Comparing annuities, IRAs and pensions as you save for retirement

When considering retirement savings, there's no shortage of options, including annuities, IRAs and pensions.

Having too many choices can make selecting the right solution more confusing and complex, not to mention stressful.

"As with any major financial decision, it's essential to have a strategy that's based on your retirement goals," says Robert Steen, USAA Advice Director for Retirement. "Finding a solution won't be a problem if you have a clear view of how you want your retirement to look and what it will cost."

What to look for in your retirement solution

How you fund your retirement is an important decision. So is having access to your money when you need it. Before we compare annuities to IRAs and pensions, here are some things to consider as you clarify your retirement goals:

• Growth potential. No matter what solution you choose, you'll want some growth so your dollars saved don't lose value over time.
• Stability. Typically, the more stable the solution, the less potential for growth. Finding the right balance can be a challenge.
• Liquidity. This determines how quickly you can access your money without the solution losing value.
• Tax efficiency. Distinctive tax implications can be found in IRAs and Single Premium Immediate Annuities (SPIAs).
• Longevity and uncertainty. The risk of running out of money before we run out of time is known as longevity. Uncertainty is added to longevity risk because we don't know how long we will live.
• Legacy. If your goal is to leave part of your wealth to family, friends, charity or some combination, you can align your retirement solutions with this goal.
• Complexity. Some retirement solutions can be more complex than others, which may not be a good thing, especially at a time when we are more susceptible to elder financial fraud.
• Income potential. If you want to generate income to support your retirement lifestyle, an asset usually needs to be converted into some type of income stream.
• Creditor protection. Your assets, such as IRAs and annuities, may not be protected from the reach of creditors by your state's laws.^{See note1}

IRA versus deferred fixed annuity

Let's take a closer look at your options so you can feel confident with whichever path you take. It's a good idea to first familiarize yourself with the annuity basics and types of annuities. Next, we'll compare IRAs with deferred fixed annuities (DFAs).

Generally, both IRAs and a DFAs are designed to help you save money for your retirement. However, they're not the same as the following information illustrates.

Key features of IRAs and DFAs

Growth

• IRA: Can hold a variety of securities, mutual funds or ETFs, which can be oriented for different levels of growth.
• DFA: Can provide some minimum level of growth depending on interest rates.

Stability

• IRA: Volatility within the IRA depends on the securities selected. Higher growth can mean more volatility, which can be OK depending on your risk tolerance, risk capacity and time horizon.
• DFA: Stable since the rate of return is fixed.

Liquidity

• IRA: Accessibility is governed by IRS rules.^{See note1} It's also potentially governed by the investments or products held inside the IRA.
  Generally, it's difficult to access money in your IRA during the accumulation phase without tax or penalties.
• DFA: You may incur fees if you need to get money out of a DFA before the end of the surrender period, depending on the requirements in the annuity contract.
  If the DFA is held in an IRA, the same IRS rules and restrictions regarding IRAs also apply.^{See note2}

Tax Efficiency

• IRA:
  • With a traditional IRA:^{See note1}
    • Your contribution is tax deductible.
    • Earnings grow tax deferred.
    • Distributions are taxed as ordinary income.
  • With a Roth IRA:^{See note1}
    • Your contribution is not tax deductible.
    • Earnings grow tax deferred.
    • Distributions come out tax free.
• DFA:Although a DFA may be held by an IRA, deferred annuities are tax-deferred products themselves.^{See note3}
  For a DFA held outside of a retirement account:
  • Contributions are not tax deductible.
  • Earnings grow tax deferred.
  • Earnings on distributions are taxed as ordinary income.

