned in Immediate Income Annuities: The Cornerstone of a Successful Retirement Income Plan, fixed income annuities have a long history, tracing their roots to Roman times with private sector annuities being available in the United States for over two centuries, they are an often misunderstood and misused investment tool.

Unlike CD’s to which they’re often compared, fixed annuities offer many more potential benefits, including generally higher rates of return over comparable terms, tax-deferral when used in nonretirement settings, potential death benefit, and availability of annuitization with guaranteed (subject to individual insurers’ claims-paying ability) and tax-favored (when used in nonretirement accounts) income, often for life. Annuitization, the last potential benefit, is the one that is the most misunderstood and misused, especially when the purpose of the annuity purchase is to produce retirement income.

When you purchase an annuity, unless it’s a single premium immediate annuity (“SPIA”) or a deferred income annuity (“DIA”), you’re generally not required to annuitize your investment. If it’s a fixed annuity, after the initial fixed, pre-defined term ends, you can withdraw your investment plus earnings subject to a potential surrender penalty, renew it similar to a CD, or invest in a new annuity contract via a 1035 exchange, deferring income taxation on the gain in the old contract, all without ever annuitizing your contract.

If you decide to annuitize a traditional annuity or if you purchase a SPIA or DIA, you will be presented with a confusing array of payment choices. In addition to deciding upon a payment method, i.e., fixed or variable, and payment frequency, i.e., monthly, quarterly, semi-annual, or annual, you will also need to choose a payment option. Annuity contracts generally offer the following four types of annuity payment options:

  1. Life annuity
  2. Life annuity with guaranteed period
  3. Joint and survivor annuity
  4. Period certain

Life Annuity

A life annuity is also referred to as a straight life annuity. This is an annuity that makes periodic payments to an annuitant that terminate upon the annuitant’s death. This option generally offers the largest periodic payment.

Life Annuity With Guaranteed Period

To protect against the possibility of receipt of a limited number of payments as a result of premature death, insurance companies offer a life annuity with a guaranteed number of years of payments. The number of years can vary, however, it is often for five, ten, fifteen, or twenty years. The periodic payment amount for this option will be less than that of a straight life annuity due to the guarantee feature.

Joint and Survivor Annuity

A joint and survivor annuity is designed to provide for ongoing income to a survivor, whether it be a spouse or some other individual, upon the death of the annuitant. In addition to receiving the identical payment amount as the annuitant, there are generally three other survivor options available:

  1. Specified percentage of the annuitant’s benefit, e.g., 75% or 50%
  2. Same payment with a guaranteed period, e.g., 5, 10, 15, or 20 years
  3. Specified percentage of the annuitant’s benefit with a guaranteed period

Period Certain

The final payment option, period certain, is also referred to as term certain. This option provides for a payment for a specified number of months or years. The payment will be made by the insurance company for the specified term to the annuitant, and potentially to an annuitant’s beneficiary(ies) in the event that the annuitant dies before the end of the term. This is the only payment option whereby the insurance company’s liability is fixed at the commencement of annuitization since a specified payment will be paid to the annuitant and potentially to his/her beneficiaries for a specified period of time regardless of when the annuitant dies.

After making the decision to annuitize an annuity, the choice of payment options is one of the most, if not the most, important financial decisions that you will ever make since it will determine both the amount and duration of income that you, and potentially other individuals, will receive from your investment. Professional guidance is highly recommended given the fact that it’s an irrevocable decision with lifelong consequences for you and your survivors.

Annuities Retirement Income Planning

Immediate Income Annuities: The Cornerstone of a Successful Retirement Income Plan

Last week’s blog post introduced a powerful income laddering strategy using a customized blend of fixed income annuities to create and optimize retirement income. As discussed, this strategy offers retirees the benefit of predictable inflation-adjusted income streams to close projected income gaps as well as generate tax efficiency for the nonretirement portion of one’s portfolio while reducing exposure to the gyrations of the stock market. Two types of fixed income annuities were introduced: immediate and deferred, with the former being the subject of this week’s blog.

