The Pros and Cons of Annuities
If you walk in to almost any stockbroker’s office and ask him for advice on what to do with your money, his first tack will be to try to get you into the stock market. “Stocks are the key to success of any portfolio,” he’ll say.
If, however, you indicate any distaste for stocks, he’ll immediately take the tax angle. “No, in your case, the key to success is to avoid or defer taxes.” That’s the opening that leads straight into a pitch for tax-deferred annuities or tax-exempt bonds.
What is the true key to your success in the new millennium? It’s flexibility — the ability to change course as needed. Our financial markets are so volatile — even fragile — it’s almost impossible to imagine a world without big surprises that upset our best-laid investment plans.
Take inflation and interest rates, for example. Almost every tax-advantaged financial product you buy today makes assumptions about inflation and interest rates, usually assuming they’ll remain pretty much where they are for the life of the plan.
But the reality is no one has the faintest idea what inflation and interest rates will be ten or twenty years from now. We could have a return to double-digit inflation, or we could even have chronic deflation. Interest rates could decline more than anyone expects and they could spike higher than anyone dreams possible. In either scenario, the dangers — and opportunities — could be enormous.
In this environment, you must keep a substantial portion of your money liquid; you must avoid, as much as possible, precisely the investments or programs salesmen like to promote the most — the ones that lock you in.
- Steer clear of annuities and insurance policies that involve large start-up commissions or large surrender charges (cancellation fees).
- Avoid esoteric investments that are easy to buy, but hard to sell. Examples: Limited partnerships. Municipal bonds that rarely trade. Penny stocks with low trading volume. “Special” opportunities in start-ups or private investments in business deals.
- Stick primarily with investments that are traded in large volume in open markets — that you can sell at any time, with no penalty.
There is a place for a long-term plan that helps you build your wealth without the continuing drag and drain of taxes. Your money grows more quickly. You reach your goals sooner. You retire with more.
But tax deferral does not come without a cost. Nearly all tax-deferred investments require that you sacrifice liquidity. The IRS will hit you hard with penalties for early withdrawal of your funds before age 59 1/2, and the insurance company charges additional penalties.
This doesn’t mean you should forego the benefits of tax-deferred investments. Rather, it means that you should carefully take steps to minimize the sacrifices that need to be made:
To begin with, don’t put all your savings into tax-deferred investments. Use these vehicles only for a modest portion of your overall nest egg. This way, the bulk of your funds will stay completely liquid and under your direct and immediate control.
Second, make sure that the money you do set aside for tax-deferred programs is money that you’re reasonably sure will not be needed for living expenses and other needs.
Next, follow along with us as we help you ask — and answer — six key questions about annuities.
What Is An Annuity Anyhow?
Few insurance agents will explain it in this way. But it’s about time someone does:
Insurance is like a life-and-death betting game. They use statistics to make the odds. Then, they use those odds to determine how much you have to pay in premiums and what the payouts will be. You always bet against the house (the insurance company). No matter which side you want to be on — life or death — the house will take the other side.
Life insurance is actually a way for you to bet on death. As we mention elsewhere, it really should be called “death insurance,” but the insurance industry decided long ago that such a name would not exactly be good for sales.
When you buy life insurance, the insurance company is betting — and hoping — that you will live longer. The longer you live, the longer they can put off paying the death benefits to your heirs, and the more they can earn on your money in the meantime.
Annuities are a vehicle for you to bet on your life — the reverse of life insurance. In effect, the insurance company is betting that you will die sooner than average. If so, they win the bet and make more. If you fool them and live longer, you win the bet and make more.
Why is an annuity a kind of insurance? Because it’s your protection against the risk that you might outlive your income.
What confuses most people is the fact that there are two entirely different kinds of annuities you can buy, and one of them isn’t really an annuity at all.
Immediate Annuities vs. Deferred Annuities
If you are near or at retirement age, you can buy an annuity immediately. So it’s called an “immediate annuity.” This is the true annuity and functions exactly as we described it above. You pay a lump sum premium now and start getting your monthly “income” checks right away.
The insurance company is, in effect, saying to you: “Give us your principal and we will give you a monthly check for as long as you live. If you live longer than average, you will receive more checks than those who don’t live as long. If you die sooner, we pocket the difference.”
If you are not yet ready to retire, but you want to start saving for that time, you don’t need to put up all your money right away. You buy a deferred annuity. This is not insurance. It’s not even a “true” annuity. Rather, it’s an investment-savings plan where you accumulate funds on a tax-free basis toward the future purchase of an immediate annuity.
Similarly, the insurance company that’s selling you a deferred annuity isn’t really acting as an insurance company. It’s acting as an investment company that’s competing directly with mutual funds and banks for your investment dollars.
We repeat: Deferred annuities aren’t insurance. They’re investments. The proof is that they come with the option to either (a) convert to an immediate annuity or (b) take the proceeds in a lump-sum settlement. If you take the lump-sum settlement, it’s purely an investment from the first to the last day. You buy. Then you sell. End of story.
