Recently we have had a few inquiries from prospective clients about a relatively new annuity product called a deferred-income annuity. Insurance companies are touting the new product as a way to build your own future retirement pension. So consumers, especially baby boomers, are naturally interested. In fact, sales of deferred-income annuities have more than doubled over the last year alone. But how do these annuities work, and are they the best option available for producing retirement income?
Deferred-income annuities are very closely related to immediate annuities. With an immediate annuity, you turn over a lump sum of money to an insurance company, and they begin providing you with income immediately, typically on a monthly basis. The income the annuity produces is a fixed amount that lasts as long as you live, although there are options to specify payouts for a minimum number of years regardless of how long you live. With a deferred-income annuity you turn over a lump sum of money to an insurance company, and in turn, receive a pension like series of payments at some point in the future: typically one year to thirty years in the future.
The benefits of a predictable stream of income are obvious, but what are the potential drawbacks of a deferred-income annuity? The first drawback is that you are handing over a lump sum amount to the insurer. Once you die, the annuity payments stop and the insurance company keeps the remainder of the lump sum, except in two exceptions. The first exception is to specify a guaranteed minimum payout period, typically ten years. The second exception is to elect a death benefit at the time you enter into the contract. In both cases, the annuity owner will reduce the annuity payout from the insurer.
Another drawback is that annuity payments lose purchasing power each year because of inflation. That means that under normal inflationary conditions the purchasing power of the annuity will be cut in half every twenty years or so. Some deferred-income annuity providers have cost-of-living riders that help keep pace with inflation, but that too will cost you in the form of a lower initial annuity payout.
The final drawback is that annuity payouts are tied to interest rates. Under current conditions, with interest rates near all-time lows, annuity payments will also be low. Since the income is deferred for at least a year anyway, it makes sense to wait until interest rates are higher to purchase a deferred-income annuity.
So are deferred-income annuities the best tool to produce income for retirees? On the one hand, they do offer retirees a steady stream of income backed by the state’s guaranty association and the financial strength of the insurance company. But that income comes at a cost. Purchasing the annuity requires giving up a substantial lump sum to produce the income, and the income has limited potential to keep pace with inflation.
Given the shortcomings of deferred-income annuities, only the most risk-averse investors should choose them. Most investors would be better off in the long run with a portfolio properly allocated between fixed income and equity investment to provide them with the necessary retirement income today, and liquidity and protection against inflation in the future.
Sources: Wall Street Journal, InvestmentNews