Income annuities are an investment vehicle that is often misunderstood by investors and advisors alike. To fully understand an income annuity, you must first examine the Efficient Income Frontier. Investopedia defines an Efficient Frontier as ‘optimal portfolios plotted along a curve having the highest expected return for the given amount of risk.” Simply put, the Efficient Income Frontier evaluates the amount of income risk an investor has within their portfolio and measures it against the Legacy Potential, which is how much they can potentially leave to their heirs. Adding annuities to a portfolio shifts down the risk without impacting the legacy potential.
Income annuities should not be confused with variable annuities, which have underlying stock or bond investments in the individual investment portfolio. Income annuity payments are determined by a wide variety of factors, including but not limited to; amount of premium, number of lives the policy covers, age and gender of policy holder, any “rider” on the policy providing for a guaranteed minimum payment, inflation protection, or legacy options selected, the date income payments are to begin. Variable annuity performance is linked to the underlying investments held within the portfolio.
Income annuities are a unique asset class. The lack of correlation and credit quality of an income annuity allows investors to bear more risk in the remainder of their portfolio, due to the fact that a portion of the income they will need is being secured by the income annuity. They are able to offer cash flows that are higher than other fixed income instruments that carry the same quality.
These annuities can be immediate or deferred. Immediate income annuities will start the flow of income as soon as you purchase the annuity. Deferred income annuities start the income stream at a later date. Starting the income at a later date allows for a higher income once the payments begin. Matt Grove, vice president, New York Life states, "Retirees face a different set of challenges as they shift from accumulating assets to planning for lifetime income. Our research, which led to the development of the Efficient Income Frontier, demonstrates that the unique characteristics of income annuities help retirees account for these differences and allows them to build efficient retirement income portfolios."
Income annuities do not come without their own set of risks however. The credit quality of the institution that is issuing the annuity is of great importance. It is also important to evaluate what, if any, survivor options would be needed. Many income annuities are issued on a single life, which for a married couple may be a concern if the life that it is issued on is the person who passes away first. This could leave the surviving spouse without the income from the annuity. One way to mitigate this risk is by purchasing an annuity that covers both the annuitant and the spouse’s lives.
It is also important to note that this is meant for only a portion of an investor’s portfolio. There are additional risks to putting an entire investment portfolio into an Income Annuity, just as there are risks with placing all of a portfolio into one investment. Diversification ensures that all of your investment eggs are not in one basket.
The most ideal income annuities will provide minimum growth levels and allow for a variety of other “riders” to the policy that would allow for increases to their payments for cost of living increases. In the current market of volatility and unpredictability, an income annuity allows an investor to create a portion of their retirement paycheck that is secured by the issuing financial institution.