Saturday Jan 19, 2019
Chapter 8 – “Annuities”
Saturday Jan 19, 2019
Saturday Jan 19, 2019
In this episode, podcast host and author of “Control Your Retirement Destiny”, Dana Anspach, covers Chapter 8 of the 2nd edition of the book titled, “Annuities.”
If you want to learn even more than what there is time to cover in the podcast series, you can find the book “Control Your Retirement Destiny” on Amazon.
Or, if you are looking for a customized plan for your retirement, visit us at sensiblemoney.com to see how we can help.
Chapter 8 – Podcast Script
Hi, this is Dana Anspach. I’m the founder and CEO of Sensible Money, a fee-only financial planning firm. I’m also the author of Control Your Retirement Destiny, a book that covers all the decisions you need to make to align your finances for a transition into retirement.
This podcast covers the material in Chapter 8, on annuities. Are annuities a bad investment? Or a good one? You’re about to find out.
If you like what you hear today, go to Amazon and search for Control Your Retirement Destiny. And, if you are looking for a customized plan, visit sensiblemoney.com to see how we can help.
There is a lot of conflicting information on annuities. Are they a good investment? A bad one? Are they even an investment at all? The answer depends on what article you happen to be reading at the time you are asking the question.
If we boil it down to the basics, an annuity is a contract with an insurance company. The insurance company provides you a set of guarantees. You place your money with them in return for those guarantees.
That makes the purchase of an annuity quite a bit different than investing in a stock, where there is no contract and certainly no guarantees.
The key to understanding annuities is understanding what the guarantees are, and how they work. That may sound easy; however, there are many types of annuities, and they are not all alike.
Let’s start by breaking annuities down into four main categories. An annuity can either be immediate or deferred. And it can be fixed or variable. As we cover each of these four categories, we’ll also discuss a few sub categories like equity-index annuities, and variable annuities with guaranteed income riders.
We’re going to start with an immediate annuity.
Picture a jar of cookies that represents your money, or a portion of it. Now, imagine you hand the insurance company this jar full of cookies. Starting immediately, they hand you back a cookie each year.
If the jar becomes empty, they promise to keep handing you cookies anyway, for as many years as you need them. In return, you agree that once you hand them the jar, you can’t reach in anymore. If one year you want three cookies, you’ll have to get them from somewhere else.
No matter how long you live, and no matter how much of your other money you spend early in retirement, you’ll still get a cookie each year. Annuities were designed for this purpose – to make sure you don’t run out of money and to make sure you have income over a potentially very long life. This is what annuities are really good at.
When people start comparing annuities to other types of investments and discussing rates of return, they are missing the point. You buy an annuity to provide guaranteed income for life. A mutual fund does not provide guaranteed income for life – so comparing those two options side by side doesn’t make any sense. If you want a portion of your income guaranteed for life, look at an annuity. That’s what they are made for.
With an immediate annuity, the income begins right away, and the payout is fixed. This type of annuity is good at two things: 1) protecting you from outliving your money, and 2) protecting you from overspending risk, as you can’t dip into the cookie jar.
What if you don’t need the income immediately, but you still want to know you will have guaranteed income in retirement? That’s where a deferred annuity comes in.
With a deferred annuity, you put a lump sum into an annuity contract, and the insurance company guarantees a specific payout that begins at a set time in the future.
There are many types of deferred annuities. One version, offered inside of retirement plans, is called a “QLAC” or Q-L-A-C which stands for Qualified Longevity Annuity Contract. With a QLAC the maximum amount you can buy is $125,000 and the income is typically contracted to begin at age 80 or 85.
Why would you want a product that isn’t going to pay out until your 80’s? Some people like the idea that they could spend everything else they have between now and age 80 or 85, with the security of knowing a guaranteed income will begin at that age.
A more common type of deferred annuity is one that is purchased in your 50’s, with the income designed to begin at age 65 or 70. For example, if you are age 55 today and your investments have been doing well, one option is to carve off a lump sum to buy a deferred annuity that will guarantee a monthly income ten years down the road.
A portion of your savings must be converted into a stream of cash flow that you can use in retirement, and a deferred annuity does this conversion for you.
