Should I Invest In Annuities?

Many of the personal finance, asset allocation, and index mutual fund books (see links below to pick up a used copy from Amazon.com) that I read and follow have included a section or two discussing one type of investment instrument not yet discussed on this blog.
This investment instrument is called an annuity.
What is an annuity?
Annuities are essential a mix between an investment instrument and an insurance policy.

You (the investor) opens up an annuity account, funds it, and in return, the insurance companies gives you a guarantee that you will receive a regular stream of monthly payments/income for a set amount of time..

In the account, your contributions can grow tax-deferred until withdrawal at the age of retirement (59.5 years of age).

It is important to also note that there are two major differences between annuities and regular retirement accounts:

1) Annuities have no annual maximum contribution limit.
2) Contributions to an annuity are after-tax. However, once in the annuity account, your contributions can grow tax deferred until withdrawal.

When does it make sense to invest in an annuity?
Because contributions to an annuity are after-tax (vs. pre-tax contributions with IRA’s and 401k’s), annuties should only be used in limited circumstances, as described below:
An annuity would be beneficial for you if…
  • You have already contributed the maximum annual amounts allowed by law to your 401k and IRA accounts.
  • You expect to keep the contributions invested in the annuity for 10-15 years or more.
What type of an annuity should I invest in?
Because there are so many different types of annuities, it can be difficult to sort through the decision of which one to go with. Some of the different types that are offerred are shown/described below.
  • Immediate – you begin receiving payment immediately
  • Deferred – you have to wait a certain period of time before the payments start (usually when you begin your retirement)
  • Fixed rate – receive guaranteed payment / interest rate for a certain number of years
  • Variable rate – your money is invested in a mixture of instruments, so the payout will vary depending on return obtained. However, usually with variable rate annuities, you are guaranteed a certain level of payout, but then also have the opportunity to earn additional income, depending on how successful your investments are.
  • No-load – have very low management fees, no surrender charges, and no sales commissions.
Since this type of investment instrument offers a guaranteed rate of return, you have to pay for the insurance policy that enables it. Typically, the fee per year for this insurance is 0.5-1% of the total assets in the portfolio.

So, now that we know what options are out there as far as annuities go, how do we go about deciding on which to choose in the real world?

Since Vanguard annuities are very highly recommended in financial literature, and I have a lot of my other accounts with them, I will restrict my analysis to the annuities that Vanguard offers.

The link below shows a good comparison of the different features that different annuities offer.

Vanguard.com – Comparison of Vanguard Annuity Products

According to this link from Vanguard, there are really 3 options. Below each option, I have noted how I have gone about deciding between the options.

  • Vanguard Variable Annuity
    • Best suited for individuals who have 10-15 years to retirement, have $5000 minimum to place in an annuity, and want control over how their portfolio is invested.
  • Vanguard Fixed Annuity – Single 5
    • Best suited for individuals who have slightly less time before retirement and have $10000 minimum to place in an annuity at a fixed rate.
  • Vanguard Lifetime Income Program
    • Best suited for individuals who are already retired and looking to convert their assets in to an income stream.

As you might have guessed, since I am young, the Vanguard Variable Annuity is best suited to my needs.

At the link below is the spec sheet for the Vanguard Variable Annuity.

In this document, I found the following highlights that are of relevance for this annuity.
  • Annuity involves two phases of ownership
    • Accumulation phase – Can add new funds to annuity at any time you work, after opening with a minimum $5000 investment.
    • Income phase – Begins when you convert your annuity assets in to a stream of payments. You also designate how long the stream of income will last. Conversion can occur any time after age 59.5 and before age 95.
    • Average cost for Vanguard Variable Annuity is 0.61%, 1/4 of industry average.
    • No sales or surrender charges.
    • Tax-free and commission-free exchanges between different mutual funds within the annuity.
    • $25 account maintance fee per year for accounts under $25,000 value.
    • A good selection of index mutual fund investment options, including money market, short-term bond, total stock market, international, and REIT index funds.

What type of investing strategy (and quantity) will I use with this annuity?

Overall, I think that adding an annuity to my investment mix looks like a great idea, since I am currently maxing out my Roth IRA and 401k accounts (may not be the case once I go to graduate school).
Therefore, what I am going to plan on doing is make it a goal for myself to invest the $5000 minimum in the Vanguard Variable Annuity later this year after the purchase of my condo calms down.

Since the investments are tax-deferred, I will make sure that I place tax-deferred appropriate mutual funds inside the account, and incorporate it in to my overall asset allocation management.

As I get closer to retirement, I will then replace the more aggressive equity investments with fixed income investments to provide a more stable portfolio.

Keep on learning!
Jacob
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