Same Old Thoughts About Annuities - Be Careful

Annuities can be a useful solution in the appropriate circumstances but be careful. There are fees, fees and more fees for every added feature that is presented. You do not receive something for nothing. The "something" may be worth the price paid in your particular situation but maybe not.

Most young people can (and should) avoid them altogether and accumulate wealth through the normal retirement account (401k, 403b, TSP, ROTH, taxable brokerage account, etc.) process. Time is on your side.

At retirement, if you need more than social security to cover your basic living needs, then an immediate annuity may make sense. If you have other pensions, too, providing monthly income then you may not need further annuitization.

25% of your total investable assets is a maximum "rule-of-thumb" to consider placing in an annuity but I also would look at your income sources. There may be no need to annuitize more than for your basic income needs of food, shelter, etc. Investments can provide for the discretionary ("fun") money desires.

Immediate annuities (not indexed to inflation) and bought in phases in retirement may be a workable solution. This is where the first one is purchased and then 5-7 years later another immediate annuity is purchased. The subsequent purchase adds more monthly income as inflation begins to eat into your purchasing power.

Indexed annuities (and there are plenty of blog entries here under the "annuities" label to the left) have caps on what you can earn and are very complicated products. Learn about them first before a salesman shows up.

Hopefully, it is obvious that the monthly payment to you includes "your own money" being paid back to you so do not be misled by guaranteed "rates of return".

Variable Annuities and GMWB or GLWB

GMWB = Guaranteed Minimum Withdrawal Benefits
GLWB = Guaranteed Lifetime Withdrawal Benefits

OK. A Variable Annuity with the above riders may be considered for a retiree or future retiree who needs a lifetime income above and beyond social security, pensions and other investments/savings but guess what? These GMWB and GLWB features cost money (slightly less than 1% per year, depending on the insurance company).

Is it worth it? You give the insurance company a certain amount of your nest egg and they, in turn, promise to let you take a percentage (often 5% per year) of your funds for the rest of your life. Aren't they nice? Of-course, some of the money you get back may be your own and not what the funds have earned in interest and gains.

This satisfies two important risks: (1) the risk of you outliving your money and (2) the risk of bad market performance.

But there are disadvantages, too:

(1) All the money from these guaranteed withdrawals comes out as taxable ordinary income

(2) You no longer have access to your original amount (only 5% per year) without substantial penalties. You should not do this if you think there is a possibility that you may need these funds.

(3) You have protection against withdrawal reductions but no guarantee that your withdrawals will keep up with inflation. They may if the income base that is used to calculate the 5% withdrawal increases. (Some policies guarantee that this income base doubles in 10 years but remember, that is not the account value but only how the 5% withdrawal is calculated).

(4) Confusing? Yet another reason to pause. You must understand the mechanics, with your planner's help if needed, before investing.

(5) That cost (referred to above of less than 1%) for this guaranteed withdrawal feature reveals, according to Jonathan Guyton (Financial Planning Journal, February 2010 issue), that this could result in a benefit that is 10%-30% less than the benefit of safe withdrawal rates from your own portfolio of investments.

Based on several studies, you MAY BE ABLE TO keep your money invested on your own and forget about Variable Annuities if:

(1) You follow asset allocation guidelines (Buckets of Money(r) strategies by Ray Lucia (r); and comments in these blog postings under "Portfolio Allocations" and "Retire-Distribution")
(2) You are wealthy and do not face longevity risk (running out of money)
(3) Your "income gap" (the additional amt. needed from your investments is less than 4%/yr)
(4) Leaving a bequest to heirs is more important than enhancing your own retirement income

Quantitative Wealth Management Analytics

This site: http://www.qwema.ca/calc.htm and the home page have some calculators and articles related to annuities and their place in a financial plan as well as other planning topics.



Though the calculators are limited without registering, the articles are quite informative.



As noted in one article, insurance companies need to be much clearer about what their products do and much better at explaining them. Too often I hear of these rates of return on annuities, for example, of 8% or higher. Read my 25+ entries on annuities (See Annuities Label on left-hand side of blog site) for futher explanation.

