Understanding the Advantages and Disadvantages of Fixed-Indexed Annuities
The following content is adapted from the book Tax-Free Income for Life by David McKnight.
In this article, I want to again revisit the topic of single premium immediate annuities (SPIAs). In a past article, I shared how the SPIA is an effective solution to eliminating longevity risk and that it offers multiple benefits around guaranteed income in retirement. I’ve also written about why so few Americans take advantage of the SPIA solution: lack of liquidity, lack of inflation hedge, and the Mack Truck Factor.
In this installment, I’ll share how insurance companies have reacted to these three chief complaints.
Insurance Companies Respond to SPIA Complaints
Insurance companies are not unaware of the perceived deficiencies associated with the SPIA. They understand that, notwithstanding their vast economic and lifestyle benefits, they are embraced by a very small portion of retirees, primarily because of the three aforementioned complaints.
To their credit, insurance companies have adapted and evolved their offerings in an effort to mitigate these objections and appeal to a broader range of retirees. One of the solutions insurance companies have developed to specifically address the shortcomings of the SPIA is an annuity alternative known as a fixed-indexed annuity (FIA).
The Liquidity Fix
With a fixed indexed annuity, the insurance company doesn’t require that you draw a lifetime income immediately—or ever, for that matter. You can postpone the election of that guaranteed lifetime income until a time of your choosing later in retirement. This provides some measure of liquidity on your assets prior to your electing a guaranteed lifetime income. Once that income option is elected, however, you would have to rely on your non-annuity assets to satisfy your liquidity needs.
The maximum annual distribution during this deferral period is typically 10 percent. Now, you may be thinking, “Wait a minute, 10 percent liquidity isn’t the same as full liquidity. I want access to all the cookies all the time!”
While it’s true you don’t have 100 percent liquidity, when you view it within the context of the Three Percent Rule, 10 percent liquidity is practically Mardi Gras. This 10 percent “free out” can go a long way toward assuaging concerns over liquidity.
Prior to electing the guaranteed lifetime income, the FIA’s accumulation account grows safely and productively. (The SPIA, in contrast, doesn’t have an accumulation account because it doesn’t have a deferral period. No deferral period equals no liquidity.) The growth of the accumulation account is linked to the upward movement of a stock market index, such as the S&P 500. Should that stock market index go up in a given year, you participate in that growth, up to a cap. Should that index ever go down, the insurance company simply credits you a zero. Meaning, you don’t ever lose money.
A Few FIA Caveats
- While the FIA does allow you to participate in the growth of a stock market index, this growth does not include dividends. This should temper growth expectations because historically dividends account for roughly 30 percent of the annual growth of an index. For example, if the S&P grows 10 percent in a given year, 7 percent might be attributed to the actual growth of the underlying stocks, while 3 percent might be attributed to stock dividends.
- The caps imposed by insurance companies are tied to interest rates. The higher the interest rates, the higher the caps. And although interest rates are rising from the historic lows of late, those caps still aren’t exactly at all-time highs.
- So, given the above, you may expect the accumulation account within the FIA to average only a 4 percent rate of return over time.
“Wait, what?” you may be thinking. Why would I take money that could have otherwise been growing at 6 percent to 8 percent in my stock market portfolio and contribute it to an annuity that’s only growing at 4 percent? Won’t that reduction in the rate of return neutralize the benefits that justified the annuity in the first place? This is where you have to remember your primary motivation for implementing the FIA. It isn’t to achieve stock market returns. It’s to lock in a guaranteed lifetime income that keeps pace with inflation.
This is where the safe and productive growth of that underlying portfolio becomes so critical. You see, the growth of your guaranteed lifetime income is also linked to the growth of those underlying indexes. Even if those indexes average only 4 percent, your income is keeping pace with inflation and protecting your purchasing power over the balance of your retirement.
A Death Benefit
To resolve concerns over the Mack Truck Factor, insurance companies stipulate that your beneficiaries receive whatever portion of your FIA’s growth account that doesn’t get spent during your lifetime. Should you get smacked by that Mack truck two years into your retirement, the insurance company will send the unspent portion of the underlying growth account to your beneficiaries.
This death benefit feature can go a long way toward neutralizing the heartburn you feel when contemplating an untimely (and inglorious) demise in your early retirement years. Not only does the FIA allow you to retain liquidity on your assets, but you don’t risk disinheriting your heirs should that Methuselah gene never kick in.
A Crack in the FIA Façade?
On the surface, the fixed indexed annuity seems ideally suited to meet your guaranteed lifetime income needs without the heartburn of the traditional SPIA approach. The 10 percent annual free withdrawal gives you more than enough flexibility to assuage concerns over liquidity. And thanks to the annuity’s index features, that stream of income can keep pace with inflation over time. Finally, the death benefit does a nice job of alleviating the angst you feel at the prospect of dying early and having a massive retirement asset disappear from your balance sheet. With the FIA, insurance companies appear to have aligned the stars.
