Best Sources of Retirement Income

As the eyes of 70 million Baby Boomers turning towards their imminent retirement, their focus is quickly shifting towards their future financial security. Many people are awakening just now to the prospect of living another 25-plus years in retirement and few feel as though they have prepared adequately. Add to this the increased uncertainty that has enveloped the economy and the markets, and it becomes even more critical to start planning ahead to establish your best sources of retirement income.

it’s not Your Father’s Retirement Anymore

When considering retirement income sources, today’s pre-retirees need to contend with certain risks that their parents and grandparents didn’t. Retirees of past generations didn’t really have to concern themselves with the risk of living too long (longevity risk). The life expectancy of retirees in the 1960s and 1970s was 73 which meant that people generally lived about 8 years in retirement. Because of that, there wasn’t much concern over the cost-of-living (inflation risk). And, because most people received guaranteed income payments from a pension plan back then, they also weren’t too concerned about which way the markets were going (market risk).

That has changed for today’s retirees who face all three risks. So, planning for retirement is now as much about choosing the right income sources as it is accumulating a sufficient retirement fund. The unfortunate fact is that people today are still not saving enough, and those that worked hard to do so may have experienced a serious setback with the severe market declines of 2000 and 2008. So, for most people, the more critical planning decision is which income sources will provide the greatest amount of security.

Guaranteed Income Annuities

At the top of the list for an increasing number of people are income annuities. Once thought to be too conservative, income annuities are now coveted for their income predictability and stability. Moreover, they are the only vehicle that can put to rest any concern about outliving your income. When a lump sum of money is exchanged for a guaranteed stream of income, a life insurance company will not only guarantee your payments, it will ensure that, no matter how long you live, you will always receive them. And, if you choose to add a cost-of-living adjustment option, your income will keep pace with the rate of inflation. Payout options are available on multiple lives so you can ensure that the income will be available for your spouse as well.

You can also choose to invest in a variable or indexed annuity that will generate income payments commensurate with the growth of the markets. Many of these annuities explained offer downside protection with minimum income guarantees, so you can benefit from the higher market returns without risking your income.

Target Date Mutual Funds

In response to the waves of retiring Baby Boomers, mutual fund companies have introduced a new type of fund that actually targets your retirement date in establishing the mix of investments for the fund. These funds invest in various asset classes, such as stocks, bonds, retirement and cash vehicles, to reflect your evolving stages of financial need and risk. For instance, the investment allocation of a younger person will lean more heavily towards stocks and growth investments. Then as the person ages, the allocation will gradually shift towards more conservative investments. The growth target for the funds is based on a retirement income requirement of 4% of the fund’s value over the life expectancy.

Obviously, these funds, with their exposure to the stock and bond markets, entail market risk, however, they are professionally managed and well diversified so risk over the long term is reduced. Because these funds target specific dates, it is recommended that you invest in more than one that will target different stages of retirement. For instance, a fund targeting a retirement date of 2025 will invest more conservatively than one targeting a date of 2030. This will allow a portion of your funds to continue to work a little harder to ensure adequate accumulation.

Make Retirement a Career

Most people today envision themselves doing something in retirement to keep active, and, perhaps, pursue a new vocation or even a business opportunity. Retirement today is much less a stage of life as it is a whole new life cycle with new opportunities to learn, grow and earn. For many people, working in retirement will be more of necessity than a desire. But, there’s no reason why anyone can’t make a career out of retirement. The most popular form of earning an income in retirement is through a small business. It could be as simple as monetizing a favorite hobby, or more elaborately, investing in a franchise of some sort. The best way to create a steady income stream from a business in retirement is to get your business started now. Everyone can use an extra source of income while saving for retirement, and when you’re ready to leave the rat race, your business income will more established and stable.

Which is the Best Source of Retirement Income?

Of course, there is no single best source of retirement income. The best strategy for creating a secure and growing income stream is to combine several different sources in order to be able to confront the certain risks of longevity, inflation and market fluctuations. You can’t avoid these risks, they are inherent in everything you do to prepare for retirement. So, the best course is to diversify your income sources to create a layer of stability, a layer of growth, and a layer of long term security.

Comparing Equity Indexed Annuities

Equity indexed annuities are the new darling of the financial planning industry. Since their introduction in 1995, they have continually grown in popularity. And with fixed yields still near historic lows, and the stock market still giving investors fits, they are emerging as the go-to annuity for retirement savers. But, just as fixed annuities and variable annuities proliferated during their periods of popularity, the number of equity indexed annuities have swelled which makes it all the more difficult to know which ones offer the best opportunity for solid, long-term performance. Comparing equity indexed annuities can be somewhat perplexing unless you know the specific criteria for evaluating them.

