Four Ways to Increase Client Income: Annuitization - Part One

The number one question Financial Advisors around the country ask me is “What can I do to increase the income of my clients?”

There are four ways, and I will explain them in turn.

1) Income-only plan
2) Systematic/Partial Withdrawal Plans (SWP)
3) Annuitization
4) Combination of SWP and annuitization

Annuitization

We’ve discussed the Income-only plan and the Systematic/Partial Withdrawal Plans (SWP). Now, we come to the third method which is annuitization. While there are only two basic types of annuities, the insurance industry has taken these two offerings and added more bells and whistles than those found on a firetruck. So, you absolutely must help your clients choose carefully. A good way to think of annuities is this: you purchase life insurance to guard against dying too soon. You purchase an annuity to insure yourself against living too long.

Two Types of Annuities

• Tax-deferred
• Immediate

Under both types, you must make two basic choices.                                   

• Variable income
• Fixed income

Tax-deferred annuity

Annuities of this type are used for retirement savings. If you are maxing out on contributions to your Qualified Retirement Plan such as 401(k), 403(b), TSP or IRA, using a tax-deferred annuity is an excellent way to increase your retirement savings. As earnings compound over time, you will increase your principal both through additions to your account and from what Albert Einstein termed “the miracle of compounding.”

Deferred annuities have no IRS contribution limits

Unlike Qualified Retirement Plans, deferred annuities have no IRS contribution limits, hence your client can invest as much as they wish for retirement. This rule can be especially useful for clients who have been compelled by circumstances to spend a portion of their retirement assets long before their retirement and need to replace the retirement assets they spent.  The years when your client is adding money to a deferred annuity is the “accumulation phase.”

Once retired, your client can begin to use funds from an annuity to create a guaranteed stream of income for life to complement their income from Social Security.  Of course, they will need to have purchased an annuity which will pay “for life certain.” Once a client takes income from an annuity, such action begins the “distribution phase.”

Annuities Only Guaranteed by Company Which Issued it

You need to ensure your clients understand why Social Security is backed by the U.S. Government and an annuity is only guaranteed by the company which issued it. If that insurance company goes under, your annuity sinks with it. As a Financial Advisor, you absolutely must either check the ratings of the insurance company or only use your firm’s approved annuity providers.

Variable Deferred

 A variable deferred annuity has a rate of return pegged to an underlying stock market index, or the principal is invested in an equity mutual fund managed by the company which issued the annuity.  This type of annuity is most appropriate for clients with long time horizons because the capital value will fluctuate.

If the market drops, the capital value will drop. You trade off guarantee of principal for the opportunity of having your principal grow over time with the stock market.  Hence, variable deferred annuities are most suitable for clients who are willing to take the market risk and have a long time horizon before they retire.

Caveat emptor

Variable annuities can have very high fees which can dramatically reduce your net return. According to Vanguard, the industry’s average annual cost for a variable annuity is 2.24% per year. For an annuity of $100,000, that’s an annual fee of $2,240. [1] If you do right by your client and perform your due diligence, you can find a quality annuity at a lower cost.

Resources:

[1] https://investor.vanguard.com/annuity/variable

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Contributing Writer: Subject Matter Expert Charles McCain