When discussing annuities, one objection I hear is that people are afraid that they will hand over their cookie jar, pass away, and essentially have given their money right to the insurance company without getting anything back. There are death benefit features that prevent this. One death benefit option is called an installment refund, where any money not paid out to you comes back to your estate. Another way to make sure your principal is paid out is to use a life annuity with a minimum term-certain payout. This means that the annuity is guaranteed to payout for your life, but if you pass early, it must continue to pay for a set time, such as ten years.
Keep in mind, every additional guarantee that is provided has a cost. An immediate annuity with no death benefit will usually provide the most guaranteed income per dollar. Why? Because it is simple to administer and the cost to the insurance company is low. As soon as you add death benefit guarantees and deferral periods, the cost to administer the contract increases. The way that cost shows up, is you get slightly less income per dollar than what you might get with a simpler, less complex contract.
We’ve covered the basics on immediate and deferred annuities. Next, we’re going to discuss fixed and variable annuities.
With a fixed annuity, the insurance company guarantees the interest rate you’ll earn, and the interest accumulates tax-deferred – meaning you won’t get a 1099 tax form each year. You don’t pay taxes until you take the money out. Any interest withdrawn prior to age 59½ is subject to the 10% early-withdrawal penalty tax in addition to regular income taxes.
Think of a fixed annuity as a CD, or Certificate of Deposit, but it is tucked inside a tax-deferred wrapper. Instead of the bank guaranteeing your interest rate, the insurance company is providing the guarantee.
The interest-rate guarantee typically runs for about one to ten years, at which point you can continue the annuity at whatever rate is then offered, or you can exchange it for a different type of annuity, or (like a CD) you can cash it in and decide to invest the funds elsewhere.
If you cash it in, you will owe taxes on the accumulated tax-deferred interest.
Fixed annuities are best compared to other safe investments like CDs, agency bonds, or municipal bonds. One thing to watch out for are fixed annuities that lure you in with a high initial rate, but the blended interest rate over the life of the contract may end up being quite low. Look for “yield to surrender” to determine what the rate would be over the life of the annuity.
Fixed annuities can also come in many sub-categories. An equity-index annuity, for example, is a form of a fixed annuity.
With an equity-index annuity, the insurance company offers a minimum guaranteed return with the potential for additional returns by using a formula that ties the increases in your annuity account to a stock market index.
For example, assume you buy an equity-indexed annuity that is tied to the S&P 500 Index. It might allow you to participate in 80% of any increases in the stock market index as measured from January 1 to December 31 each year, with a 10% maximum return in any one year, and a 3% minimum return.
Equity-index annuities can sound like the best of both worlds, a minimum return and the ability to earn more?! Watch out though - the participation rate, 80% in the example I just used, and the cap, which was a maximum of 10% return in my example, both limit the upside return potential.
When factoring this in, research studies have shown that over various five-year time periods, equity-index annuities can be expected to deliver results much like five-year CDs. This is not a bad thing – just something to be aware of. As long as you understand you are buying something more like a CD and less like an investment in the stock market, these can be solid contracts.
Many of these equity index annuities also offer a feature called a guaranteed income rider. This type of rider is an extra guarantee that you purchase which spells out the amount of future cash flow that the insurance contract will payout starting at a specific age.
The last type of annuity I want to cover in this podcast is a variable annuity.
First, let’s take a step back. Various federal and state licenses are required to sell insurance and investment products. It requires an insurance license to sell an annuity. The fixed annuities we have discussed, both immediate and deferred or equity-index, only require an insurance license. To sell a variable annuity, the agent must also carry a securities license, as a variable annuity has a component that is invested in market-based investments.
To put this in perspective, the planners at my firm, Sensible Money, can give advice on how an annuity fits into your plan, and what type might work for you, but they cannot collect a commission from the sale of a product, so no insurance or securities licenses are required. Instead, we require designations such as a Certified Financial Planner and Retirement Management Advisor, which signify a specific type of education. A license signifies that you are legally allowed to collect a commission for the sale of a certain type of product. I discuss this topic in Chapter 12, “Whom to Listen To”.
Ok, back to variable annuities.
With a variable annuity, you choose a selection of investments within the insurance contract. These investments function like mutual funds, although they are not called mutual funds. Within an annuity they are called separate accounts.
Variable annuities also come with optional death benefit features which guarantee what will be paid to your beneficiaries upon your death. And they offer living benefit features that guarantee how much you can withdraw each year without running out of money. Each of these features has a cost.