Reporting by insurance salesman that a distribution income stream (part return of your own money) or a cash balance that accumulates at a guaranteed rate (but cannot be accessed except by a monthly withdrawal) are not the same as the real internal rate of return. Be very careful.

Annuities - Part XIV: Fees

Fixed deferred annuities and fixed immediate annuities do not show fees separately.

For fixed deferred annuities, fees are included in the interest rate.

For immediate annuities, if you like the monthly payment provided then calculate the rate of return based on how many years you think you will live.

For variable annuities, there are the expense ratios and mortality and expense fees stated.

Rule #5: Remember that fees, and this goes for mutual funds and ETF's and just about everything else, are based on asset values not on profits. This is a big complaint of mine and the reason I started this blog on financial planning.

If the fees are 2% and you earn 4% on your money then the company took 50% of your profits. Yikes! It is so insidious. It is one thing if you are getting that much value from the advisor who sells you a product but they even earn money when your asset value goes down.

Fees also may be charged for additional riders (like guaranteed living benefits) and some companies increase the fees based on when you exercise an optional rider. Read the full contract for fixed annuities and the prospectus if it is a variable annuity.

Annuities - Part XIII: Inflation and Annuities

Actually, TIPS (Treasury Inflation-Protected Securities) and I-Bonds (Inflation Indexed) are possible alternatives to annuities so consider them also.

And, believe it or not, since stocks are based, in part, on earnings they also are useful to keep your portfolio in pace with inflation. Stocks and bonds though will go down in value with high interest rates. So, with moderate inflation where interest rates stay reasonably (historically) low they do keep pace. Stocks historically average about 5-6% higher than inflation, bonds average 2-3% above inflation.

Annuities do also. Splitting annuities is an alternative:

(1) Buy a single premium fixed, immediate annuity to provide you the monthly extra income you desire ($50,000 in 2009 will get you about $250-$300 per month)

(2) Buy a deferred annuity for a fixed period - for example, 10 years - that grows at a minimum rate based on your expectations of inflation (a fixed or variable annuity could do the trick, though I would consider allowing your stock/bond portion of the portfolio cover the next 10 years, or even laddered CD's possibly).

(3) In 10 years, then, purchase another annuity to augment the first one and cover the additional amount needed for inflation (if inflation were at 3% you would need 50% more in about 10 years, or in this example, another $125-$150 per month).

The combination are endless.

Annuities - Part XII: Finally Getting Monthly Benefits

If you have a deferred annuity, unlike the 95% of owners who do not choose a monthly benefit, you may actually want to do this.

An alternative may be to take the accumulated balance (if allowed) and trade the annuity for life insurance because, as mentioned in previous posts, life insurance proceeds are not taxable to the beneficiaries. Remember, annnuities are purchased for "your" benefit, not for your survivors.

Why? You need the income.

(1) If you are insurable (check first), you could annuitize and use the monthly benefit to purchase an insurance policy if you have found that over the years you do want to provide a tax-free benefit to heirs.

(2) When you annuitize, then only a portion of your monthly payment is taxable because some of that money is a return of your own original investment. This is a nice benefit from a cash flow and tax-wise point-of-view. Unlike partial withdrawals which are 100% taxed, you may find that only 40% of a monthly annuitized payment is taxed (exclusion ratios are calculated for you by the insurance company).

(3) It is possible that if you live long enough, eventually all of your original investment will be paid out and the rest, of-course, would then be 100% taxable to you. Keep that in mind for tax planning.

(4) Before annuitizing an old contract, shop around. Other products may provide a better monthly payment if you can get out of the contract you are in and, remember, the older you are the higher the monthly payment (based on life expectancy).

Annuities - Part XI: When to Buy

If . . . for income purposes, then an income annuity (whether fixed or variable) should be purchased not a day before you actually need the monthly income to help you live the life you desire.

If . . . for longevity insurance (so you assure yourself of income for life) purposes, I agree with a variety of researchers and Kerry Pechter in Annuities for Dummies (2008) who writes: "...when you reach age 60 replace the bonds in your portfolio...at age 75, ...replace the stocks in your portfolio..." (that is, just the bond or stock portion required to meet your goals and still, most likely, no more than 25% of your total portfolio).

