Search
More About This Website
Content can appear here in your navigation bar, too. You'll be able to put content in this area just as easily as you can edit and add journal entries. See your website manager for more information.
Subscribe
No RSS feeds have been linked to this section.
Login
Powered by Squarespace
« Market Risk: It's Everywhere! It's Everywhere! Part 1 | Main | Our Legacy »
Saturday
Feb162008

Annuities: Their Uses and Abuses

As we "baby-boomers" contemplate retirement, the big question we all have is "Will my money last as long as I do?"  Until we can answer that question in the affirmative, we need to be very careful about burning bridges at work.  There are plenty of folks in the financial services industry anxious to help us plan our successful exit from the work world, and many of them are pushing  annuities.  In some cases, an annuity may even make sense.  Those cases are few and far between in my opinion, so let's take a look at annuities and what they can accomplish.

An annuity is simply a contract between you and an insurance company.  Virtually all annuities include some element of life insurance in their contract, but it is usually insignificant and certainly no reason for purchasing one.  In its most basic form, the fixed annuity, you give the insurance company a sum of money and the insurance company promises to make periodic payments to you (or someone else whom you designate as the annuitant) for as long as the annuitant lives.  The amount of these payments (typically monthly) are dependent upon how much money you paid, what the interest rates were when the contract was finalized, and the age and life expectancy of the annuitant.  Fixed annuities are just that: fixed.  The rate of return on your investment may be reset from time to time to reflect changes in the prevailing interest rates, but once you begin taking payments, everything is usually fixed for the rest of your contract period.  Make sure that you like the terms.  Changing them later gets complicated and very expensive.

If your contract specifies that payments to you will begin within the year, you have an immediate annuity; if they do not begin until some time later in the future, you have a deferred annuity.  With either of these as a fixed annuity, you have the guarantee of specified payments for a specified time period.  You may choose from an array of payout periods: your lifetime (life only), the life of you and your spouse (joint and survivor), or a time certain period, i.e. twenty years (life annuity with period certain).  How long you choose to receive you payout will affect the size of your monthly check.  So with  a fixed annuity you know what your monthly check will be.  It will provide you with  steady retirement income, but this steady retirement income can and will be eroded by inflation.  For a price, you can have your payments increased periodically in an attempt to offset inflation.  The cost, of course, is that your payments will begin at a lower level.  There is always a cost, isn't there?

The immediate fixed annuity is relatively simple and the one that offers the best value and best fit into most of our retirement plans. But annuity sales departments have been busy and have brought out an array of new products  in an attempt to have something for every financial situation.  Just remember, as more bells and whistles are added to an annuity, the annuitant will pay with a decrease in his monthly payout.

Rather than fund your annuity with a lump sum, you may choose to make periodic payments over a period of time called the accumulation phase.  This period can be for several years if you so choose.  You can forgo the fixed annuity altogether and opt for the variable annuity, the one that has enjoyed the most sales recently.  In this model, a portion (perhaps all) of your purchase money, or premium, is used to buy shares of a diversified investment portfolio.  You will be offered a number of mutual-fund like options called sub-accounts, and you will determine the percentage of each payment that will be invested in each sub-account.  Your ultimate payout will be determined by your investment savvy and the performance of your chosen portfolio.  Almost all variable annuities sold today are of the deferred variety where your premium payments are made over a number of years prior to your receiving any annuity payments.  Variable deferred annuities offer the guarantee of some income during retirement as well as the potential of benefiting from investing in stocks and bonds.  They also offer the investment risk associated with any investment in those markets.  Like any deferred annuity, they also allow you to defer payment of taxes on your account's investment gains until you begin receiving payments.  At that point the portion of your payment attributable to investment gains will be taxed as ordinary income.  That is one of the disadvantages of such annuities: you forgo the lower tax rate normally levied on dividends and capital gains.  All of the investment gain is treated as ordinary income by the IRS.

A recent innovation by the annuity folks is the equity-index annuity.  This is a form of a fixed annuity where the contract is tied to a stock index (e.g., the S&P 500 index) that provides the opportunity to earn a return better than those in a traditional fixed annuity, but less than those of a direct investment in the market itself.  In this contract, the insurance company chooses the investment mix.  While the purchaser has no choice in the investment itself, he/she is able to participate to a degree in the stock market gains during a rising market.  If stocks fall, the contract guarantees a minimum return, typically 3%.  Thus, the equity-index annuity has less downside risk than does the variable annuity.  This is the feature that is trumpeted the loudest by annuity salesmen, and it is attractive if you are terrified of an investment in the stock market.  The catch is that this annuity allows its owner to "participate" in only a portion of any upward move in the underlying index, typically 80 to 90 percent of that upward move.  This participation rate may even be as low as 50% with some companies.  This type of annuity comes with a very complicated contract difficult for the layman to understand.  They also often come with other expenses that detract from their value such as high sales commissions and various management fees.  In my opinion there are any number of options which will serve you better than the equity-index annuity.  By simply holding a well diversified portfolio of stock, bond, natural resource, and REIT (real estate investment trust) mutual funds, one will face far less onerous fees and achieve better long-term results than with this type annuity.  At least that is what the insurance company is counting on doing or they would not make such guarantees to their equity-index annuity holders.