Annuities have a long history, tracing their roots to Roman times. Contracts during the Emperor’s time were known as annua, or “annual stipends” in Latin. Roman citizens made a one-time payment in exchange for a stream of payments for a fixed term or for life.

In 1653, a Neapolitan banker named Lorenzo Tonti developed a system for raising money in France called the tontine whereby individuals purchased shares in exchange for income generated from their investment. As shareholders died, their income was spread among the surviving investors until the last person alive collected all of the remaining benefits. Although the use of tontines spread to Britain and the United States to finance public works projects, it was eventually banned since it created an incentive for investors to eliminate their fellow investors in order to obtain a larger payout.

Private sector annuities have been available in the United States for over two centuries. In 1759, Pennsylvania charted a company to provide survivorship annuities for families of ministers. In 1912, The Pennsylvania Company for Insurance on Lives and Granting Annuities was founded and became the first American company to offer annuities to the general public.

The earliest commercial annuities became the predecessor for immediate income annuities, otherwise known as single premium income annuities, or “SPIAs,” that are in widespread use today.

Immediate income annuities, or SPIAs, are distinguished from deferred income annuities, or DIAs, based on the timing of commencement of payments from the insurance company to the annuitant. “Immediate” is somewhat of a misnomer since the payments don’t begin immediately after investment in an annuity contract. Most annuity investors choose a monthly payout and therefore receive their first payment from a SPIA one month after purchase. Initial payments will be delayed for one quarter, six months, or a year when quarterly, semi-annual, and annual payout modes, respectively, are elected.

While a customized blend of SPIAs when used in conjunction with deferred income annuities, or DIAs, can be an ideal retirement income laddering strategy, an individual SPIA can solve many income needs. As such, it’s often used as the cornerstone of retirement income plans. SPIAs’ unique characteristics and benefits are very appealing to retirees since they include the following, several of which also apply to DIAs:

  1. Immediate, predictable, guaranteed income (subject to individual insurers’ claims-paying ability), often for life, beginning at retirement
  2. Protection against outliving assets
  3. Flexible choices of payment plans to meet one’s needs
  4. Choice of frequency of payments
  5. Reduction of income tax liability through tax-favored status in nonretirement accounts, potential reduction of taxable Social Security benefits, and reduction of required minimum distributions (RMDs) in retirement accounts
  6. Reduced exposure to fluctuation of the stock market to the extent that funds used to purchase SPIAs were previously invested in the market
  7. Reduced dependence on ongoing investment management and associated reduction of investment management fees to the extent that funds used to purchase SPIAs were previously professionally managed

As a tradeoff for the foregoing seven benefits, it must be kept in mind that the purchase of all annuity contracts, including SPIAs, is usually an irrevocable action. Once an annuity has been purchased, the owner doesn’t have the right to terminate the contract and request a refund without incurring a substantial penalty. In addition, depending upon how the payout is structured, it could last for many years, potentially over the lifetimes of two or more individuals.

Immediate income annuities, when properly customized for a particular financial situation, can result in reduced financial worries and an associated positive retirement experience. While they can be an effective cornerstone for many retirement income plans, however, they usually aren’t a total solution for creating and optimizing retirement income.

Annuities Deferred Income Annuities Retirement Income Planning

Using Fixed Income Annuities to Build Your Income Portfolio Ladder

The previous two blog posts introduced the income portfolio plan strategy and the importance of designing laddered income streams to fund a retirement income plan. If you haven’t read these two posts yet, I would recommend that you do so before reading this one. This post introduces a powerful income laddering strategy that can be used to create and optimize your retirement income.

As stated in last week’s post, due to the fact that our financial situation and needs will change at different stages of our retirement years, a retirement income plan must provide for different and distinct income streams to match our expense needs associated with each stage. One of the most efficient ways to do this is through the use of a customized blend of fixed income annuities. Before discussing this technique, let’s first review some basics of annuity investing for those of you who may not be familiar with this often misunderstood type of investment.