Please note: (1) the purpose for using an annuity in the statements above (because neither may apply to you) and (2) that this is concerning "income" annuities (where you actually plan to take a monthly amount because 95% of annuities purchased are never "annuitized")

Since your money is pooled with others:

Rule #4: the older you get and the shorter your life expectancy, the more money you will be able to get on a monthly basis due to "survivorship credits" (if you live longer then average, those who died earlier have helped you to earn a better monthly payment than you could do on your own in many circumstances).

Annuities - Part X: Variable Annuities

Variable annuities allow you to invest in stocks and bonds with an insurance wrapper and death benefit and the option to, at some late date, take a monthly benefit.

No guarantees on investment returns. Losing money is a real possibility but the insurance company offers a "floor" usually. Only fixed annuities guarantee a return rate.

Annuities are not free! The fees are added on to whatever the fees of the underlying mutual funds or other investments offered happen to be. And when you add on any additional features, like the four typical ones below, more fees are added. They are not usually enormous fees (but it is important to shop around) - for example, ".25% - .60%" - but over 20 years, .60% may be a 12% reduction in the ending balance amount, so the costs are not unimportant.

But, on the other hand, you are paying for features that regular index funds, mutual funds or other investments do not provide (so ask if you need these benefits):

(1) a death benefit (you may not need if you have no one depending on your income or you have saved and invested enough resources of your own);

(2) optional income for life (you may not need if your basic needs are covered by a pension, social security or other sources with a reasonable 2-5% of the balance as your withdrawal rate);

(3) tax deferral (you may not need if you have retirement funds like IRA's and a qualified retirement plan); and

(4) no RMD's (that is, required minimum distributions which, if you qualify for the ROTH IRA, also has no RMD's).

And the features, at extra cost, are:

GMWB - Guaranteed minimum withdrawal benefit (if retired or near retirement of 5, 10 or 15% typically); provides a way to get to that lump-sum money you gave the insurance company (liquidity) without annuitizing (taking a monthly payment).

Nice, you should consider this feature but, remember, none of these benefits come without an additional fee (think "expense ratio" in mutual funds).

GMIB - Guaranteed minimum income benefit (for example, 10 years to retirement or more); lifetime minimum income amount (to help you sleep at night knowing there is a base amount you will never lose). But, again, if you have to annuitize to get at your money, then this can be a disappointing return rate when all is said and done.

Insurance companies like to say your investment is guaranteed to "double", for example, in 10 years (which is a rate of return of around 7%), but then, surprise, you can't then take the money and run. It is not "yours", it is with the insurance company, and the only way to get at that "doubled value" is to take a monthly payment at some ridiculously low payout rate of, for example, 2.5% or so. Quite misleading and unfair but you now know the questions to ask.

GMAB - Guaranteed minimum accumulation benefit (annuity monthly payment is deferred for a set period but set at some rate of increase; this has nothing to do with your rate of return though).

I am so frustrated with insurance sales people stating a "guaranteed rate of return" when it is really a return of some of your own money. Again ( see other posts), do not fall prey to this nonsense. Variable annuities do not guarantee a rate of return since you are deciding how to invest the money.

Rule #3: If the annuity is not described honestly to you, then possibly disregard that product and that person. If you don't know, see an independent financial planner from NAPFA. (You would do this, hopefully, if you were buying a used car, right?)

GLWB = Guaranteed lifetime withdrawal benefit (kind-of like the GMWB feature with a twist); if you never take any withdrawals, then you may get to combine this with a GMAB. Oh boy!

Annuities - Part IX: The Complexity of Fixed Indexed Annuites

For a fixed, indexed deferred annuity the amount that is added to your initial balance is not a fixed interest rate but a calculated rate (but some minimum rate is also usually set).

If you do not understand the contract calculations, then do not buy. You must understand what you are buying at all times since alternatives always exist to these products.

That calculation in the contract is (1) complex and (2) possibly changing from year-to-year so go slow, read and have a professional, independent planner review it first. The parts to the calculation are:

(1) The index used = usually the S&P 500 (large-company; U.S. stocks)
(2) The participation rate = some percentage of the movement of the index up to a maximum cap. (You never get all the gains and none of the losses - dream on).