There are very few times when purchasing an annuity makes sense to me or to many financial planners (unless, of course, they are trying to sell you one).  If, after maxing out your 401k, fully funding your and your spouse's IRAs, saving for your child/children's college fund, and making every other tax-advantaged contribution you can find, you still have extra funds to save, an annuity will offer another tax-advantaged way to save.  Even then the argument can be made that an investment in a non-tax-advantaged vehicle may offer a better opportunity.  Annuities are notoriously illiquid as most have lockup periods from 5 to 9 years during which you will pay a very hefty penalty for access to your money.  You will also pay the IRS a 10% penalty, on top of any surrender charges the insurance company may impose, if you need that money prior to your turning 59 and one-half years old.

So, with this little bit of annuity information, let's summarize the pros and cons of annuities as I see them.  First the cons:

  • Variable annuities are an expensive way to invest in the stock market.  Many carry high commissions and annual fees around 2%; you have to make 2% on your investment just to overcome this expense.
  • Many offer mediocre, at best, investment choices.
  • All annuities lack liquidity
  • Annuities turn capital gains and dividends into ordinary income for tax purposes.
  • Typically, you relinquish control over funds that you may have annuitized, and you will not leave any of those funds in your estate if you have begun taking payments from a fixed annuity at the time of your death.  If you die shortly after beginning your payments, too bad for your heirs; the company selling you the annuity just made a very good deal for themselves.  Thus if you are in poor health, a fixed annuity (life only) may not make sense. 
  • Your heirs will also pay ordinary income tax on any appreciation if you leave an annuity in your estate.

Now, the pros:

  • Annuities can offer a guarantee of an income for as long as you live.  Fixed annuities are the way to go for this benefit.
  • Annuities do offer a tax deferred way of growing you retirement savings.
  • Annuities do offer some life insurance benefit in their contracts.

In my opinion, the cons outweigh the pros.  There is one case, however, where I think an annuity makes sense.  If you are facing retirement without a pension in some form, other than Social Security, you may find that an immediate fixed annuity will fit nicely into your financial picture.  The ideal scenario is to have your fixed expenses each month (food, housing, insurance, utilities, etc.) covered by income that you absolutely know will be there.  A fixed immediate annuity can accomplish this goal.  Then you can tap your other savings for discretionary expenses (travel, entertainment, etc.) and futue inflationary pressures.  By turning part of your retirement savings (no more than 20%) into an annuity you greatly increase the odds of your never outliving your savings.  An article in the December 2001 issue of the Journal of Financial Planning discussed this issue, and the research that supported it, in length; and made a very persuasive case for this idea.  You can go to www.immediateannuities.com and quickly determine how much a fixed annuity may offer you.  For example, a 65 year old man in Tennessee recently could realize a lifetime payment of $675 per month for an initial premium of $100,000.  This is the one case where I think an annuity can make a compelling contribution to one's retirement security.

If you are interested in an annuity purchase, you should begin by talking with either the Vanguard Group, Fidelity Investments, or TIAA-CREF.  These three firms offer some of the best deals on annuities, are all low-cost providers, and are known for their customer service.  Additionally, they all have very user-friendly web sites.

All annuities, especially the equity-index variety, are fairly complicated.  Make sure you thoroughly understand what you are buying prior to parting with any of your money.  You should never buy any financial product that you do not thoroughly understand.  In short, make sure that you are "buying" the product and not being "sold" the product.  This is especially true for annuities.  I strongly suggest you talk with a trusted financial advisor before making any annuity purchase.

I realize this discussion was less than titillating and inspiring; dare I even say dull?  There are so many financial services folks hawking these products though, that I wanted to share my views regarding their uses.  I borrowed much for this article from the Wall Street Journal edition of November 14, 2007; a Motley Fool article: Annuities: What's to Like?; and the Complete Retirement Guidebook by Glenn Ruffenach and Kelly Greene.  I hope this gives you some info on annuities and something to think about.

Coming soon:  Where to put our savings now!

 

Fly/Drive Safely!

PrintView Printer Friendly Version

EmailEmail Article to Friend

References (59)

References allow you to track sources for this article, as well as articles that were written in response to this article.
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: Lindsay Lohan
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: dieta da usp
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: Zen Body review
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: medi weight loss
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: Rosacea Skin Care
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: revive skin care
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: qr.net
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: skin care Products
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: getdomain4free.com
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: themenra.com
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: local.google.com
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: diet chef
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: can t build muscle
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: Not working?
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: http://3dvf.me/
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: gg.gg
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: aws-web.net
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: Rev Test
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: Procellix
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: seo houston
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: boys baby names
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: her latest blog
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: Ceuticell Reviews
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: Audiobook Jungle
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: EXTRA RESOURCES
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: avataria hack
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: avataria hack
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses
  • Response
    Response: fruta plant
    Retirementflightplans - Journal - Annuities: Their Uses and Abuses

Reader Comments

There are no comments for this journal entry. To create a new comment, use the form below.

PostPost a New Comment

Enter your information below to add a new comment.

My response is on my own website »
Author Email (optional):
Author URL (optional):
Post:
 
Some HTML allowed: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <code> <em> <i> <strike> <strong>