Annuities are offered by life insurance companies through a contractual relationship between the insurance company and the owner of an annuity contract. A distinguishing feature of annuities from other types of investments is “annuitization,” or the ability to convert the annuity to an irrevocable structured payment plan with a specified payout by the insurance company to an individual(s), or “annuitant(s)” over a specified period of time through different lifetime and term certain options offered by the insurance company.

Unlike most non-retirement vehicles that have ongoing income tax consequences associated with them while you own them, a basic distinction between annuities and other types of investments is that annuities offer the tax-deferred advantages of retirement assets such as 401(k) plans and IRA’s without several of the negative tax consequences associated with the latter.

There are two basic types of annuities, both offered by life insurance companies: fixed and variable. Fixed annuities are similar to CD’s since they have a fixed, pre-defined term and interest rate and don’t fluctuate in value. Unlike CD’s which are offered by banks and are insured up to FDIC limits, fixed annuities guarantee principal subject to the claims-paying ability of individual insurance companies. Variable annuities, on the other hand, are invested in equity investments, such as mutual funds, and as such, fluctuate in value and have greater risk associated with them.

When annuities are annuitized, they are referred to as “income annuities.” Unlike any other income planning strategy, in addition to closing projected income gaps, fixed income annuities can be structured to provide predictable inflation-adjusted income streams as well as tax efficiency for the nonretirement portion of one’s portfolio. Two types of fixed ncome annuities that will be the subject of, and will be discussed in more detail in, the next two blog posts can, and generally should, be used: immediate and deferred.

Single premium immediate annuities, or “SPIAs,” make periodic payments, typically monthly, for a specified number of months or for an individual’s lifetime or joint lifetimes as applicable. The payments generally begin one month after purchase of a SPIA, hence the term “immediate.”

While the use of SPIAs is widespread, deferred income annuities, or “DIAs,” are currently offered by only a handful of life insurance companies. Like SPIAs, DIAs pay periodic income for a specified period of time or over one’s lifetime or joint lifetimes as applicable. Unlike SPIAs, however, the start date of the payments for DIAs is deferred for at least 13 months from the date of investment.

The power of the use of a customized blend of fixed income annuities, including their preference as a retirement income planning solution, will become apparent in future blog posts. Suffice it to say, this is definitely the way of the future for many retirees to benefit from predictable inflation-adjusted income streams to close projected income gaps as well as generate tax efficiency for the nonretirement portion of one’s portfolio while reducing exposure to the gyrations of the stock market.

Retirement Income Planning

Is Your Income Portfolio Plan Laddered?

After ten previous posts, last week’s blog introduced the first strategy for creating and optimizing retirement income – an income portfolio plan. It explained that an income portfolio uses streams of income to close the gap between projected income needs and projected income sources while accomplishing the same objective as a traditional investment portfolio, i.e., minimization of investment risk. It also stated that the investments used to generate the income streams include, but are not limited to, CD’s, bonds, life insurance, and annuities.

Generally speaking, no single investment can be used to fund a financial plan. The success of any plan is dependent upon a combination of investments, each serving a specific purpose, working together to achieve the goals of the plan. In the case of an income portfolio plan, streams of income from several investments are used to achieve the goal of the plan, i.e., to close the income gap, or difference between projected income needs and projected income sources. While the income streams can occur simultaneously, this post discusses sequential, or laddered, income streams.

What are laddered income streams and why should they be used to fund a retirement income plan? If you know that you are going to retire at age 65, live to age 85, your annual expenses will be $60,000 with no changes, there will be no inflation, you will not be subject to federal or state income taxes, your annual Social Security benefits will be $20,000, you have $800,000 that you want to live off of the income and leave to charity when you die, and the interest rate on high-quality 20-year corporate bonds is 5%, you could simply invest your life savings in one or more bonds to generate the $40,000 per year ($800,000 x 5%) that is required to close your income gap (annual expenses of $60,000 less Social Security benefits of $20,000).

