Would You Buy This Annuity?
I thought it might be useful to occasionally show you how I use annuities to benefit real clients in Toledo and Northwest Ohio.
So, here’s an actual planning situation.
My client is 70 years young and has roughly $380,000 in IRAs.
Social Security and a pension provide the income she needs to live a secure and comfortable retirement. Bank savings and a money market fund provide emergency and opoortunity funds.
We’re considering putting $120,000 — about one-third of her IRA money — into a 7-year annuity paying 5.65% guaranteed.
Would you do it?
That’s actually not the first question to ask.
The first question is: What problem would the annuity solve for me?
Start with the problem, not the product
This is the way I believe an annuity should be evaluated.
Don’t start with the rate.
Start with the retirement plan.
In her situation, I see two related problems we’re trying to address.
Problem #1: She wants a larger portion of her retirement money in a guaranteed account.
She has roughly $380,000 in IRAs, and we don’t want all of that money exposed to the same market risk, particularly as she moves further into retirement.
One option would be to use bonds or other fixed-income investments for the conservative portion of her portfolio.
The annuity gives us another option to consider.
We’re looking at putting $120,000 into a 7-year annuity paying 5.65% guaranteed, subject to the contract terms.
The goal isn’t simply to chase a higher rate.
The goal is to give a portion of her retirement money a more conservative role while the rest of her IRA remains available for other purposes.
Problem #2: What happens when her RMDs begin?
In about three years, we estimate her required minimum distributions will start at around $12,000 a year.
Now consider what could happen if the market is down significantly when those RMDs begin.
She will still have to take the distribution.
If the money needed for that distribution is invested in stocks or other market-based investments, we may have to sell investments while they’re down to raise the cash.
That’s not an ideal situation.
The annuity gives us another potential source for those dollars.
Because the contract allows annual penalty-free withdrawals, subject to its terms, we could potentially use money from the annuity toward her RMD rather than selling market-based investments during a significant downturn.
The annuity doesn’t eliminate market risk.
It gives us another place to get money from when market conditions aren’t cooperating.
She’s not putting all of her IRA into the annuity
This is an important part of the decision.
The proposed annuity would represent about one-third of her IRA assets.
The other two-thirds would remain outside the annuity.
That means she would still have substantial retirement assets available for growth, liquidity and other retirement needs.
We’re not asking the annuity to do everything.
We’re giving it a specific job.
What could she benefit from?
If the annuity is ultimately the right choice, she could benefit from having a portion of her retirement money positioned more conservatively with a stated 5.65% guaranteed rate for the seven-year period.
She could also have another potential source for her future RMDs.
That could become particularly valuable during a significant market decline, because we may be able to use money from the annuity rather than selling market-based investments simply to raise cash for an RMD.
And because we’re only considering putting one-third of her IRA into the annuity, she retains the majority of her retirement money outside the contract.
That’s the structure that makes the planning decision interesting.
So why 5.65%?
The 5.65% guaranteed rate is certainly part of the discussion.
But the rate isn’t the reason by itself.
A rate can look attractive until you understand what you’re giving up getting it.
That’s why we need to look at the entire contract.
How long is the money committed?
What are the withdrawal provisions?
What happens if her circumstances change?
What guarantees are actually being provided?
What happens to the money at the end of the guarantee period?
What are the costs, limitations and other contract provisions?
And how does the annuity compare with the alternatives available for the conservative portion of her retirement money?
Those questions matter more than simply finding the highest rate.
Would you buy this annuity?
I don’t think there’s a universal answer.
Someone else who is 70 and has $380,000 in an IRA could have a completely different situation.
They might need more liquidity.
They might have different income needs.
They might already have substantial guaranteed income.
They might have a different investment mix.
Or they might have no reason whatsoever to consider an annuity.
That’s why I don’t start with the product.
I start with the problem.
If there is a legitimate need for additional guarantees and another potential source of retirement income during a market downturn, then an annuity may be worth considering.
If there isn’t a need, I don’t think we should force one into the plan simply because the rate looks attractive.
The bigger point
This is how I believe annuities should be evaluated:
Prove a need exists.
Determine whether an annuity is justified.
Then match the annuity to the problem.
In this case, we’re trying to make a portion of her retirement money more conservative and create another potential source for RMDs during a market downturn.
The annuity may or may not be the right solution.
The point is to solve a retirement problem — not simply buy an annuity.
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