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  • Nate Carter

Retirement: Effectively Using Annuities

Annuities Overview

An annuity is a financial product investors purchase to receive a series of future payments. For example, Lars pays $100,000 for an annuity providing $400 per month for the rest of his life. The two main reasons to buy an annuity are financial simplicity and stability. Annuity payments are guaranteed income, unaffected by volatility in other asset classes such as stocks, bonds or real estate. These characteristics make annuities popular with retirees who are risk averse or afraid of outliving their income.

However, annuities are disliked by many investors for their high fees and low returns compared to other investments. An annuity may offer a return of 4.5% compared to an average return of 10% from stocks. Annuities are also not an effective way to leave assets to heirs as the payments usually cease once the annuitant dies.

Common Types of Annuities

There are a few main types of annuities. Immediate annuities, as the name suggests, begin paying out right away. Deferred annuities pay out at a future date such as five or ten years from the date of purchase. Deferred annuities offer higher returns because the purchaser could pass away before a single payment is made and the annuity provider has more time to invest the funds before making payments. Annuity payments can be for a fixed amount or payments can increase over time. These increases help maintain the purchasing power of annuity payments as inflation rises.

There are also variable annuities which offer a mix of guaranteed payments and some exposure to investing in stocks. Adding such features makes annuities more complex, removing both the simplicity and stability that made them attractive in the first place.

Guaranteed Income Supports Happiness

Studies published in the Wall Street Journal show that retirees with guaranteed income are both happier and live longer than other retirees. This guaranteed income eliminates the fear of outliving your money and reduces money related stress in retirement. It also encourages retirees to spend more on what they enjoy, knowing they can rely on next month's annuity payment.

Making Annuity Payments Tax Free

Buying an annuity with a Roth Individual Retirement Account (IRA) makes the payments tax free. Some investors use a strategy of adding a tax free annuity to their portfolio while also holding stocks, bonds, real estate, and other investments. This provides some guaranteed tax free income, without over investing in annuities with lower rates of return. Diversifying investments this way provides some guaranteed income while allocating the bulk of retirement savings in assets that historically earn higher returns. It also allows retirees to leave some assets to their heirs.

Three Examples of Effectively Using Annuities

Below are three examples of investors effectively using annuities to achieve their retirement goals while also avoiding common pitfalls that cause investors to dislike annuities.

1. Annuities to Provide Security:

Felix is 40 years old and has no intention of ever getting married or having kids. Longevity runs in his family and thinks he may live to his mid-90s. He will retire at age 60 and does not plan to work again. His 401k is invested in stocks and bonds that he expects to be worth $500,000 when he retires. He will withdraw 4% of this balance or $20,000 in his first year of retirement, plus inflation adjustments in the following years. He also has a rental property that will provide $6,000 in annual rental income.

Felix bought a deferred annuity this year for $100,000 that begins paying out at age 60. The annuity will pay $750 per month or $9,000 per year. Therefore, Felix will have $35,000 in retirement income from diversified sources (stocks, bonds, real estate) to keep up with inflation and some guaranteed annuity income to navigate market downturns. At age 67 Felix will draw Social Security Retirement Benefits of $20,000 boosting his annual income to $55,000.

2. Annuities to Simplify Retirement:

Alex and Fatima are using an annuity to create simplicity in the event of losing a spouse. Fatima works in finance and manages the family's investments. Alex is an architect with no interest in personal finance. Fatima maintains a diverse range of investments. However, if she passes away or becomes incapacitated she has provided specific instructions to a trusted financial planner to help Alex sell these holdings and convert most of the proceeds to immediate annuities. The balance will fund a trust for their children.

If Fatima passes away Alex will have more than $60,000 per year in annuity income for life. The payment will be indexed for inflation so his income does not lose purchasing power over time. Alex plans to continue working for many years and he will also collect Social Security Retirement Benefits. Fatima's strategy allows her to invest they way she prefers while still providing Alex with financial simplicity in retirement, if something happens to her. If Alex were to pass away early, Fatima would continue managing the investments.

3. Annuities to Increase Happiness

Ken and Brigette both had financially successful careers and retired early to enjoy more time with their son, friends and to travel. They are both aware that holding investments in stocks, bonds, and real estate earns higher returns, but they are willing to forgo better returns to eliminate volatility. The stability of annuity income makes them happier in retirement by reducing money related stress. They have $30,000 in a savings account for emergencies and intend to leave their son their house, which is paid off, as an inheritance.

When they were both age 50 they bought a joint immediate annuity. The surviving spouse will continues to receive the payments if either of them die. The annuity provides $80,000 per year with a 3% annual increase as a hedge against inflation. The annuity was very expensive, costing most of their retirement savings. They will both receive Social Security Retirement Benefits at age 67 adding $24,000 each to their annual retirement income.

If the simplicity and stability of an annuity matches your long term goals consider these examples as a guide. Making a plan for retiring early is about balancing goals for financial freedom with maximizing happiness. It is not always about earning the highest rates of return on investments. For details on building a plan for financial independence see the Loaded for Life books.

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