As we all know, life is not so simple. There are numerous variables that need to be considered when designing an income portfolio plan. Many retirement plans either assume an initial annual expense amount that increases by a fixed inflation factor from the date of retirement through the date of death or are instead based on a rule of thumb that your retirement income needs to be a specified percentage, say 80%, of your pre-retirement income.

Neither one of these approaches takes into consideration the fact that our financial situation and needs will change at different stages of our retirement years. As a result, the primary goal of an income plan should be to generate different and distinct income streams to match our expense needs associated with each stage while also funding periodic one-time needs, e.g., home improvements, car purchases, child’s wedding, etc.

It’s essential when designing an income portfolio plan to identify the various projected stages, or segments, in retirement and the associated expenses associated with each stage. Once this is done, the projected known income sources can be taken into consideration to determine an appropriate investment strategy for generating specific income streams to close the gap between one’s projected income needs and projected income sources in each stage. Since the projected income shortages will differ in each stage depending upon needs vs. available resources, different types of investments and investment strategies can and should be used.

The end result should be a plan that is designed to generate sequential, or laddered, streams of predictable income to match one’s needs. Like any financial plan, an income portfolio plan needs to be periodically monitored and modified to reflect one’s changing financial situation and needs.

Retirement Asset Planning Retirement Income Planning

Withdrawal Drag – The Silent Killer

As you approach retirement, are you aware of the silent killer lurking on the horizon? Let’s call our silent killer “W.D.” When you enter the retirement zone, W.D. will be right behind you, looking over your shoulder, waiting to spring into action. When you dare to take your first withdrawal from your portfolio, W.D. will pounce – only you won’t know it. You will continue on, as if nothing happened, innocently taking your withdrawals each month. As each deposit hits your checking account, W.D. will extract a toll on your portfolio, one that will increase in size with each transaction. And guess what? You will never know what hit you. You see, W.D., or “Withdrawal Drag,” is the ultimate portfolio silent killer.

Before we expose the secrets of “withdrawal drag,” first some background. When you’re saving for retirement, or you’re in the “accumulation stage,” as we retirement income planners like to refer to it, assuming that you take no withdrawals from your portfolio, you realize the beauty and grace of compounding rates of return. To appreciate compounding, let’s start with simple interest.

With simple interest, you earn interest on your principal. Let’s say you have a portfolio that’s worth $500,000 and it earns simple interest of 7%. In year 1, you will earn $500,000 x 7%, or $35,000. Your portfolio will be worth $535,000 ($500,000 + $35,000) at the end of year 1. In year 2, you will earn $500,000 x 7%, or $35,000. At the end of year 2, your portfolio will be worth $570,000 ($535,000 + $35,000). And so on. That’s OK, however, there’s a better way to go – compounding.

Through compounding, in addition to earning interest on your principal, you also earn interest on your interest. Using the previous example, after year 1 when your portfolio is worth $535,000, in year 2 you earn interest on $535,000, not just $500,000. You earn $535,000 x 7%, or $37,450 vs. $35,000 and your portfolio is worth $572,450 vs. $570,000 at the end of year 2 using simple interest. The benefit to you of earning compound vs. simple rates of return increases each year. For a simple example of the magic of compounding, please see Exhibit 1 – $500,000 Growing At 7% Compound Interest. Per Exhibit 1, over 26 years, you have earned $2,403,676 and your portfolio has grown from $500,000 to $2,903,676. Although it isn’t illustrated, this is an increase of $1,493,676, or more than double, over the value of your portfolio of $1,410,000 using simple interest.

