Variable Annuities Explained -- Guaranteeing Your Retirement With A Variable Annuity
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Retiree's Biggest Concern
The biggest concern for retirees today is out living their money. Life expectancies continue to increase due to advancements in health care and medical science. Company pension programs have disappeared and Social Security is expected to be depleted in 2042. Since these two programs were expected support a retiree throughout his retirement, without them retiree’s are now responsible for their own retirement funds. In today’s market with low guaranteed interest rates, stock market volatility, increased health costs and inflation how are you able to guarantee that you will not run out of money?
Variable Annuities is one answer to this question. Yes, I said the word annuities. I have met a lot of people that once you say annuity, they stop listening. A lot of these people when asked why they do not like them have no answer, they just don’t know. They have been told that they were expensive, difficult to get your money out of them and had long surrender periods. In the past that may have been true but this is no longer the case. If you ask these same people if they would be happy with a pension, they will all say ‘yes”. They will tell you that they would like a guaranteed income that would last their entire life. Guess what, pensions are created out of annuities, so how can you like one thing but not the other, especially if they are the same thing. So what are annuities and how can they aid you in retirement? Great question let’s take a look at them and see what they can do.
What Are Annuities
Annuities are insurance contracts designed for tax free savings and investments designed for retirement. There are two kinds of annuities; fixed and variable. Fixed Annuities are contracts that receive a fixed interest rate much like a CD or savings account. Variable Annuities are investment accounts in which the value is determined by market investments. Both types of contracts are tax deferred, which means you don’t pay taxes on the growth until after you take the money out of the contract. They both have a time frame in which the money needs to stay with inside the contract and a penalty if you take the money out early, much like a CD penalty. Fixed Annuities typically start at 5 years and can go up from there. Variable Annuities typically are in the 6 – 9 year range, although some contracts have a 3 year commitment and even no time commitment. I feel that Variable Annuities are perfect for retirement plans; I use them all the time in retirement planning. (Just a reminder, never ever let a Financial Advisor put all your money into one product). Why do I like Variable Annuities? Continue reading.
Variable Annuities values, as I mentioned earlier, are dependent on market results. Within the annuity are mutual fund like investments called sub-accounts which is invested in the market. These investments are practically identical to the mutual funds you would buy in a brokerage account, but in an annuity they are given a slightly different name, while everything else is pretty much the same. In a Variable Annuity there are many different funds from many different fund families. The funds they have are usually the top performers in the market which is monitored daily. If these funds perform poorly over a period of time, Variable Annuity managers will replace them with another fund that is performing better. They also have a death benefit, the insurance part of the contract, usually during the original term it is a return of premium guarantee. Some death benefits will increase each contract anniversary if the contract value is higher than the current death benefit. This is considered the base investment account, but you can add riders to the contract to enhance the product to your needs. Let’s take a look at these riders and see how they can help.
GMAB - Guaranteed Minimum Accumulation Benefit
The Guaranteed Minimum Accumulation Benefit guarantees the return of your original premium, usually after 10 years if your contract value falls below your original investment. With most contracts, on each subsequent anniversary, a new guaranteed amount is established, and is equal to the greater of the previous guaranteed amount. Each guaranteed amount has its own 10 year waiting period. After the end of the specified 10 year waiting period, you are able to withdraw the guaranteed amount without penalty.
As I mentioned earlier there is usually a death benefit available on the contract. This benefit guarantees that your family or beneficiaries will receive at least the original investment upon your passing. Some contracts have additional riders that will lock in yearly gains, thus moving the death benefit up. Once the death benefit is set at a certain amount, it cannot go down; your beneficiaries would receive the death benefit minus the withdrawals. Typically the reduction in the death benefit is a proportionate to the percentage of the annual withdrawal amount divided by the contract value. For example, lets assume the death benefit is $100,000, the withdrawal is $8,000 and the contract value is $80,000. Since $8,000 is 10% of $80,000 the death benefit would drop to $90.000 (10% of the death benefit of $100,000).
Lifetime Guaranteed Minimum Withdrawal Benefit
This brings us to the Lifetime Guaranteed Minimum Withdrawal Benefit, this is the feature I use for retirement planning. This benefit guarantees a certain amount of money that can be accessed each year for the rest of your life (your personal pension), regardless of the contract value. This protected benefit amount is not to be confused with the contract value, it is only used to calculate a lifetime income stream. I call this protected benefit amount the pension base. The pension base is guaranteed to increase, at least each year, by a certain amount, usually between 5% - 7%, or the contract value if that value goes above the previous pension base.
Let’s assume the initial investment is $100,000, the pension base is $100,000 and the contract value at the anniversary is $90,000 and the pension base guarantee is 6%. In this example the pension base would increase to $106,000, (the account value is less than the pension base thus the guarantee takes over). Now lets consider the contract value is $110,000, the pension vase would then increase to $110,000, because the contract growth beat the 6% guarantee. This occurs each year for the first 10 years. Typically the pension base is guaranteed to be 200% of the original value on the 10 year. Some contracts guarantee the pension base will be 400% after 20 years. With most contracts the guaranteed pension base increase stops at the first withdrawal and locks in the current base amount.
When you are ready to take your income, you are guaranteed a percentage of the pension base guarantee each year for the rest of your life. This amount can be taken yearly, bi-annually, quarterly or monthly and will continue for the rest of your life, or stop if you decide you no longer need the income stream. The percentage amount that is used to determine this amount based off of your age. At 65 -70 that percentage is usually 5%. Some contracts allows you to set up the program to cover both you and your spouse’s lifetimes. This income stream will continue even if the contracts value is completely exhausted and the contract goes down to zero. Any remaining death benefit will be paid to your heirs upon your passing.
Again let’s assume that the initial investment is $100,000 and you wait 10 years before taking an income stream. Let’s also assume that the market has been flat or negative those entire 10 years (highly unlikely, check out my hub Should I Invest in the Market. Because the guarantee is that the pension base will double in 10 years, it would be at $200,000. Based off a 5% payout, your income would be $10,000 per year guaranteed for life, thus giving you just under $1000 per month. If you started with $500,000, the base would be set at $1,000,000 providing an income stream of $50,000 per year guaranteed for life. As you can see depending on how much you start with, you can create a nice pension for yourself.
Most contracts also have a free withdrawal amount of up to 10% which allows you to take out money during the contract term without surrender penalties. There may be a penalty for withdrawing from the contract if you are under 59 1/2 and growth comes out first, so there may be tax implications, be sure to check with your financial professional if there would be any consequences.
Since the insurance company is in business to make money, they do not give these guarantees for free. The average cost to the contract and adding the Lifetime Guaranteed Minimum Withdrawal Benefit and the underlying sub-account (mutual fund) fees is 3% - 4%. You may think this is high, but I consider it a small price to pay to make sure you have money for your entire life. Isn’t your financial security in your retirement years worth it?
This is how I set up a personal pension plan for my clients, including one for my mother, who is receiving a check every month at this time. Added to anything else you might be getting, such as stock dividends, CD interest, bond interest, and savings you can make sure you will not outlive your money. Annuities can be very effective in retirement planning, but always discuss your options with a Financial Professional.
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