Indeed, many people who buy deferred annuities never intend to convert them into an immediate annuity. They use the deferred annuity as an investment vehicle and for its tax advantages. Then they simply take out the cash when they retire. Nothing wrong with that. Just make sure you recognize it for what it really is — an investment like any other.
Variable Annuities vs. “Fixed” Annuities
When you buy a deferred annuity with an insurance company, you can either retain control over where your money is invested, or you can leave those decisions entirely up to the insurance company.
Variable annuities give you the control. You choose from a range of options — such as a mutual fund investing in stocks, a bond fund, or a money market fund — and you assume the investment risk. If the market value of your investments goes up, you reap the benefits. If it goes down, you suffer the losses.
In effect, you are investing in mutual funds affiliated with the insurance company — and with the additional advantage of tax deferral.
As with mutual funds, your investment is kept in “separate accounts” which are segregated from the insurance company’s general pool of assets. When you’re ready to get your lump sum distribution, you get your fair share of what’s in those accounts, depending on the performance of the funds.
With “fixed” annuities, you let the insurance company make all the investment choices; and they assume a part (but not all) of the investment risk. Your money goes into a general pool. And no matter what happens, the company guarantees you a certain bare bones minimum result.
Two warnings: We put the word “fixed” in quotes for a reason. It’s not really fixed. Plus, there’s a big difference in the safety of variable vs. fixed annuities. More on both of these in a moment.
Do I Really Need An Annuity To Begin With?
No matter how attractive it might sound, and no matter what the salesperson may tell you, buying an annuity is not a foregone conclusion.
Remember: When you invest in a deferred annuity, you are giving up some liquidity. And when the time comes to buy the real thing — an immediate annuity — you are completely giving up your principal to the insurance company. It’s irreversible and final.
There is another option. Instead of buying an annuity, you can direct your own retirement investments. To help you make this critical decision, let’s take a closer look at how an annuity works and how it compares to other investments.
Let’s say you put $100,000 in a deferred fixed annuity at age 50. And let’s assume there are no front-end charges or maintenance fees. Further, let’s assume the original “crediting rate” (yield) is 5% guaranteed for one year.
On the first anniversary of your policy, your account value will have grown to $105,000. So far, the account pays interest just like a CD, with the sole difference that you do not have to pay income tax on the $5,000 worth of interest income.
Problem: Now the one-year guarantee period on your crediting rate has expired. So the insurer will reassess your rate. If interest rates are rising and their investments are performing well, they will probably raise your rate. But the company also has the option to lower your rates for the coming year if they feel a need to do so.
Sure, it is in the interest of the company to keep rates competitive, but if interest rates on competing investments are going down, theirs will probably go down too. They can’t drop your rate below their minimum guaranteed rate, but that’s usually set pretty darn low. Then, each year thereafter, the company reassesses their investment performance and declares a rate for the coming year.
That’s why the term “fixed annuity” is really a deception. We can’t even count the number of people who have told us they didn’t read the fine print and were shocked when their rate went down. They’d never let a mutual fund get away with a product name like that. But the insurance industry does it all the time. The truth is that the rate is fixed for only one year at a time.
So the growth in your account value will depend on the rate declared each year. For the purpose of illustration, let’s say the rate is 5% in year two, and 6% in year three. Your $100,000 annuity would be worth $110,250 at the end of the second year and $116,865 after three years.
Now, let’s say you need to withdraw some money. Under the terms of your contract, you are allowed to withdraw 10% with no surrender charges. That would be $11,686. If you need $20,000, you’d have to pay a surrender charge on the remaining $8,314.
Surrender charges for most policies start at 7% for the first year and decline by 1% each year: 6% in the second year, 5% in the third year, and so on, until you get down to zero charges in your eighth year and beyond.
So, if you are making a withdrawal during the fourth contract year, the charge would be 4% of $8,314 or $332. Your account balance now stands at $96,865.
You would also have to pay regular income taxes on the interest income portion of the funds that are being withdrawn plus a 10% tax penalty, if you’re under 59 1/2. This is generally not as grievous as it sounds since you still have had the advantage of deferring the income taxes for the three years.
This is the most common example. And it’s simple. But there are many policy features that can vary substantially from company-to-company and policy-to-policy that you should know about — surrender fees, other fees, and bailout rates.
Surrender fees: Although the most common surrender fees start at 7% and are scaled down to 0% after seven years, some companies charge more — 9%, 10%, sometimes even 15%!
Even if you are fairly sure you will not need access to your money soon, don’t even think about getting stuck in policies with such huge fees. Unexpected things do happen.
Bailout rates: While they are not as popular as they were several years ago, certain contracts offer a bailout provision in their annuity contracts. This provision allows you to withdraw all your funds without penalty if your interest rate drops below a set figure, such as 6%.
The bailout option will be especially useful if the rate decline is due to specific problems in the company’s investments. However, if the rate drop is due to generally declining interest rates, you may not be able to find a comparable investment with a better return elsewhere.