Enter Mr. W.D., or “Withdrawal Drag.” Continuing on with our example, let’s take a look at Exhibit 2 – $500,000 Growing at 7% Compound Interest With Annual Withdrawals. Now you’re 65 and you’ve entered the retirement zone. You’re still earning a compound rate of return of 7% on your portfolio, however, you’re taking withdrawals from your portfolio each year. Let’s assume that your withdrawals at age 65 total 5% of the value of your portfolio, or 5% of $500,000, or $25,000, and they increase by 3% each year. Per Exhibit 2, after starting with $500,000 at age 65, after 26 years, or at age 90, (1) your withdrawals total $964,000, (2) you earned $926,000, and (3) your portfolio is worth $462,000, or $38,000 less than what you started with. Not a bad result, right? Well, yes and no.

To answer the question, let’s step back and look at what your $500,000 portfolio would have been worth if you never took any withdrawals and you subtract your total withdrawals and ending balance of your portfolio at age 90 after taking withdrawals:

$500,000 growing at 7% compound interest for 26 years per Exhibit 1: $ 2,903,676
Less: Total withdrawals at age 90 per Exhibit 2 (   963,826)
Less: Ending balance of portfolio at age 90 per Exhibit 2 (   462,230)

Withdrawal Drag $ 1,477,620

What happened to almost $1.5 million? Ah, hah – mystery solved! The culprit is, guess who? Mr. W.D. Sure enough, per Exhibit 3 – Withdrawal Drag, the difference between your total earnings of $2,403,676, assuming no withdrawals per Exhibit 1, and your total earnings of $926,056, assuming withdrawals of 5% of your starting principal increasing by 3% per year per Exhibit 2, is exactly $1,477,620. At first, seemingly innocent, extracting a mere $1,750 from your portfolio at age 65 per Exhibit 3, Mr. W.D. doesn’t seem like such a bad guy. With each, passing year, however, Mr. W.D. gets greedier and greedier, taking almost $20,000 at age 72, $59,000 at age 80, and helping himself to $160,000 at age 90.

And so ladies and gentleman, as you enter the retirement zone, keep a close eye out for Mr. W.D. each and every time that you take a withdrawal from your portfolio. He’ll be watching you!

Celebration Retirement Income Planning

Retirement Income Visions™ Makes Its Debut

Welcome to Retirement Income Visions™! As many of you know, I’ve been writing and publishing Financially InKlein’d™, featured on Financial Design Center’s website, for the last 20 years.

Whereas Financially InKlein’d™ covers a spectrum of timely personal financial planning topics revolving around the theme of Planning, Managing, and Protecting Your Financial Independence™,   Financial Design Center’s trademark, the focus of Retirement Income Visions™ is Innovative Strategies for Creating and Optimizing Retirement Income™.

As always, I’m inspired and motivated by my clients. The birth of Retirement Income Visions™ is no exception. While retirement planning has been the cornerstone of my financial planning practice for years, the importance of retirement income planning as a separate and distinct discipline was magnified during the October, 2007 – March, 2009 stock market decline.

My goal in writing this blog is to bring to your attention innovative planning strategies that you can use to create and optimize your retirement income, and, in many cases, reduce your exposure to adverse financial market conditions. The customization and implementation of these strategies for your needs by an experienced retirement income planning professional should enable you to visualize and live a more fulfilling and less stressful life.

I’m excited and I look forward to sharing my knowledge and expertise with you on a regular basis. Subject to change, my plan is to publish a new blog post each Monday morning. I invite and encourage you to share your thoughts with other readers of Retirement Income Visions™ by clicking on “Comments” at the end of each blog. Your feedback is very much appreciated and will be considered in connection with the development of future topics.

If retirement income planning is of interest to you, please click on “Subscribe” in the navigation bar above and I will make sure that you automatically receive each edition of Retirement Income Visions™.  Finally, if you know others who you feel would benefit from Retirement Income Visions™, please click on “Email this” or “AddThis!” following this and each forthcoming blog post.

Finally, since the subject matter of this blog is technical in nature, a Glossary of Terms is available for your reference. New terms will be added as they appear in each blog post. You may access the Glossary by either clicking on Glossary in the navigation bar at the top of this blog or by clicking on unbolded blue links in each blog post.

Thank you for visiting.  Until next time!