Key Points of Comparison

The most effective way to evaluate equity indexed annuities is to focus on the key components that drive their performance: The participation rate, the cap rate, the floor rate, the length of the surrender period, and the company’s renewal rate history.

Participation Rate

The yield credited in an equity indexed annuity is tied directly to the percentage gain of a corresponding index, such as the S&P 500. But, the actual yield that is credited is based on the stated participation rate which can range from 50% to 100%. The higher the participation rate is, the higher the portion of the index gain your account will receive as a credit. So, if the index gains 20%, and the participation rate is 100%, your account will be credited with 20%. Lower participation rates are not necessarily a bad thing if they are guaranteed for a longer period of time. If an annuity offers a high participation rate, it is likely to have shorter and more frequent rate renewal periods which means you could end up with a much lower participation rate at some point in the future.

Performance Cap Rate

After your participation level is determined, the annuity provider will apply a cap rate which can further limit the amount of the index gain that is credited to your account. So, using the previous example, if the participation rate is 100% resulting in a 20% yield credit, a 10% cap rate would limit the credit to 10%. The cap rate is a mechanism used by the annuity provider to ensure that they generate revenue for their own account, and it also provides them with a cushion to cover their losses when they apply a minimum floor rate in a down market.

Essentially, the cap rate becomes your principal protection device. Regardless, you will want to look for annuities with higher cap rates, or no cap rate at all. As with the participation rate, you will want to consider the rate renewal terms of the contract to avoid being lured in with a high initial cap rate only to have it lowered in the future. Also, it is not uncommon to find an annuity with a high cap rate that has high expenses as a way to recoup the lost revenue.

Floor Rate

One of the distinguishing features of an equity index annuity is the downside protection it provided during declining markets. This is achieved through a floor rate or minimum rate guarantee. Obviously, the higher the floor rate, the better your annuity may perform over time should the index encounter persistent market declines.

Surrender Period

Most people who invest in annuities do so with a long term horizon and with sufficient liquidity in other parts of their portfolio, so the withdrawal provisions are usually of little concern to them. Still, you may want to consider how much flexibility your annuity has in accessing funds should you need them. Most annuities allow you to withdrawn 10% of your account value without charges. However, excess withdrawals made during the surrender period will incur a surrender fee. The fee, which can start as high as 15% in the first year of the surrender period, declines by a point each year until it vanishes all together.

Regardless of how concerned you are with accessing your funds, you may want to consider those annuities with shorter surrender periods. However, equity indexed annuities that offer more competitive participation and cap rates tend to have longer surrender periods. So, if you have little or no concern over getting access to your funds, you could benefit from annuities with higher rates.

Renewal Rate History

With most equity indexed annuity contracts, the annuity provider has the ability to change the key rates on the contract’s anniversary. For instance, it could reduce your participation rate. Or, if there was, initially, no cap rate, it could introduce one. It would be important to look for contracts that have extended guarantee periods for these rates, but, where there are none, it is then important to consider the providers history on rate renewals to see how frequently or how greatly they adjust the rates. This is why it is important to only consider providers who have established track records with equity indexed annuities.

Company Strength

Unlike variable annuities in which your funds are invested in separate accounts, the funds of equity indexed annuities are invested in the general account of the issuing life insurance company. While life insurers are heavily regulated in the manner in which they can invest your funds, and they generally tend to be very conservative in their approach, it would very important to work with those companies that have a demonstrative record of safety and sound management. Companies that are rated highly by the independent ratings firms are considered to have superior financial management capabilities and a much stronger outlook during shaky economic periods.

How to Compare Annuity Quotes

Annuities reached their peak of popularity back in the 1990s when the yields on fixed annuities were relatively high, variable annuities were performing well against the backdrop of surging markets, and indexed annuities, with their innovative principal protection features were just being introduced. Then, interest in annuities began to subside in the 2000s when interest rates began to fall, and the stock market become more volatile. Now, with tens of millions of Baby Boomers on the threshold of retirement, annuities are back in the limelight as one of the few vehicles that can provide stability and predictability during uncertain times. With literally hundreds of different annuity products to choose from the challenge for most people is in how to compare annuity quotes in a way that won’t drive them absolutely bonkers.