This never includes dividends (because as I mentioned in a previous post, the investment is in stock options not the actually stocks and so dividends are not included); 100% up to some percentage cap sounds nice, but 50% of a higher number may be even better. Sometimes it is stated as a margin (or spread) below the index.

(3) Annual reset = the gain or loss in the index measured is calculated based on a certain time period.

This time period is important. Some contracts average the returns over a calendar year or anniversary of the date you started the annuity; some look at monthly returns, some are "point-to-point". Depending on how this "annual reset" is calculated could mean protection from losses one month before your anniversary date or no protection.

(4) High water mark = protects gains in our accumulated balance by setting your balance at the highest balance that occurs during a particular period.

(5) Required annuitization = if the contract allows you to accumulate assets within the annuity but the only way to get the money out is to "annuitize" (take a monthly payment), then you must understand how that works.

If the monthly payout is the only way out of the contract, then your overall rate of return must include this payout period and your life expectancy. After looking at a 5-10 year accumulation period and then a monthly check for the rest of your life, the rate of return may be very disappointing.

The complexity of these fixed indexed, deferred annuities suggests using an independent professional to run the numbers before accepting the salesman's theories. Many of them do not understand the products they sell.

My advice: buy if you understand them and they fit into a strategy, but never let anyone "sell" you one.

Annuities - Part VIII: Indexed Annuities

Indexed annuities are not investments in stocks. Wrong! The insurance company does what you could do on your own:

Buy a zero-coupon bond for example for $650 that guarantees you $1,000 in 10 years and then invest the remaining $350 in stock options - yes, options, not the actual stock. If your investment works out you will make more than your $1,000 but if you lose, at least you get your $1,000 minimum return.

Don't know much about Zero-Coupon bonds and stock options? Great, then consider buying an equity-indexed annuity. EIA, for short, is what they used to be called but not anymore. Now they are just called indexed annuities. There is much to know about them however (in my next post) but for now:

Do not compare a fixed indexed annuity to stock investing - it is not a proper comparison. It is more like a bond investment with a little extra opportunity.

Annuities - Part VII: What is an MYG?

MYG = Multi-year guaranteed fixed annuity. This is like a EE bond or a Zero-coupon bond where you put in a certain dollar amount and after a fixed number of years you get a higher dollar amount at a specified rate of interest.

Never purchase a fixed annuity with only a one-year guaranteed interest rate. In an annuity, this multi-year guarantee is better than a zero-coupon bond (Zero-Coupon bonds should only be bought in a retirement account since interest is not paid out until the term is over but you must pay tax as you go).

The MYG fixed income annuity interest is deferred, too, and when purchased with after-tax money outside of a retirement account you get the tax deferral, in part, and pay tax on only a portion of your monthly payment (based on the exclusion ratio).

Remember, though, that you tie up your money for the period stated (usually 5 or 10 years).

Also remember, that with fixed income annuities the fees are never stated but all that matters is the interest rate and the guarantee period to you. If you like the interest rate and it is better than CD's and savings accounts and money market funds then it should be considered as an alternative to those types of investments, especially if you stay under the $100,000 (in some states higher) state guarantee amount.

Annuities - Part VI: Interest Rates and Annuities

When the Yield Curve is steep, this is a better time to buy annuities. The Yield Curve can be defined a number of ways but I am referring to the difference between short-term Treasury Bills (at less than 1/2%) and long-term Treasury Bonds (hovering in the 4.25% area) - the difference is considered huge.

You can expect an annuity payment (this is not the return rate, however) of about 2-3% above the long-term rate when the Yield Curve is steep like this...so about 6-7%. Again, this is not your return since some of the payment is principal (your own money).

Of-course, in the early eighties, when the Yield Curve was steep but with different numbers (short-term was 5-6% and long-term was 12% during a unique infaltionary period), an annuity payout was about 15% of what you put down.

So, it does matter what the interest rate environment is when purchasing an annuity.

Annuities - Part V: The Good and the Bad

Good:

Higher monthly income (because dollars are pooled with others)

Assurance of income

Bad:

Lack of liquidity

Maybe reduced benefits for survivors (beneficiaries)

Annuities - Basics: A Contract

Kerry Pechter, author of Annuities for Dummies, writes on page 44: "Investments involve risk...investors actively seek investment risks in order to get rewards..." (better returns)

He continues, "...Contracts involve the transfer of risk...Annuity buyers actively see to limit investment risk..." (most importantly, whatever the 'guarantee' it will not be free).