What could possibly go wrong?
The Dangers of Tax Rate Risk
Although the traditional use of the FIA addresses longevity risk in a satisfying way, it largely ignores the other huge retirement risk: tax rate risk. During my more than twenty years in the financial services industry, I’ve made a troubling observation: 95 percent of all retirement accounts in the United States are situated within the tax-deferred bucket. These include qualified plans such as IRAs, 401(k)s, 403(b)s, and 457 plans.
Remember, when you contribute money to these accounts, it’s like going into a business partnership with the IRS, and every year, they get to vote on what percentage of your profits they get to keep. Doesn’t sound like a very good business partnership, huh? So, you could have $1 million in your IRA, but unless you can accurately predict what tax rates are going to be when you take the money out, you really don’t know how much money you have. And it’s hard to plan for retirement if you don’t know how much you have.
Given this backdrop, let’s examine the single greatest shortcoming in the way the FIA is traditionally implemented. Retirees who utilize the FIA for guaranteed lifetime income do so almost exclusively within the tax-deferred bucket. They roll a portion of their tax-deferred retirement assets into an FIA and, after a period of deferral, elect their guaranteed lifetime stream of income. But they often do so without any thought for the cascade of unintended tax consequences that follow.
It’s important to note that once you elect a guaranteed lifetime stream of income from the FIA within the tax-deferred bucket, it will be taxed at ordinary income rates for the rest of your life. That’s all well and good should tax rates stay level for the balance of your retirement. But if taxes rise to the level necessary to keep our country from going bankrupt, you’ll keep much less of that guaranteed income stream than you ever thought possible.
How will you plug that ever-expanding hole in your guaranteed income stream? By taking more money out of your stock market portfolio. Not only will you lose that money, but you’ll lose what it could have earned for you had you been able to keep it and invest it over the balance of your retirement. As a result, you’ll run out of liquid capital much sooner than you ever thought possible.
What’s worse, if you’re forced to spend down your stock market portfolio to compensate for the hole in your retirement income, you invite that old nemesis sequence-of-return risk back into your retirement picture. If higher taxes force you to withdraw money from your stock market portfolio during a down year, then your retirement assets take a double hit. This means you’ll have even less money to address those discretionary needs later in retirement.
In short, even though the pre-tax amount you’re receiving from the insurance company is guaranteed, the after-tax amount is not. That part is subject to the constantly growing capital needs of a revenue-hungry federal government. Such are the dangers of electing a guaranteed lifetime stream of income from your tax-deferred bucket!
Social Security Taxation
The second significant disadvantage of drawing lifetime income from your tax-deferred bucket is Social Security taxation. It’s important you recognize that the IRS keeps tabs on something called provisional income. That’s the income they track to determine if they’re going to tax your Social Security. Any 1099s that come out of your taxable bucket count as provisional income, as do any distributions from your tax-deferred bucket. To make matters worse, half of your Social Security also counts as provisional income.
The IRS adds all this provisional income up, and if it totals more than $34,000 for a single person or more than $44,000 for a married couple, then up to 85 percent of your Social Security can become taxable at your highest marginal tax bracket!
It’s important to recognize that any guaranteed lifetime income drawn from the tax-deferred bucket is considered provisional income by the IRS. So not only could you lose a portion of your guaranteed income to rising taxes, but you could unwittingly forfeit a portion of your Social Security as well! But that’s only the beginning of your problems. Should tax rates double over time, your Social Security tax bill doubles right along with it! And how will you plug that ever-expanding hole in your Social Security? You guessed it! By taking even larger distributions from your stock market portfolio!
A Double Whammy
Consider the impact on your investment portfolio if you were required to compensate for holes in your guaranteed income and your Social Security due to rising taxes. I’ve looked at this from every possible angle and here’s the cold, hard truth: these additional distributions could force you to spend down your stock market portfolio twelve to fifteen years faster than you otherwise planned. And that’s assuming you didn’t succumb to sequence-of-return risk along the way!
Traditionally, investors have steered clear of guaranteed lifetime income annuities because of concerns over the lack of:
- inflation hedge
- death benefit feature
The insurance industry has done an admirable job of creating a tool that addresses these concerns in a way that satisfies the average consumer. However, they’ve largely ignored the tax implications of drawing lifetime income from the tax-deferred bucket in a rising tax rate environment.
How We Can Help
I know I’ve shared a lot of information here, and you may have questions specific to your own financial plan. If you’d like to discuss how to guarantee your own income for life and you have not yet implemented a strategic plan with Hanson Wealth Management, please reach out for a consultation. The approach we use to plan your secure retirement includes lowering your tax burden and optimizing your income streams with the objective of achieving a tax-free retirement so you can truly live your best life.