Annuity comparison sites offer you the best opportunity to quickly narrow down your choices. They have very powerful data aggregation and search engines that enable you to sort annuity products based on certain preferences and types.  While this can save you time, if you aren’t quite sure of what it is you are comparing, you could easily run yourself off the rail.   The specific information or features to compare differ from one annuity type to the next. In addition to key features, rates and expenses, there are a multitude of options (with additional costs attached) to consider as well.  It would be impossible to provide an exhaustive guide in this short of space, but we have at least outlined some of the key points of comparisons for four of the primary annuity types.

Fixed Annuities

The most important feature to most people is the interest rate. If there were just one type of fixed annuity this would be a fairly straightforward comparison. But interest rates are applied differently depending on the way the fixed annuity is structured, so you want to make sure you are comparing apples-to-apples. The primary parameters for comparing interest rates are: the initial fixed rate, the rate period (and what part of it is guaranteed), the minimum rate guarantee, bonus rate (if offered for larger deposits).

On the expense side, the key parameters are: the surrender provisions which include the surrender fee schedule, annual expenses such as mortality costs and administrative costs.

Indexed Annuities

These should be thought of as fixed yield annuities with the yield being determined by participation in a stock index instead of an insurance company’s bond portfolio. So, there isn’t a comparison to be made of yields, but, rather a comparison of the way the yield is credited. When the stock index is positive for the year, the percentage gain in the index is applied as a credit after a participation rate and a cap rate are factored in.  The higher the participation rate and the cap rate, then the higher the yield that is credited. So, these become the primary points of comparison as does the minimum rate guarantee. The higher all three of them, the better the potential return.

But the rates aren’t everything. It is important to look beyond the rates to see how they are determined and how long they last. If the initial participation rate is only guaranteed for a year, it means it could be reset at a lower rate in the future. It might be better to have a lower initial participation rate and have it guaranteed for a longer period. The same holds true with the cap rate.  Also, a high participation rate may not be such a good deal if the annuity has a lower cap rate. These points of comparison need to be weighed in light of the long term performance of the annuity.

Variable Annuities

Variable annuities are comprised of separately managed investment accounts, so there is no way to use current rates as a point of comparison. And, it is not recommended that you try to compare the investment accounts based on past performance. Rather, you should consider how the investment objectives of the accounts mesh with your own objectives. There should also be a sufficient number of accounts from which to choose to better create the proper allocation of funds to meet your profile. Because variable annuities include investment management expenses, these can be a direct point of comparison – the lower the better. You can expect more actively managed stock accounts to have higher management expenses than less actively managed accounts, but higher expenses don’t necessarily translate to better performance.

Immediate Annuities

These are a much easier product to compare side-by-side.  You are looking for either the highest monthly payout based on a lump sum deposit, or the lowest amount of deposit required to meet your income need.  All comparisons are based on the same parameters: your age, your income need or deposit amount, your life expectancy or specific income period.  You will also need to do a comparison of payout options, such as joint life, single life, term certain with refund. These will be based on your family situation and the need to continue income after your death.  It is important to note that any options you choose are irrevocable, so careful thought needs to be given in their selection.

Narrow Your Choices before Comparing

Even when you know what to look for in comparing annuity quotes, it can still be a very daunting task due to the large number of annuity products. Your best bet is to set your criteria up front in order to narrow the field. The recommended approach is to limit your search to those products from the highest rated insurance companies (A+ or better with A.M. Best, AAA with Standard & Poor’s). You will still have a few dozen products from which to choose and the higher rated companies can be as competitive as the lower rated companies.  More importantly, their superior financial strength will provide one more layer of security.

High Yield Annuities

For many people who experienced the roller coaster decade of 2000 to 2010, they may be looking back wishing that they had invested their money into fixed annuities which generated average annualized returns of 4.73% as compared with a negative 4.74% in the S&P 500 index. Of course, the long term, historical return of the S&P 500 is better than the average fixed yield return in the same time frame, many people today live in the moment, and this particular moment is marked by uncertainty. As the tens of millions of Baby Boomers edge towards retirement, predictability and stability are at a premium for them.

High yield annuities offer interest rates, on average, that are anywhere from a half a point to two points higher than those offered through bank CDs. The same spread exists between high yield annuities and regular fixed yield annuities. Those types of interest rate differences can translate into a substantial advantage in accumulated earnings over time. But, as with anything in life, there are no free lunches, and in order to gain an advantage in one area, you are likely going to have to give up something in another. High yield annuities do offer very appealing rates, but it is important to know a little more about what’s under the hood of the annuity contract.

