Should you use an annuity for retirement as a US expat?

If you’re approaching retirement, a critical phase of transitioning from accumulating wealth to distributing it for lifelong income, you might be concerned about outliving your savings. This concern often leads to increased risk aversion both before and during retirement, with individuals seeking products that promise guaranteed income, market participation, and no risk of loss. This is why some turn to annuity products. But do annuities truly enhance a strategic income plan? Let’s delve into annuities and their alternatives.

A short story, having worked with some US personnel from an expat point of view, it can be difficult because there is a lot of legislation and hurdles to know and understand so that you don’t get penalised. Having worked with a few US expats and looking at becoming an expat advisor for US citizens abroad I noticed that there were potential opportunities. This being one if the situation is right, please note, this is not personal financial advice, I write this for educational material for you to research and explore further.

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What Is an Annuity?

Annuities are financial contracts offered by insurance companies to provide income either immediately or at a future date. There are two fundamental types: immediate and deferred.

1. Immediate Annuities: With immediate annuities, you make a lump-sum payment to the insurance company in exchange for fixed or variable income payments that begin on a specified date. The payout can be for a fixed number of years or for your lifetime. However, immediate annuities have become less popular among investors due to unfavorable internal rates of return and the reluctance to give up access to a significant portion of savings.
2. Deferred Annuities: Deferred annuities, as the name suggests, start the income phase at a later date. These annuities allow flexible premium contributions during the deferral period, which can extend up to age 90 in some cases. They come in fixed, equity-indexed, or variable forms, with gains accumulating on a tax-deferred basis. Early withdrawals from these annuities can incur penalties, and any gains are subject to ordinary income tax rates, with an additional 10% penalty if withdrawn before age 59 ½. Variable and equity-indexed annuities often come with riders, with the most common being a guaranteed income rider.

Types of Annuities

Deferred annuities come in various forms and may include different features and options to cater to investors’ needs and preferences. Here are some common types of deferred annuities and additional options:

1. Fixed Deferred Annuities: These annuities offer a guaranteed interest rate for a specific period, typically ranging from one to ten years. They provide a predictable income stream and are less susceptible to market fluctuations.
2. Variable Deferred Annuities: Variable annuities allow investors to choose from a variety of investment options, often resembling mutual funds. The return on these annuities is tied to the performance of the selected investments. While they offer the potential for higher returns, they also come with more risk due to market exposure.
3. Equity-Indexed Annuities: Equity-indexed annuities combine features of both fixed and variable annuities. They provide a guaranteed minimum interest rate, like fixed annuities, but also offer the opportunity for higher returns tied to the performance of a specific stock market index.
4. Immediate Deferred Annuities: These annuities start the income phase shortly after purchase, typically within a year. Although they are considered “immediate,” they can still be classified as deferred annuities since you’re deferring the income phase for a short period.
5. Bonus Annuities: Some insurers offer bonus annuities that provide an upfront bonus or enhanced interest rate when you purchase the annuity. This can be an attractive feature, but it often comes with longer surrender periods and higher fees.
6. Guaranteed Minimum Income Benefit (GMIB): GMIB is a rider that can be added to a deferred annuity, particularly variable annuities. It guarantees a minimum level of income, usually based on a specific percentage of the initial investment, regardless of how the underlying investments perform.
7. Guaranteed Minimum Accumulation Benefit (GMAB): GMAB is another rider for variable annuities, ensuring that the annuity’s account value will not fall below a certain amount, even if the investments perform poorly.
8. Guaranteed Minimum Withdrawal Benefit (GMWB): GMWB riders guarantee a minimum annual withdrawal amount, typically a percentage of the initial investment, over a set period. This can provide income stability while maintaining control over the annuity’s underlying investments.
9. Long-Term Care Rider: Some deferred annuities offer riders that allow you to access a portion of the annuity’s value to cover long-term care expenses without surrender charges or penalties.
10. Death Benefit Rider: This rider guarantees that your beneficiaries will receive a specific minimum amount upon your death, regardless of the annuity’s account value at that time.
11. Income Rider: An income rider guarantees a minimum level of income during the distribution phase of the annuity. It can help protect against outliving your savings.

Annuity Fees

Let’s explore the fees associated with the most common types of deferred annuities sold to investors: variable annuities and equity-indexed annuities.

• Mortality & Expense Ratio (M/E Ratio): This fee, typically around 1.25% annually, covers the insurance company’s risk of the policyholder’s death and is deducted directly from the annuity.
• Surrender Fees: These fees follow a declining scale, reducing to 0% after a specified number of years. Early withdrawals during the surrender period incur penalties, with first-year fees that can be as high as 10%.
• Sub-account Fees: Similar to the expense ratio of mutual funds or ETFs, these fees apply to the investment products within the annuity. They can vary but are usually under 2.0%.
• Rider Fees: Additional fees for features selected by the investor, such as income guarantee or death benefit riders. These typically range from 0.50% to 1.50% for each rider.

In essence, most annuities with at least one rider cost investors an average of 2.5% to 3.5%, and they often require a commitment for a specific number of years.

Alternatives to Annuities

1. Financial Plan: Develop a customized financial plan to guide your decision-making and secure a reliable retirement income stream.
2. Diversification: Maintain a diversified portfolio to spread risk across different asset types, reducing vulnerability during market fluctuations.
3. Short- and Long-term Investment Accounts: Keep three to five years of living expenses in short-term, liquid investment accounts, like bond funds, to avoid selling equities at a loss during market downturns. Invest any surplus assets for growth and inflation protection, with adjustments made as needed.
4. Tax-efficient Withdrawal Strategy: Work with your wealth manager to establish a disciplined spend-down strategy, considering all potential sources of retirement income, including Social Security.

Summary

In summary, while annuities may have their merits, they come with significant fees and limitations. Exploring alternative strategies, like those mentioned above, can offer a more efficient path to securing a comfortable retirement income without locking you into long-term commitments or sacrificing access to your savings.

As I mentioned before, this isn’t personal financial advice, this is a topic for you to explore.

Other articles I have written for US expats are:

• Finance Tips for US Expats in the UK
• Brokerage Accounts for US Expats
• 401k Accounts If You Have Left The US