Annuities could be redundant … or resplendent

Do you really need annuities in your retirement portfolio?

Very likely you don’t. To start with, your monthly Social Security check is an annuity and, if you’re reading this, you probably have a financial advisor telling you how important it is to diversify your income streams. If you’ve got the low risk/low reward corner covered, then a prudent move might be to have some dividend income and maybe even some buy-low/sell-high speculation going on in your portfolio – within reason.

Also, because anyone with a state-issued insurance license can sell basic annuities – depending on the state, that means they passed anywhere from one day to one month of coursework – you’re going to find a lot of people pressuring you to buy them. (It does take greater professional attainment to sell variable annuities, which we’ll discuss soon.)

But that’s not a hard “no”. There is at least one use case for annuities in a well-structured investment array, courtesy of a new federal law. So, let’s see where that comes from and what you might be able to do with it. Review our annuity advice below.

Defining our terms

An annuity, according to the U.S. Securities Exchange Commission, “is a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future. You buy an annuity by making either a single payment or a series of payments. Similarly, your payout may come either as one lump-sum payment or as a series of payments over time.” The period through which you’re paying the insurance company is called the accumulation phase. Once the insurance company starts paying you, that’s the annuitization phase.

Typically, someone might buy them for any combination of three reasons:

  1. Periodic payments for a specific amount of time, usually for the rest of their life, or their spouse’s life;
  2. Death benefits to be paid to the person named as beneficiary; or
  3. Tax-deferred growth, since taxes on annuities’ income and investment gains are not taxed until withdrawal.

There also happen to be three different types of annuities:

  1. Fixed, through which the insurance company promises a minimum rate of interest and a fixed amount of periodic payments;
  2. Indexed, through which the insurance company credits you with a return that is based on a stock market index, such as the Standard & Poor’s 500 Index and
  3. Variable, through which the insurance company allows investors to direct annuity payments to different investment options, usually mutual funds.

The last one is called “variable” because payouts vary based not only on how much an investor puts in, but also the rate of return on those investments as well as the extra expenses associated with actively managing a vehicle such as this. These include administrative fees for both the annuity and for whatever underlying funds it’s invested in. These also include fees for guaranteeing a minimum income benefit or for the initial sale or for transferring from one underlying fund to another. Further, there’s probably a charge for “mortality and expense risk”. This typically amounts to a hefty 1.25% of the annuity’s value, payable every year. It essentially compensates the insurer for the risk of the investor’s death which, if you think about it, ought to be baked into an insurance product.

The U.S. Securities and Exchange Commission regulates variable annuities and has chartered the Financial Industry Regulatory Authority, or FINRA, to test and license those who sell variable annuities.

You’ve probably heard of FINRA’s Series 7 exam, which most advisors who trade in stocks and bonds usually test for.  The Series 7 is not necessary to sell variable annuities. Rather, variable annuity representatives have to pass a trimmed down version – the Series 6 – which focuses more on mutual funds. That’s because a variable annuity is basically a mutual fund with a new paint job.

New law

If it sounds like we’re sour on annuities, that’s not so. We think of them like an anti-ADHD drug – good for use in dealing with a specific condition, but prescribed way too often.

In the case of annuities, that specific condition is actually a good thing: living longer. However, most people who are retiring now have spent the greater part of their careers paying into a defined-contribution plan rather than a defined-benefit pension. The best thing about those old-time pensions is, no matter how long you lived in retirement, that check would still be landing in your mailbox every month. But if you rely solely on a 401(k) or IRA for supplementing your income, then you need to time your withdrawals to make sure you don’t outlive your money. And for those of us who have no idea when our number is up, that’s really an impossible task.

What makes the problem worse is that 401(k)s and IRAs have required minimum distribution rules. You must start taking RMDs no later than a certain birthday. Also, you must annually withdraw a minimum amount determined by a formula. Depending on the tax treatment you previously selected for your plan, those RMDs might well be taxable events.

In an attempt to  make things easier on everyone, Congress passed the SECURE Act 2.0, which was tacked on to the bottom of a $1.7 trillion appropriation bill. This provision was intended as a sequel to the popular, bipartisan 2019 SECURE Act, which improved the rules under which people can contribute to and receive distributions from their retirement plans.

According to Groom Law Group, a Washington-based firm specializing in employee benefits, SECURE 2.0 offers such changes in the law as:

  • Increasing the RMD age from 72 to 73, and then to 75 beginning in 2033;
  • Changing the amount and tax treatment of catch-up contributions;
  • Permitting student loan-matching programs and
  • Making the Saver’s Credit payable as a direct contribution to the retirement account rather than as a tax refund.

In addition to all those positive developments, SECURE 2.0 also changes the treatment of qualified longevity annuity contracts. These QLACs have been around since 2014, when the Internal Revenue Service adopted a rule in response to widespread dissatisfaction with how RMDs were calculated.

What is a QLAC?

Basically, QLACs enable you to split your retirement plan into medium and long-term components. That is, you can say that most of your 401(k) or IRA is intended for the first stage of your retirement, when you’re more likely to be reasonably healthy and active. You still have to take at least your RMD by the year you turn 73 if you are now at least 63 years old; if you are not yet 63, you have until 75. In either event, you can take out as much as you like starting at age 59½.

However, you can carve a QLAC out of that, which SECURE 2.0 says you don’t have to touch until you’re 85. Not only does it guarantee that you’ll have money in your later years, it reduces the RMD amount you have to take each year – and thus the taxes you have to pay on those RMDs – in the meantime.

The new law raises the limit you can dedicate to a QLAC to $200,000 from $145,000. That’s a potential $200,000 that you don’t have to include in your RMD calculation. Further, you won’t owe taxes on it until your QLAC reaches its annuitization phase.

These contracts are certainly not without their downsides.

“The drawbacks to a QLAC are the upfront cost and that if an emergency occurs and you need money before the beginning of payouts, you can’t touch it. It is locked in,” according to The Wall Street Journal.

Is a QLAC a good idea?

There are two ways to get a QLAC. One is through your employer-sponsored retirement plan. That isn’t an option for everyone because not every 401(k) plan offers them. Of course, IRAs have nothing to do with employers.

The other option is through a financial planner. If you are fortunate enough to have a trusted advisor in place, they will be able to present you with an array of QLAC choices, if not a marketplace of insurance companies for you to consider engaging.

A true professional will also give you honest annuity advice to determine if it is a suitable investment for you, given your circumstances.

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