What to Look for in High Yield Annuities

The Promotional Rate

The fixed annuity market is extremely competitive with hundreds of products vying for your money. While there are many ways to measure how competitive an annuity product is, the one feature that is used to get your immediate attention is the initial yield. To stand out from the rest, annuity providers are willing to put up promotional rates, typically a half to a full point higher than the prevailing market rate. The rate is designed to lure you in but it is important to read the fine print on it. In most cases, it is only guaranteed for a short period of time, usually a year, at which point it is then adjusted. It is important to know what happens at the rate adjustment. It is not uncommon for a provider to lure you in with a very high first year rate only to adjust the rate below market rates in order to recoup their loss on the initial rate.

The Fixed Rate Guarantee

Most high yield annuities are structured with multi-year rate guarantees. The provider is willing to guarantee a high yield for a fixed period of time because it is counting on keeping your money longer. This enables them to invest their portfolio in longer term bonds which can generate higher yields. The rate guarantee periods range from a year to 10 years. Generally, the longer the rate guarantee period, the higher the rate guarantee. Again, it is important to understand the fine print in some annuity contracts in which a multi-year rate is offered, but only guaranteed for a limited number of years. For example, you might see an annuity advertising a 10 year rate of 4%, but the actual rate guarantee is only good for three years.

Because the fixed rate is only payable for a certain period of time, it is also important to know how the provider goes about adjusting their rates, and what the minimum rate guarantee is. While it is always in the interest of the provider to remain as competitive as possible – after all, you can simply transfer your annuity funds to another annuity if you’re not happy – they may need to drop their rate below the market in order to recoup any losses from the higher rate. Also, some annuity providers are braced for the possibility that you may want to transfer your funds with higher surrender fees. Surrender fees, which are charged for withdrawals made during the surrender period that are in excess of 10% of the account value, tend to be higher in high yield annuities with long multi-year guarantees.

It is recommended that you shop for high yield annuities by comparing both their fixed rate guarantees and their minimum rate guarantee. If the initial fixed rate guarantee is inadequate, you might be better off looking for annuities that offer the highest minimum rate guarantees. Also, if you are concerned with being able to withdraw your funds or transfer them to another annuity at some point, you will want to shop for annuities with the most liberal surrender provisions – meaning lower fees or shorter surrender periods. Most people who invest in annuities do so with long time horizons, so they usually don’t concern themselves with the surrender provisions.

Bonus Rates

Finally, keep your eye out for bonus rates offered on larger deposits. These could add anywhere from a half to a full point to your yield which will make a substantial different in your long term accumulation. Bonus points don’t become available until the deposit amounts exceed $50,000 or $100,000, depending on the provider. So, if you’re considering investing $40,000 into a fixed annuity, you may want to consider allocating another $10,000 from your savings account if it means adding an extra point to your yield.

Keep an Eye on Expenses

When you find a high yield annuity that offers a “too-good-to-be-true” guaranteed rate, the first place to look is at its expenses. We already discussed the surrender provision which is one way they can recoup the cost of the higher yield. The other place is with the annual expenses. Annuities do have certain expenses that are paid for out of your account value each year. Expenses for mortality (to cover the cost of the death benefit), and administration are paid as percent which can range from .05% to 1.2% per year. An annuity that offers a high initial yield for a period of time may be enticing until you find that its annual expenses are higher than the norm. The problem is that the high fixed yield may not stay high, but your annual expenses will. Better to shop for the lowest annual expenses because these could have a bigger impact on your accumulation over the long term.

There’s more to High Yield Annuities than Yield

Sure we all want the highest possible return on our money. But to get something really good, you usually have to give up something – it’s the old risk-reward continuum. You can find some very high yields on today’s annuities, but you just need to be aware of the costs. A high initial yield with a low minimum rate guarantee may not be a good trade off if you think interest rates may fall in the future. A ten year rate guarantee may seem attractive unless we enter a period of rising interest rates in which you would have locked yourself into a lower rate. That big promotional rate may be the lure that locks you into some very rigid surrender provisions.

The point is that high yield annuities are a great alternative for safety conscious people who don’t want to completely sacrifice a reasonable rate of return. As with any investment, it is important to understand everything there is to know in terms of the upside and the downside.

Indexed Annuities vs S&P 500

Sales of indexed annuity products have soared since the beginning of the 2000 decade which was marred by the tech stock implosion and period of volatility in the stock market. Sales again spiked following the 2008 market crash topping out at $31 billion for the year ending in 2010 (2001 sales were $6.5 billion).  The primary source of funds fueling this growth has been investor money fleeing the stock market as well as cash deposits from savings accounts and CDs that have been yielding next to nothing.  The rising popularity of indexed annuities is indisputable which has drawn the ire and the scrutiny of financial advisors and brokers, as well as the obvious comparison of their performance with that of the S & P 500 index to which many indexed annuities are linked.