There are five categories of fees in a variable annuity. There are:
- Mortality and expense charges
- Administrative expenses
- There are investment expense ratios
- Surrender charges if you cash in the contract early
- And there are additional costs to the death benefit and living benefit riders
When you add all this up, it is not uncommon for me to see variable annuities with total fees of 3 – 4% a year. I get really frustrated when I see these products sold as the Swiss Army Knife of investments, as if they do everything… I’ve seen people make it sound like you can’t lose with this product.
In reality, what can happen is the fees are so high that the investments can’t grow fast enough to recoup the fees, and you are forced to rely on the minimum guarantees offered by the insurance company. Let me explain with an example.
Many variable annuities offer a feature called a guaranteed lifetime income rider or guaranteed withdrawal benefit. Too many people who buy these products think this is a guaranteed investment return. It’s not.
Think of it like this. Picture two wallets. In Wallet 1, is the money you put into the variable annuity. It grows based on the performance of the investments you choose, and fees come out of it. When you take a withdrawal, it reduces the amount in Wallet 1, just as if you took a withdrawal from your bank account.
Wallet 2 is an enhanced image of Wallet 1. Think of it like a holograph. It’s not real money. It’s an accounting entry that the insurance company uses to calculate the amount of guaranteed income you can later withdraw. The advantage to Wallet 2 is that even if Wallet 1 becomes empty, because the investments do not do well, you can continue to receive the guaranteed income amount specified in the calculations based on Wallet 2.
If Wallet 1, the real money, does grow fast enough, you’ll be able to draw out more than the guaranteed amount. But, if the investments in Wallet 1 do not do well, or, if the fees are so high that they can’t do well, then you can always rely on the guaranteed income provided based on Wallet 2.
There is nothing wrong with this structure; however, Wallet 2 is not real money. You can’t cash in the annuity and take what is in Wallet 2. With Wallet 2, you can only get the minimum amount of withdrawal each year. I have met many people who bought this type of product and did not realize that Wallet 2 was an accounting entry. They thought it was a guarantee of the principal amount of money they would have. Many feel betrayed when they find out how the product actually works.
If you already have such a product, what should you do? Well, don’t do anything until you have a plan. As planners, we do an analysis on products before making any decisions. In some cases, products that are several years old offer valuable guarantees that can’t be purchased any more. When I come across these cases I recommend the person keep the product.
In other cases, the best use of the product is to turn on the guaranteed income stream and use the features provided by Wallet 2.
And in some cases, if there are no more surrender charges, it makes sense to exit out of the contract and put the funds into something with lower fees.
In conclusion, when you look at all the bells and whistles that you can add onto a variable annuity, it makes them one of the most complex consumer financial products I have ever come across. From what I see, many of the representatives who sell these products don’t understand them. They often misrepresent the product simply because they don’t know any better.
My biggest frustration with annuities is they are frequently recommended without any analysis on how they fit in with the client’s holistic plan. What do I mean by holistic plan? Let me give you an example.
In 2007, I worked with a client who had IRA accounts that I managed. One of their parents passed, and they received an inheritance of about $200,000. About the same time, they met an annuity agent. This agent recommended they put the $200,000 of inherited money into an equity-index annuity. They never discussed it with me and told me after the fact. They still remember the horrified look on my face when they told me. I was horrified because it was hard for me to grasp why they would not have asked me to do an analysis before making the decision. These products have incredibly large surrender charges, so once it is purchased, there is not an easy way out.
There was nothing wrong with the product. However, from a tax perspective, it would have been better if they used $200,000 of IRA money to buy the equity-index annuity, and then we would have invested the $200,000 of inherited funds in a portfolio of investments that would qualify for long term capital gain and qualified dividend tax rates. The overall outcome would have been the same amount of guaranteed income. But, based on their tax situation, by owning the annuity in the IRA it would have significantly reduced their tax bill over their lifetime.
Holistic planning would have saved them money.
In conclusion, annuities are not good or bad investments. They are simply one of many tools available to help you plan out your retirement income, and they are best evaluated as part of a plan.
Thank you for taking the time to listen today. Chapter 8 of the book Control Your Retirement Destiny has additional content that covers various types of annuities in more detail. Visit amazon.com to get a copy in either electronic or hard copy format.
You can also visit sensiblemoney.com, to see how a staff of experienced retirement planners can help.
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