Longevity and uncertainty

• IRA: This will depend on what is held in the IRA. If the IRA consists of investments geared toward growth like stocks or mutual funds, then there may not be any guaranteed protection against longevity.
  However, the investments inside the IRA could be turned into an income stream, or an annuity, at some point. More uncertainty exists around what the value will be when that time comes.
• DFA: Since DFAs carry fixed rates of return, there is less uncertainty regarding what they will be worth at maturity.
  A DFA can also be annuitized^{See note4} at some point. Some may purchase DFAs to use as a future "floor" to create future guaranteed^{See note5} income.

Legacy

Both IRAs and DFAs can be used to leave a legacy for loved ones or charity, but it's important to understand beforehand the tax ramifications involved with this decision.

Complexity

• IRA: Depending on the underlying investments and owner's age, IRAs can range from simple to more complex to manage.
• DFA: DFAs are generally simple to manage since they don't have moving parts. Again, if a DFA is held in an IRA, you're subject to the same IRA rules.

Income potential

• IRA: Again, the potential for generating guaranteed income will depend on what is held in the IRA.
  At some point the IRA will have to be distributed to the owner or the beneficiaries, based on IRS rules.
• DFA: You really can't say that a DFA has more, or less, income potential than an IRA without knowing what is held in the IRA.
  However, the income from a DFA is predictable and may not be subject to required minimum distributions (RMD) if held outside of a retirement account.

Creditor protection

Both IRAs and DFAs may provide varying degrees of creditor protection, depending on individual state laws.

Pros and cons of an IRA versus a DFA

Comparing IRAs to DFAs isn't a simple exercise because an IRA serves as sort of a wrapper that can hold various investments or annuities. Here are a few key takeaways that can help you make your decision:

IRAs

Pro: IRAs provide a great way to save for retirement since they offer so much flexibility in terms of their tax treatment, what you can hold within the account and their growth potential.

Con: They can require some management depending on what you own in them or when you need to take money out.

DFAs

Pro: DFAs can work well for those who want simplicity, some growth and tax efficiency — especially for money held outside of retirement accounts.

Con: If you break the contract early, it may be difficult to get your hands on your money quickly and without penalties or taxes.

Pensions versus SPIAs

Pensions and SPIAs are designed to provide some level of guaranteed income for retirees. Combined with Social Security or other benefits, they can help provide a stable retirement lifestyle. "The fact that these solutions are so much alike makes it a challenge to determine which — or if either — is best for your retirement strategy," Steen says.

Since pensions and SPIAs are so much alike, let's look at how they are different.

Availability

Employer-provided pensions are harder to come by these days. So, think of a SPIA as a private pension that you create for yourself. A SPIA can be purchased from an insurance company by just about anyone. All it takes is the necessary funds to be converted into an income stream.

Term flexibility

Employer-provided pensions are generally designed to provide lifetime income to the retired employee and possibly the spouse. A SPIA may offer more flexibility when selecting the payout term.

Guarantees

Public and private pensions and annuities can be guaranteed in different ways.

• Private employer pensions may be covered up to certain limits by the Pension Benefit Guarantee Corporation (PBGC).^{See note1} This helps protect covered workers when private company benefit plans have trouble making payments.
• Public pensions are guaranteed by state and local budgets and are supported through taxes.
• SPIAs are generally guaranteed by the financial ability of the issuing insurance company.

Pros and cons of pensions versus SPIAs

Pensions

Pro: Traditional, employer-provided pensions are hard to come by these days. If you have access to one, it's a great benefit for guaranteed income during retirement.

Con: Some employer plans may offer a lump-sum benefit at retirement versus the pension. Think through your decision before skipping the opportunity for the guaranteed income that a pension can provide.

SPIAs

Pro: SPIAs work much like a pension in that they can provide needed guaranteed retirement income.

Cons:

• Unless they have a cost-of-living rider, SPIAs don't keep pace with inflation. That's why it may be a good idea to have other funds invested and growing so that your standard of living keeps pace with inflation.
• Once you've committed part of your savings to a SPIA, you give up some liquidity. That's why having sufficient assets available for emergency and other liquidity needs should always be considered before committing to a SPIA.