Monday, September 25, 2023

Annuities – Beginners Passive Income


While this is an insurance product, annuities shouldn’t be confused with life insurance. Imagine if you didn’t have to die to get the life insurance money? Better yet, say you are concerned about what the future holds and as a safety net, you buy guaranteed passive income streams to be “turned on” later in life. Take the stage: Annuity Contracts.

What are Annuities?

In its simplest form, annuities are contracts with a financial institution that if you pay them now (lump sum or premiums), they promise to make payments to you for as long as you need. You can choose between starting payouts immediately or defer to a time in the future. Payments can continue for a set period of time or for the rest of your life! Either way, you are “borrowing” the income and the contract will not continue on indefinitely like stock dividends can throughout generations. There are generally 2 options for annuities: Fixed and Variable Annuities.

Fixed Annuities

As you probably guessed from reading our other “fixed income” articles. This contract allows investors to buy an annuity contract with constant payments. There are also special features that can be added to contract called “riders”. You could add various features to ensure this will be a good option down the road such as an inflation-adjusted rider to cope with future costs of living, a death benefit rider for some additional cash similar to life insurance policies, or even a payout accelerator if a terminal illness befalls you.

Variable Annuities

Hopefully these names are helpful! Variable annuities…vary in their payouts. This is due to the premiums you pay being invested into various annuity funds of your choosing which is extremely similar to mutual fund investing. If the funds you invested in go up, then you have the opportunity to have a higher payout than the fixed annuity option. Riders can also be added to these annuities such as having some guaranteed income to hedge against a downturn in the market when you need the income.

How Does This Grow My Passive Income?

Before the payout period begins, when money is coming into the annuity through premiums or a lump sum (could even be from a 1035 exchange), this is considered the accumulation phase since funds are building up. Once the payout period begins, the annuitization phase kicks in and funds are received over whichever time period you prefer: a lifetime, over a joint lifetime (with a significant other, whoever dies last), in a lump sum, over a certain period, etc.

The flexibility in arranging how and when this income hits your bank account makes this income stream attractive for estate and tax planning. This is essentially insurance for the income streams your building to hedge against any black swan events we can’t plan for.

Why Would I Want This Passive Income Stream?

Hopefully it’s pretty clear but if not let’s run through a scenario: Let’s say you did a good job saving money from your career(s) to invest in various passive income streams over your lifetime. You have dividends and capital gains reinvesting in your investment accounts and you own a real estate rental. You assumed a steady 2-4% rise in inflation and feel confident in your portfolio’s ability to earn 10% a year. It’s 2022 and you are a couple years out from becoming financially independent.

Then inflation rises dramatically to 8-10% and your confidence, and purchasing power, decline just as dramatically. You don’t know if the inflation is “transitory” or here to stay. Maybe you feel you are already exposed to the market forces and you are looking for something guaranteed over this uncertain time. This is where an annuity contract could make sense. You could buy a contract to payout in a couple years when you quit your job to ensure you have enough cushion if dividends and capital gain get cut or rents go down for some reason due to a market downturn. Great timing right?

The point here is, instead of having to go do a lot of investment due diligence about a company or rental opportunity, you can borrow this income stream to immediately or in the future hedge any bets you’ve made about your investments future performance.

Risks & Considerations

Similar to bonds, you have illiquidity risk and default risk. Illiquidity risk due to the money paid in during the accumulation phase being tied up in the annuity. You might be able to withdraw some of your invested money but certain withdrawal rules will apply and you could get your initial investment decreased by fees to pull it out early. Default risk references a company’s ability to payout. If the financial institution has only been in business a few years, that may be a higher risk since annuitants will be counting on this income for years to come and need confidence the company will be around when they need them the most.

If you invest in a variable annuity, then your initial investment and future payments are subject to market risk as well. Thankfully, annuities do have a lot of rider features to try and combat various scenarios so be sure to ask the agent/broker you are working with about them.

Lastly, while during the accumulation phase, funds grow tax-deferred but can be taxable once payments are being withdrawn. Working with a financial advisor who is not incentivized to sell one specific annuity is preferable when getting advice on which options fit best with your financial plans.

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