Few topics in finance preoccupy the general public more than when to purchase assets. Popular wisdom envisions investment success as knowing when to buy and (although this gets less attention) when to sell. In fact, this mentality is suited for trading, not investment. Few people possess the combination of qualities required to trade successfully. Most people should strive to be competent investors.
For everyday investors, the important issues of timing are internal, not external. Investors do not base their buying and selling decisions on the state of the market, news events, technical market data, or the season or month of the year. They buy or sell based on the status of their financial plan, their personal financial life cycle, and the dictates of their personal circumstances. This applies to purchases of annuities just as it does to stocks, bonds, and other financial assets.
The Life-Cycle Decision to Purchase Annuities
The right time to purchase annuities arrives when the investor is beginning to focus somewhat less on growth and more on safety and income in retirement. Classically, this window opens roughly a decade before retirement, yawns widest at retirement, and closes steadily thereafter. Although this generality applies to different annuity types, it is still appropriate to consider them separately.
When to Purchase Fixed Annuities
Fixed annuities are essentially fixed-income investments. Deferred fixed annuities are fairly conservative accumulation vehicles that offer the option of taking guaranteed lifetime income at retirement. Surrender charges are a standard feature of annuities, and the IRS levies penalties on annuity withdrawals made before the holder is age 59 ½. The duration of the surrender charges varies, but 10 years is not unusual. Thus, purchase of a deferred annuity 10 years before retirement would schedule the surrender charges to expire just as retirement age is reached, allowing income distributions to begin just as they are needed. The 10-year interval is just a rule of thumb; purchase should be coordinated so as to time the onset of distributions with expiration of surrender charges, sometime after the investor’s age 59 ½.
The deferred fixed annuity can be purchased with installments previously allocated to (say) an equity mutual fund. (The transaction can occur either inside or outside the framework of a tax-advantaged retirement account.) This reallocation helps to lay the groundwork for retirement by creating a source of income to take up the slack created by the loss of employment income. It also makes the portfolio more conservative and less risky, which is appropriate for an individual nearing retirement and increasingly vulnerable to stock-market declines.
When to Purchase Immediate Annuities
The months surrounding retirement are the ideal time to purchase immediate annuities, which start their payout no later than one year after purchase. These are pure distribution vehicles; the inference is that the purchase money was not invested in an annuity. (Otherwise, it could have been annuitized.) There is no contradiction involved in accumulating money using aggressive growth investments but distributing it from conservative assets. For example, employees whose retirement was financed primarily by profit-sharing or 401(k) investments in company stock are excellent candidates for immediate annuities. No matter how successful the company investment was, the necessity for diversification and security cannot be denied.
When to Purchase Indexed and CD Annuities
Indexed annuities and CD annuities might be purchased anywhere in the financial life cycle, but are well-suited for retirement investment. The indexed annuity allows the retiree to participate in stock-market gains without being forced to endure the agony of losses or threats to principal value. Their minimum guarantees of return provide insurance against loss of principal value. CD annuities are a parking place for retirement funds that are between investments. Their liquidity is limited by the penalties levied for premature withdrawal, so retirees should probably patronize maturities of 3- and 6-months.
When to Purchase Variable Annuities
Variable annuities are essentially a way to gain tax deferral for mutual-fund investments outside of a retirement plan such as an IRA or 401 (k). (For example, an investor who had reached annual retirement-plan contribution limits could preserve tax deferral by purchasing a variable annuity.) Because their subaccounts are functionally identical to mutual funds, variable annuities might tempt an investor early in the financial life cycle. Actually, variable annuities are a poor fit for most young, growth-oriented investors. Surrender charges severely limit their liquidity, which might inconvenience young families who experience illnesses, job changes, relocations, and other unexpected needs for cash. The IRS tax penalty on withdrawals by investors younger than age 59 ½ is another deterrent.
One potential exception to this rule of thumb is a young professional seeking shelter against litigation. In many states, life-insurance proceeds cannot be attached in litigation, which makes the variable annuity a good way to achieve tax-deferred growth with less risk. Note that this category of investor is less likely to need liquidity and more likely to hold the variable annuity long enough to outlast surrender charges and IRS penalties.
About a decade shy of retirement age, investors enter their highest-income-earning years. They may covet more tax-deferred investment after the contribution limits in their retirement plans are reached. While their portfolios are gradually becoming more conservative, they still have a need for growth – particularly if they are behind schedule in their retirement saving. This timing allows for the expiration of surrender charges and IRS penalties before annuitization or discretionary withdrawals from the variable annuity.
Once retirement has begun, the variable annuity becomes a less-attractive purchase. Liquidity constraints are unattractive for retirement investment. Tax rates may well be low during retirement, when income is no longer earned; this reduces the value of the tax-deferral feature. Each of these drawbacks makes the retiree less willing to incur the potentially-higher expenses and fees of variable-annuity investment.
One countervailing circumstance is lengthened life spans, which increases the need for growth in retirement investment. Another is the roster of guarantees (for income, withdrawals, and rate of return) provided by “living benefits” featured in newer variable annuities. Time will reveal whether insurance companies can make good on these promises during the depths of a serious recession.
Impact of External Circumstances on the Decision to Purchase Annuities
Even though external circumstances should not exert the decisive influence on an annuity-purchase decision, it is still useful to identify the likely effects of economic fluctuations on annuity prices and payouts. Too much should not be made of these effects. It would be foolish, for example, to purchase an annuity prematurely just in order to take advantage of what appears to be a favorable yield. External circumstances should merely serve to “break ties” in close cases rather than to drive investor decisions.
Interest Rates
In general, low interest rates are favorable to fixed-income investments because asset prices move inversely to interest rates. The fixed coupon payment of a bond will, for example, constitute a larger percentage of a smaller price, and vice-versa. When focus is restricted to income only, however, high interest rates are preferable because they enable the investor to lock in a high long-term yield. This applies to annuities as well as bonds.
“High” and “low” are relative terms. In this case, the important relation is not to past values but to the rate of inflation. A high interest rate is a high real rate; it is high compared to the inflation rate. During inflationary times, such as the late1970s, high nominal interest rates often coincided with low real interest rates, due to the high rate of inflation.
Recession
Recession factors in mostly through its effect on interest rates. High real interest rates are often observed at the beginning of recessions and represent an opportunity to lock in a high long-term yield.
Expansion
High real interest rates are often a feature of mature expansions; they are a sign that the increase in incomes has increased the demand for money, driving up rates. Once again, this is an opportunity to lock in a high long-term yield.
Summary
The investor’s particular circumstances – financial plan, life-cycle position, and personal life – should be the driving force behind decisions to purchase annuities. In general, the years prior to retirement are the prime time to purchase deferred annuities, whether fixed or variable. Immediate annuities occupy the spotlight at retirement. Indexed and CD annuities can be purchased further into retirement itself.
External circumstances, such as the level of interest rates or the stage of the business cycle, might decide close cases but should not be the prime motivation behind a decision to purchase annuities.