Front-end load and other fees: Few policies now on the market carry either front-end loading fees (fees subtracted from your cash value when you first purchase the policy) or yearly maintenance fees. However, policies with from 1% — 3% in front-end loads and with yearly fees of $25 to $100 do exist. Avoid them.
Settlement options: As we mentioned to you at the outset, most policies provide at least two ways to use the proceeds of your deferred annuity when it matures. You can choose between:
Option #1: “Lump-sum withdrawal.” You take out all of your accumulated cash values when the contract matures or at retirement, or...
Option #2. “Annuitization.” You convert it into an income annuity, putting you in the same situation as someone who is buying an “immediate annuity.” This will typically pay out the funds to you monthly for the rest of your life. The actual amount of the monthly check will depend on the investment climate at the time of annuitization. As a result, most policy illustrations will show both a guaranteed payout (the minimum the company will offer) and a current rate payout (the amount it would be if the current interest rate were in effect at the time of annuitization).
Some companies design their annuity products to encourage annuitization. As a result, these policies may give you a poor lump-sum payout but a good annuity option. Others are just the reverse. Reflecting these differences, your company may track two separate cash values — one for lump-sum settlement and the other for annuitization.
So before you even buy, you need to select an annuity that will fit into your financial plan. If you plan to take a lump-sum settlement, annuitization values are only important if you change your mind. If you plan to annuitize your policy, the cash value takes on lesser importance.
Don’t know ahead of time which option you will exercise? Fine. Then select a policy that offers reasonable earnings for both. That way you keep all your options open.
To Annuitize Or Not To Annuitize?
The term of your deferred annuity is up, and you face a decision: Do I take all my money in a lump sum? Or do I “annuitize” — use the money to buy an immediate annuity?
Or, even if you don’t have a deferred annuity, and you’re at or near retirement age, your question is similar: Do I buy an immediate annuity, or not?
We warn you again: Whatever you decide, don’t be overly influenced by insurance agents, stockbrokers or financial planners who sell annuities. The facts:
- A lot more depends on your individual circumstances than the salesperson may indicate. For example, if you feel you’re healthier than the average person, or you come from a family of people who usually enjoy long life, annuities have an additional advantage to you, beyond the standard advantages. Otherwise, the annuity may have additional disadvantages for you.
- Many salespeople will push the annuity that will give them the largest commission, not necessarily the one that’s best for you.
- Many will compare immediate annuities to Treasuries or CDs. But they’re apples and oranges because, unlike most fixed income investments, an immediate annuity is absolutely non-cancelable.
Aside from a short grace period (which may vary from 10 to 30 days depending on each state’s laws), once you’ve bought an immediate annuity, that’s it. You’re in for life.
And unlike other assets, immediate annuities cannot be passed onto your heirs. Except for a specified period in the early years of an annuity contract, once you’re gone, the asset is gone.
If you can accept these disadvantages, the advantages are still worth considering:
Advantage #1. Loved ones can be provided for. You can purchase an annuity called a “joint and survivor annuity.” In that way, some or all of the annuity income will continue going to the survivor when the original annuitant dies. Also, with one of the most common contracts — “10 year certain and life”— monthly checks keep coming for a minimum of 10 years and for as long as you live thereafter. If you die before the 10‑year period is up, the checks are sent to a designated beneficiary for the balance of the 10‑year period.
Some companies may give you the option of buying a “certain and life” annuity that ranges between 5 and 20 years. The payout amounts differ from company to company, perhaps by as much as $60 a month on a $100,000 annuity. So compare monthly income payments carefully.
Advantage #2. Reduced income taxes. You don’t pay taxes on roughly two‑thirds of your monthly check, depending on your contract and your age. If you’re in a 28% tax bracket, for example, and your monthly annuity check is $400, you’d pay taxes on just $130. So all you’d owe Uncle Sam each month is about $36. (However, in some states you may have to pay premium taxes.)
Advantage #3. Favorable monthly income compared to CDs. Assume a 70‑year widow in the 28% tax bracket invests in a $50,000, 5‑year CD yielding 5%. She makes about $2,500 per year in interest, leaving about $1,800 in after‑tax income.
By contrast, if she bought a $50,000 immediate “10‑year certain and life” annuity, she could get a check for roughly $385 a month, or $4,620 a year. This includes both interest and principal. The interest portion is $143, which after taxes, gives her $103 per month or $1,236 per year. Adding in the principal portion, the total money she receives comes to $345 month or $4,140 a year. That’s a cash flow of 8.3% even after taxes.
Advantage #4. Annuity income for a lifetime.With other investments that pay out principal as well as interest (like a Ginnie Mae bond, for example), when you deplete your capital, the checks stop coming. But with an immediate annuity, because of the insurance aspect, the payout of principal does not result in a cut‑off of your monthly checks. You continue to receive the checks for the rest of your life.Remember: The insurance company — which bases payouts on average life expectancies and the earnings on its investment portfolio — is, in effect, betting that the funds paid in will cover all the funds paid out. That’s why it’s so important to buy annuities from strong companies that can back up their promises with their own reserves if they miscalculate their earnings or their liabilities.