Fixed annuities are insurance products that allow you to conservatively plan for retirement, without risking loss to principal you purchase.
In an era where employers are deleting defined benefit plans, the fixed annuity serves as an interesting option for retirees (and future retirees) seeking to reduce risk. Fixed annuities are tailored in an excess number of forms, but they all maintain certain, fundamental characteristics. First, fixed annuities provide a minimum guaranteed return over the life of the insurance contract. While the overall return may vary based on the performance of an index, as is the case with fixed index annuities, all of these financial products include a minimum rate. Second, as long as the contract’s terms are not violated, the principal you purchase is protected from loss.
We begin by discussing the historical background concerning sources of retirement income, including the increasing relevance of fixed annuities as a strategy to use in retirement planning. The second part provides clarification on the types of fixed annuity products we offer at Ohio Annuity Insurance.
Demise of the defined benefit plan
Traditionally, retirees relied on three sources for income: social security, pension, and personal savings. Financial planning practitioners commonly refer to these sources as the “three-legged stool” of retirement income.
Of course, social security was only intended as a rudimentary, supplemental income. Think of social security as the “wobbly leg.” (Incidentally, our eyes were opened from our experience in tax preparation, where each year, we come across several retired clients managing to stay above water with social security serving as their only viable earnings source.)
Defined benefit plans
Employer pensions, also known as defined benefit plans, are similar to social security in how they operate. Both pay a lifetime (defined) benefit when you retire. Actuarial accountants determine payable amounts using formulas, which are based on life-expectancy statistics. In essence, social security and defined benefit plans serve as retirement income insurance, because they provide the retiree guaranteed income for life.
The challenge with the defined benefit system, just described, is that people are dying at older ages. And, in many cases, the system no longer works. Now, it’s quite common for employers to pay pensions 20, or even 30, years after a worker retires. Where before, when life expectancy was much shorter, these situations were minor exceptions. As a result, a disturbing trend developed, the disappearance of defined benefit plans.
Defined contribution plans
Employers gradually replaced defined benefit plans with alternatives that allow employees to make tax-deferred contributions into an investment account, like the 401(k) and 403(b) savings plans. These programs are referred to as “defined contribution” plans. Based on their characteristics, we categorize defined contribution plans with personal savings.
For employers, defined contribution plans remove the financial uncertainty associated with pensions. But, the gradual replacement of defined benefit with defined contribution raises concerns.
Defined benefit plans are akin to a forced participation program. Typically, the pension applies to all vested employees, and the payable amounts are ascertained using factors like years of service, average annual wages, and age of employee when benefits begin. With defined contribution, an employer can automatically enroll employees and provide certain matching incentives, thus encouraging enrollment. But, the employer cannot require participation. This election, to defer receipt of earnings, is an employee’s decision.
Also, the ten percent tax penalty for accessing money contributed to a defined contribution plan before age 59.5 is severe. Many employees simply prefer (or need) to receive the money now.
Finally, defined contribution transfers the investment risk from employer to employee. Employers can mitigate the employee’s investment risk by conservatively limiting the investment choices available within a defined contribution plan. But, even conservative investments are subject to market folly, and the untrained employee may buy and sell at the most inopportune moments. Employees may also lack the temperament to make purchase and sale decisions. Moreover, unsatisfied employees can rollover 401(k) or 403(b) assets into an IRA, where riskier investment alternatives are available.
A modern three-legged stool
The evaporation of defined benefits leaves retirees with a “two-legged stool,” social security and personal savings. We believe fixed annuities can act as the third leg, supplanting the role previously played by pension plans as a primary source of retirement income.
Fixed annuities as a strategic option
Fixed annuities allow you to purchase future income without fear of losing insured principal. When combined with social security, this strategy provides a foundation of retirement income, which is not subject to market turbulence.
Fixed versus variable annuities
We offer fixed, as opposed to variable, annuities. All fixed annuities provide a minimum guaranteed rate for the life of the insurance contract. Variable annuities are securities, and thus, returns depend on the market. The cash value of variable annuities can decrease when markets sour.
Fixed interest annuities
Fixed interest annuities operate like bank CDs. The product’s interest rate, over the life of the contract, is set in advance of purchase. Depending on the contract’s terms, an insured may be allowed to withdraw interest each year without surrender charges. Insurance companies, operating with lower overhead, are often able to offer guaranteed interest rates that exceed the rates offered in comparable bank CDs.
Fixed index annuities
If you want a guaranteed minimum return, with an ability to participate in market upside, consider the fixed index annuity. These products provide a guaranteed minimum interest rate, but overall return is determined by the performance of an underlying index during the insurance contract period.
Fixed index annuities vary tremendously in how they credit interest. Our preference is to use a participation rate, based on the annual (point-to-point) return of the S&P 500. With these products, the interest credited to your account is determined, annually, by the performance of the S&P 500. For example, if the index is up 20% in a particular year, a 40% participation rate would result in an eight percent interest credit to your account (40% of 20% equals eight percent). Notably, if the index is down 20%, the interest credited to your account that year is zero. But, the annuity will not lose value when the market is down.
Income tax advantage
Lastly, we should mention the tax advantage with annuities, as compared with, for example, bank CDs. If you do not receive distributions from your annuity, the interest credited to your account is tax-deferred during the policy’s term. On the other hand, if you own a CD, you would annually receive form 1099-INT, reporting the interest income you must include on your tax return. Tax deferral is a major advantage annuities hold over CDs. However, in the case of annuities held inside IRAs, this tax advantage is lost, because IRAs already feature tax deferral.
Defined benefit plans appear headed towards extinction. Perhaps, we will see a revival. In the absence of this retirement income source, we believe many retirees, or those approaching retirement, would be well-served with a fixed annuity. If you would like to discuss retirement planning, or if you are interested in learning more about fixed annuities, please call (513) 460-7691 and schedule a free initial consultation.