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Do Annuities Belong in Your Retirement Tool Kit?

These vehicles can be bewildering.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Many savvy investors are put off by annuities because they're not fond of their reputation as being high cost and overly complex. But are they really? Joining me today to talk about what role annuities might play in a retirement plan is Christine Benz. Christine is Morningstar's director of personal finance.

Thanks for being here today, Christine.

Christine Benz: Susan, it's great to be here.

Dziubinski: Now, annuities are a really broad category. What are some of the things that tie the different types of products together, some of the key themes?

Benz: You're right, Susan. It's such a broad category that it's almost unhelpful to call them all annuities because there's such a disparity among the product types. I guess when you think about the unifying themes: They are contracts with insurance companies that are designed to provide you with a stream of income for the rest of your life. And it's also important to note that once you partake of one of these contracts or sign one of these contracts, the assets become the property of the insurance company. What is yours is the claim on the stream of income from the annuity. So, it's also important to note that if you put money into an annuity, it's no longer part of your portfolio.

Dziubinski: If retirees are looking to investigate annuities a little bit further to see if it's a good fit for them, which products do you think should be at the top of their list to research further?

Benz: Well, it's interesting. It wouldn't be an annuity at all really. I would say that if you've done your homework and you've determined that you really need more lifetime income, your first stop ought to be making sure that you're wringing as much from Social Security as you possibly can, provided you're eligible for it. So, the virtue of Social Security is that, like an annuity, it pays you a lifetime stream of income, and the benefits for delaying are very generous. So, start there if you've determined that you need more lifetime income. Then if you've decided that you would like to lock in even more lifetime income, then you might look at some type of a very simple income annuity. That would be my bias to steer people there. They're very transparent. It's easy to comparison-shop. And there are really two main flavors of basic income annuities. One is immediate, where you say "I would like my payouts to start right now and last through the rest of my lifetime or last through some period of time" that you determine with the insurance company. Or else a deferred annuity, where the payouts start at some later date. So, a common configuration with the deferred income annuity would be you purchase it at age 65, but the payouts don't begin until age 85. So, those are the two most basic, most vanilla products. They tend to be cheapest and most transparent. I would start there.

Dziubinski: Christine, so-called "fixed indexed annuities" have been getting some attention lately. Why is that?

Benz: Well, it's because of the lack of income that is on display throughout the financial markets. Fixed indexed annuities key there returns off of equity market returns. So, it's a way of earning potentially a higher return along with some guarantees than you can earn in the fixed-income market. Roger Ibbotson, who founded Ibbotson Associates and is one of the leading lights in asset allocation, talked favorably in a research paper about fixed indexed annuities in exactly this context. He acknowledged that, yes, they might not be the greatest equity surrogates, but they might serve investors well as a component of their fixed-income portfolios, particularly given how low yields are today. But these products are certainly more complicated than the very simple income annuities that we just discussed.

Dziubinski: And how about variable annuities? Those would fall quite a bit lower on your list, right?

Benz: They would. If we're putting a simple income annuity at the top of the heap in terms of being cost-effective and being transparent, I would say variable annuities would be at the opposite end of the spectrum where costs can be very, very high, sometimes on the order of like 3% all-in. And if you are thinking about return potential from the stock and bond market not being that great over the next decade, and I think that's a realistic starting point, think about having such high fees gobble up a piece of your return. And then, they also are significantly more complicated than the products that we've talked about. So, it's difficult to comparison-shop. The transparency isn't nearly as good as it is with the simpler income annuity product. So, I would tend to not generally recommend variable annuities. They may make sense in certain situations, but they wouldn't be a first stop for most investors' retirement assets.

Dziubinski: And what about annuities and taxes? Are these good vehicles from a tax perspective, bad vehicles?

Benz: Well, I would say neither good nor bad. They do offer an element of tax deferral, similar to what you would have with having your money in, say, an IRA where as long as you aren't pulling from the product, if you're not pulling any income from it, you won't owe any taxes. When you do begin taking money out, the assets are taxed based on your contribution. So, you won't be re-taxed on the money that you've put in, assuming that you've already paid taxes on those funds, but you will pay taxes on any money that's in the account that hasn't already been taxed. So, that's something to keep in mind. It's also worth thinking about what's called a "qualified longevity annuity contract," or a "QLAC" it's sometimes shorthanded as, and this is a type of deferred income annuity that offers a neat element in that it is deemed to satisfy your required minimum distributions. The amount that you put into such a contract is deemed to satisfy your RMDs. So, it is a way for people to reduce the amount of their portfolios that are subject to RMDs. This is a spot to get some investment advice from a disinterested observer and also get some tax advice, but this can be a strategy for people who are concerned about required minimum distributions potentially lifting them into a higher tax bracket.

Dziubinski: Well, Christine, thank you for your time today, helping us walk through a little bit of the annuities landscape and perhaps giving some investors some food for thought about these vehicles in retirement.

Benz: Thanks so much, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.