As Different as Apples and Oranges

Indexed annuity critics are quick to draw comparisons with the performance of the S & P 500 index, however, there is actually very little that can be compared apples-to-apples as the only aspect they share in common in the term “index”.  If a comparison is made between an equity indexed annuity linked to the S & P 500 index, and an S & P 500 exchange-traded fund (ETF), it is done so between two very different types of investments that address very distinct investment objectives.

An ETF invested in equities is a growth investment while an indexed annuity is a principal preservation investment.  The ETF offers unlimited upside growth potential, with commensurate downside risk, and the indexed annuity offers fixed rate returns tied to stock index gains, with no downside risk. The ETF is appropriate for investors willing to assume market risk, while the indexed annuity is suitable for risk-adverse investors seeking higher fixed yields.  So, what is there to compare?

Index Annuity Returns can Outperform the S&P 500

The first problem with performance comparisons is that there are so many variables when considering stock market data, and the variables in the yield crediting methods of indexed annuities are far ranging which doesn’t allow for straight forward comparisons. It’s fairly easy to data mine historical data to skew the results in favor of one type of investment over another.  And, trying to use past performance as a predictor of future performance has never found any validity. Stock market investment models almost never account for major “Black Swan” events such as the huge natural disaster in Japan, or the financial meltdown of 2008 which can result in significant market declines. Conversely, there is no real reason to account for unexpected market calamities with indexed annuities because of their mechanism for locking in positive gains while providing minimum investment returns in down markets.

The data on indexed annuity performance only goes back to 1996, the year they were first introduced, while historical stock market data goes back many decades. So, the direct comparison would only encompass less than two decades which many would consider too short a period of comparison. Plus, the stock market encountered two major events in that period that led to major market declines in which investors lost significant value in their portfolios.  But, isn’t that the point of the comparison? Don’t we want to see how an indexed annuity treats investor returns versus the way the stock market does? Take, for example, the period between 2001 and 2011, which was a period of tremendous stock market volatility. The S & P 500 finished 4.74% down in that period. An indexed annuity with annual resets that locked in positive gains, and in which down years were treated as zero return (although most indexed annuities credit a minimum return), would have achieved a 132% gain.  Indexed annuity advocates won’t argue the fact that their upside return potential is limited. Investors don’t buy them for the upside potential. They buy them to protect their principal during times of market and interest rate volatility.

What about Liquidity Risk

With no clear advantage in annual returns to point to, indexed annuity critics then turn to the issues of liquidity risk and expenses to extend the comparisons. The main argument made against annuities is that they are not liquid and they have large surrender charges.  But, when compared to the liquidity risk of owning stocks or an ETF, annuities may still hold an advantage.  Annuities do allow for annual withdrawals of 10% of the account value without incurring a surrender fee.  Setting aside the fact that the surrender fee declines over time so that, within a five to ten year period they vanish all together, annuities may be more liquid than a stock or mutual fund portfolio.  If you are a retiree who needs to withdraw funds from your mutual fund account that has lost value, you might consider not taking it in order to allow them to recover their value.  If you do withdraw the funds at a loss, you will never regain the value.  So, there is liquidity risk with equity investments, perhaps more so than with indexed annuities.

Yeah but, What about those Expenses?

Most indexed annuities don’t charge a sales load, or management fees, or 12b-1 marketing fees. The same cannot be said for mutual funds.  ETFs tend to have lower expenses than mutual funds, but there still is the inherent expense associated with market loss when it occurs. And, if you are withdrawing funds during periods of market loss, that becomes a permanent expense.  The expenses for indexed annuities are recovered by the carriers through their yield crediting method which consists of a participation rate and a cap rate. This, essentially, allows them to create a spread between what they earn on their portfolio and what they actually credit to the account. They cover their expenses through that spread.  More competitively priced annuities will have a smaller spread allowing the investors to earn a higher yield.

What it Really Comes Down to

What any comparison of indexed annuities and the S & P 500 index fail to consider is that investors who buy indexed annuities have some degree of risk intolerance. For these investors, an 8% return achieved with no risk, may be more superior to them than a 20% return that came with the possibility that it could have been a 20% loss. The bottom line is that indexed annuities were not created to compete with index investing. Indexed annuities are of a completely different asset class than equity investments – they are principal protection investments, not growth investments.