Because of survivorship risk (also called mortality pooling), annuity contracts can be a very efficient way to:

(1) Maximize an income stream

and

(2) Guarantee that income for life (though maybe not inflation-adjusted).

Annuities - Part IV: Tax Considerations/Exclusion Ratio

If you purchase an annuity within an IRA or 401k or similar retirement account, you must take RMD's (required minimum distributions) and, worse, all of your withdrawals are fully taxable as regular income.

Though insuring for longevity may be a reason to do this, in most situations, annuities should not be purchased with retirement money because:

(1) you lose the tax benefit in the annuity monthly payments and

(2) the retirement account is already deferring taxes - so that idea is redundant.

If an annuity is purchased with after-tax money, no RMD's are ever required, and you only owe taxes on your interest and gains and not on the portion that is a return of your own money (your principal). Yes, it is true that stock market gains are taxed at regular income rather than at capital gains rates if you chose stock investments within your annuity. This, though, is more of a concern at the higher tax brackets and not nearly as much of a concern in lower tax brackets - yes, there is a difference but it may be as little as about 5% at the lower end.

Exclusion Ratio: This is a complicated calculation of how much of your monthly payment (when actually annuitizing) is considered a return of your own money versus interest/gains. To give you an idea only:

For a fixed, immediate annuity it is about 30-40% taxable and 60-70% non-taxable and the insurance company will calculate it for you. This is important because this can help you reduce taxable income versus a simple CD or Money Market strategy that creates 100% taxable interest.

Annuities - Part III: Reasons Not To Buy

(1) A deferred annuity is the only asset you can own that does not get a “step-up in basis” at the time of your death. Real estate and stocks could appreciate and be passed on to heirs upon the death of the owner with no income tax whatsoever. But an annuity does not enjoy this tax feature. Specifically excluded from the step-up in basis rule, the entire gain in the annuity is subject to income tax (and regular income tax rates to boot) when received by the beneficiary.

So, if you want to pass on your savings at death, a life insurance policy rather than an annuity would be a better choice and are paid to the beneficiary income tax free. Stocks and bonds get a step-up in basis, minimizing taxes since there would be no gains if sold immediately, and are another good choice to pass on a financial legacy.

(2) Annuities are not FDIC insured. They are not deposits, obligations of or guaranteed by the bank or any federal government agency.

(3) Annuities involve risk, including the possible loss of principal. All guarantees are subject to the claims paying ability of the insurance company you use. There are state guarantee programs and, in Virginia, the first $100,000 is insured. This is a good idea to keep each annuity below the state guarantee amount.

(4) For retirees, particularly older retirees, deferred variable annuities can be a financial disaster. Why? Because they require a cash outlay late in life without the guarantee of certain returns. Early-withdrawal penalties and surrender charges could limit a retiree's ability to access cash in a pinch (though I will discuss in later posts the guaranteed withdrawal benefits of the latest iterations of annuity products). Much of the controversy surrounding variable annuities has focused on their sale to older people.

A "sweet spot" for considering annuities is probably in the age 60 - 75 range, if at all appropriate.

(5) Fixed income payments from an annuity may not keep pace with the rising cost of living. This is quite important and the cost of an inflation rider may not be worth it. You might be better off keeping other money aside (that is why no more than 25% of your total portfolio should be commited to annuities) that can grow. This will allow you to purchase another annuity years later to help provide the inflation boost you may need.

There are many advantages of annuities, too, to be in a future post.

Annuities - Part II: Income versus Wealth Growth

Rule #2: The use of variable annuities to guarantee certain levels of income increases probabilities of the plan's success, but erodes net worth faster (especially in poor markets).

As logic suggests, and as I wrote previously, guaranteed income has a price. But not just the fees, but rather the potential growth in your portfolio that may be sacrificed.

So, the question needs to be asked: "What is the goal?" Retirement income guarantees or more legacy wealth accumulation for inheritances to survivors later?

Annuities - Part I: Immediate versus Deferred

If you are under 65, then an annuity of any type may not be right for you but there is a place for them in the right circumstances if you are willing to pay for them.

