For Your Fixed-Income Pot, Consider an Annuity That Behaves Much Like a Bank CD
Multi-year guarantee annuities can outperform bonds and bank CDs — but before you buy, here's how they work.
Financial experts recommend setting your asset allocation and sticking to it until your life circumstances change.
You should typically split your investments among equities and fixed-income investments and perhaps a pinch of commodities.
For example, you might decide on 49% in stocks, 49% in fixed income and 2% in commodities. If stocks have a big run-up and become, say, 60% of your portfolio, you should consider rebalancing to get back to your original allocation.
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What's the best asset allocation for you is highly individual and depends on many factors, including age. Most people become more conservative as they enter retirement and cut back on stocks and increase fixed-income assets, which include bonds and bank certificates of deposit (CDs).
But they aren't the only choices. As the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and lifetime income annuities, I am a nationally recognized annuity expert and know all about those choices.
Fixed-rate deferred annuities — especially multi-year guarantee annuities, or MYGAs — provide safe, steady interest but without most of the drawbacks of bonds or bond funds. They also usually pay higher rates than CDs and are tax-advantaged.
These annuities can thus substitute for some of the bonds or CDs in your fixed-income allocation. But you need to be aware of liquidity and taxation matters before committing.
MYGAs avoid bond-market volatility
Issued by insurance companies in exchange for a single premium deposit, MYGAs share some similarities with bonds and even more with CDs. Like CDs, they earn a guaranteed rate of interest for a set period, usually two to 10 years.
But there are some key differences between bonds and fixed annuities, which have more guarantees and lower risk.
First, you can lose money in bonds. Both CDs and MYGAs guarantee interest and principal. But the market value of a bond fluctuates with changes in interest rates. If rates go up and you sell a bond prior to maturity, it will be worth less than its original cost. With an individual bond, you can avoid this problem by holding it to maturity.
Bond-fund investors don't have that option. If rates spike up after you buy a bond fund, the value will decline. Especially with a long-term bond fund, it may take many years to recover your full principal, if ever.
Second, owners of individual bonds (except Treasuries and U.S. agency bonds) also face default risk. A company or municipality may run into financial problems and fail to make timely interest or principal payments. A default means you could lose part or all of your investment.
In contrast, an annuity is guaranteed by the issuing insurance company. There is no federal deposit insurance, so buyers need to choose carefully. Insurers with strong financial ratings are considered very safe. Rating agencies like AM Best provide a letter grade to insurers.
With fixed annuities, the insurance company bears the underlying investment risk, shielding annuity owners from both bond market volatility and default risk.
Most corporate, municipal and government bonds pay out interest every six months. Normally, there's no ability to reinvest interest so that it can grow and compound at a high rate.
Bond funds let you reinvest your dividends automatically, but the price per share varies as interest rates change. You may have a gain or loss on reinvested dividends when you cash in the fund shares.
More advantages
MYGAs let you compound interest earnings. Reinvested interest gets the same rate as the base annuity, so the yield is guaranteed. Depending on the annuity, owners who need income can usually choose to receive interest earnings monthly, quarterly or annually.
Interest from corporate bonds and Treasuries is taxable in the year it's received. Annuities in nonqualified accounts (not in an IRA, a 401(k) or a similar plan) are tax-deferred.
All interest earnings left inside the annuity grow and compound tax-deferred until withdrawn, a significant tax-planning benefit. You can wait until retirement, when your tax bracket is likely to be lower, to start receiving payments. Without taxes taking a cut, your money compounds faster.
Many corporate and municipal bonds are callable. When rates are high, it may look like you nailed down a great deal. However, a few years later, when rates are lower, the issuer may call the bond back, and you'll have to reinvest the proceeds at a lower rate.
Fixed-rate annuities, like CDs, can't be called. The interest rate is set for the duration of the guarantee period.
Annuities also offer the ability to create a guaranteed lifetime income stream via annuitization. It's the only financial product that offers this option.
Liquidity and taxes
MYGAs have less unpenalized liquidity than bonds and bond funds. You can always cash them in, but you'll pay a penalty for early surrender. Second, interest earnings withdrawn from nonqualified annuities before age 59½, with a few exceptions, are subject to a 10% IRS penalty, plus ordinary income tax.
By the way, MYGAs can work very well as a fixed-income allocation in IRAs, providing "ballast" that counteracts the swings of the stock market while earning a high guaranteed rate of interest.
Because they have less liquidity than bonds, you probably wouldn't want to put all of your fixed-income investments in MYGAs. Among other things, it might limit your ability to rebalance.
But there is some liquidity. Many fixed-rate annuities let you withdraw up to 10% a year penalty-free. They're thus usually more liquid than CDs, which have stiff penalties for any early withdrawals.
Furthermore, you can stagger multiple MYGAs with different terms so that you'll have new ones coming up for renewal every year or two.
Not for everyone but maybe for you
MYGAs aren't right for everyone, but many people can benefit from their unique features. They provide steady, reliable interest that you can usually receive monthly, quarterly, semiannually or annually if you need the income. Or you can let interest accumulate in the annuity and grow tax-deferred.
MYGAs can also work very well in both IRAs and Roth IRAs.
There's nothing wrong with bonds and CDs. But take a look at MYGAs. One or more may be a good fit for you.
Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. Ken is a nationally recognized annuity expert and widely published author. A free rate comparison service with interest rates from dozens of insurers is available at www.annuityadvantage.com or by calling (800) 239-0356. The firm also offers an income-annuity quoting service. There are no fees or charges for the firm's services; 100% of the client's money goes to work for them in their annuity.
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