Many research studies show that you can minimize your risk of running out of money in retirement (longevity risk) by moving 25% of your portfolio into an annuity. If you already have enough income from pensions and social security (both are also annuities by the way) to cover your lifestyle, then your own personal annuities may not be needed.

Cover your basic expenses first with reliable income sources and consider an annuity only if you are short of meeting your basic needs.

Terminology:

Immediate - you start receiving monthly payments (annuitization) as soon as you put the money down to buy the annuity. (Types: fixed, equity-indexed and variable)

Deferred - you put money in to let it grow and then take monthly payments out later (do not compare the growth to stock investments but compare it to your bond/cash/fixed income type investments). (Types: Variable with a variety of living benefit riders, for example, guaranteed minimum income or withdrawal benefits).

Most people who have annuities never "annuitize" them but keep them for tax-deferred growth and this may not necessarily be the right strategy but it depends on many factors.

If you are young, you most likely don't need annuities because you have lots of time to allow your investments to grow, you are working and you don't need annuity income. The only time it might make sense to buy an annuity is if you have maximized all other retirement plans (401k, 403b, 457, Traditional IRA's, ROTH IRA's to whatever maximums allowed - and, if married, both of you).

There are other tax deferred planning vehicles besides annuities to consider also like Variable Universal Life (VUL) and other products. For most of my working clients, middle-income Northern Virginia households, annuities and VUL products are just not needed.

Annuities can be complicated, so I will break up this information.

Rule #1: Immediate annuities provide more income than deferred variable annuities with living benefits (from page 24 of Annuities for Dummies by Kerry Pechter)

Switching Annuities

A good website for annuity information is: http://www.annuityfyi.com/

If you are considering switching annuities for the "latest model", FINRA (the financial regulatory agency) recommends knowing the answer to these questions first:

(1) Is the current death benefit or living benefit greater than the surrender value?

The new annuity may restart surrender charges and surrender periods again.

(2) What are the surrender charges expressed as both a dollar amount and a percentage?

This is a real cost to you to get out of the old annuity that would have to be made up by the better return rates of the replacement.

(3) How long was the variable annuity held that you are thinking of trading in?

Investments held in stock accounts are a longer-term plan and, possibly the surrender charge period has finally been reached or charges are low if more than 5-7 years have passed.

(4) What are the fees (MEA, Benefits, Sub-Accounts Fees, Asset Allocation Model Fees) of the new / proposed variable annuity as compared with the existing one?

So important to compare fees and rates of return. Do not confuse a distribution rate with rate of return. They are very different since during distribution (annuitization) you are getting your own money back as a part of the monthly payment. Be very careful and do not be mislead by high rates.

(5) Is a bonus being offered to make up for any surrender charges?

This is dangerous because the bonus is not "real" money but the surrender charges are real cash. The bonus affects your accumulation amount (income base) and this is different than your cash value. Again, do not be mislead.

(6) How old are you?

FINRA believes that above age 75 the benefits of a variable annuity diminish greatly though there may be some variable products that can make sense for older investors. In addition, if you are under age 50 a deferred annuity may not be a suitable investment unless you have maximized all other avenues of tax-deferral.

Benchmarking an Annuity Payout (Gives you an idea)

First, see a professional planner before considering an annuity. There are all kinds: Fixed, Variable, Immediate, Deferred, etc. They may be useful for a retiree but for anyone with 10 or more years to retirement an annuity may not make any sense at all. NAPFA advisors do not sell them so we can be objective in their usefulness for your specific situation.

Based on an online calculator (from Vanguard), a 65-year-old male who invests $100,000 in a traditional annuity gets $781 as his first month's payment, versus $590 from the inflation-adjusted one. Use for comparison purposes when shopping for an immediate, fixed annuity.

Remember $781/month is $9,372 per year (basically 9% of the lump-sum provided to buy the annuity but the payout includes a return of principal so it is not a 9% return on your money by any means).

This is also a SINGLE-LIFE annuity payout and would be substantially less for a Joint&Survivor option, at an earlier age than 65 (since the life-expectancy would be longer) or if you are a female versus a male participant for the same reason.