September 2010

September 2010: WHAT YOU NEED TO KNOW ABOUT - Annuities

Author: Lew Wessel | Photographer: Photography by Anne

Maybe you’ve seen it on YouTube: Suzy Orman is on MSNBC saying absolutely, definitely, no way should anyone buy a variable annuity; and then a woman calls in and explains that the basic death benefit in her deceased husband’s variable annuity netted her a bonus $70,000 over the account value. Oh, well…in that case, Suzy retreated, it did make sense.

My point is this: Annuities, like most financial instruments, are neither good nor bad, but instead are either appropriate or inappropriate tools to address a particular financial situation. One thing is certain. They are unique, very different investments from stocks and bonds. And because they are so different and potentially useful, in my opinion, they should at least be considered, if not actually included, in everyone’s retirement planning. Here’s what you need to know:

There are many types of annuities, and they can be difficult to understand, but let’s look first at the plain vanilla type: the single premium immediate annuity, or “SPIA.”

The SPIA is your grandfather’s Buick. It’s been around in pretty much the same form since the 1600s when it was invented by a Florentine banker named Lorenzo Tonti. And who could forget the distress of Balzac’s Père Goriot when he sold his small income annuities to support his no-good spoiled daughters. But I digress…

With an SPIA, you give the insurance company a lump sum of money and, in return, the insurance company agrees to give you a fixed monthly payment for the rest of your life. That’s it. No catches. No hidden tricks. You live to be 120, you still get the check. You die tomorrow, no more check.

Since most people aren’t comfortable with the second part of that equation, insurance companies have come up with variations to the SPIA wherein payments are guaranteed for a specified number of years, usually five or ten, even if you die earlier (“period certain”). In addition, joint annuities are available that will pay until both you and someone else dies; this is usually purchased by married couples, but any two people can be joint annuitants.

The amount of the monthly check is based primarily on the insurance company’s calculation of your life expectancy. This is their calculation of the amount of time they’ll have to be sending those monthly checks. The shorter the time, the larger the check. Other factors in the equation include the interest the insurance company will credit you with during the period, their estimation of their administrative expenses and, of course, a profit. It’s these last factors that can vary substantially between companies, so it pays to shop around.

Are SPIAs safe? At least theoretically, SPIAs are not as safe as a federally-insured CD, but they are clearly one of the safer investments you can make. Insurance companies and annuity contracts are highly regulated, and every state has a guarantee fund backing up immediate annuities should the issuing company fail. South Carolina’s guarantee is up to $300,000 of face value. You should also check out the insurance company’s ratings with the major rating agencies and stick to the larger and higher rated entities.

The ideal retirement plan begins with matching guaranteed lifetime expenses for food, shelter, transportation, medical, etc. with guaranteed lifetime income. In the days of yore, that guaranteed income came from Social Security and a company pension. Today, Social Security remains, but the rest of the equation is up to you. As unexciting and unspectacular as it is, an SPIA is the only investment available that will guarantee a specific dollar amount every month for the rest of your life (and your spouse’s life in the case of a joint annuity).

The key word here is “guaranteed.” Certainly there is a possibility of making more money in the stock market or in some other investment; but, if you truly want to guarantee that you will never run out of money, an SPIA is a guaranteed paycheck for life and a terrific solution.

When the Dow Jones Industrials plummeted from 14,164 on October 9, 2007 to 6,594 on March 5, 2009, a dizzying 53.4 percent drop, it devastated millions of retirees’ financial plans. Take for example, the case of a 75-year-old widower with a portfolio of $1 million, who was counting on withdrawing a “safe” four percent or $40,000 per year to live on. With his portfolio down to around $500,000, his annual withdrawal of $40,000 is now an unsustainable eight percent. His options are to drastically cut his living expenses or, as an alternative, take $300,000 and purchase an SPIA, which at today’s rate, will garner a guaranteed payout of about $30,000 per year for life. This leaves a gap of $10,000 per year to come from the remaining $200,000 portfolio, but now at a much safer withdrawal rate of five percent.

An SPIA is normally used to cover basic expenses, but I’ve also seen it used to fund a guaranteed annual vacation: The “cruise” annuity. My favorite “fun” SPIA use was the grandfather who bought a joint annuity with his grandson and arranged for the annual check to be paid on his grandson’s birthday. While he was alive, the check went to him every year and served as a reminder to wish his grandson a happy birthday. After he died, his grandson, as the surviving joint annuitant, began receiving the check, reminding him every year on his birthday of how much his grandfather loved him. Pretty sweet!

Now that I’ve explained the easy stuff, let’s move on to the deferred variable annuity. This is the investment that really gets Suzy O going. Her main objection, and, of course, she’s not the only naysayer, is that these financial instruments have “very high” fees. Fair enough, but these fees actually pay for some pretty neat guarantees. This investment can be a terrific addition to your financial plan if these guarantees are important to you. If not, by all means, stick to the no-load, low fee index mutual funds or ETFs.

Unlike the SPIA whereby the annuity payments begin immediately upon purchase, the basic deferred VA has an investment growth period called the accumulation phase. During the accumulation phase, your money is actually invested per your instructions in a brokerage-like “separate account” consisting of mutual funds. This is your own separate, individual account, and unlike an SPIA, is not part of the general fund of the insurer. However, by virtue of being in a variable annuity “wrapper,” your account is tax-deferred; i.e. it grows tax-free like an IRA. It also comes with a basic “death benefit”; when you die, the insurance company will pay your beneficiary the higher of your account value, whatever it is, or your investment in the VA less any withdrawals you have made. This basic guarantee, which comes with a cost of about one and a quarter to one and a half percent per year, was pretty much pooh-poohed by financial experts until the reality of the last horrible stock market decade showed just how important it could be.

At some point, you will decide to start taking distributions from your VA. As with other tax-favored retirement accounts, distributions from the VA must begin after age 59 and a half or be subject to a 10 percent penalty. Generally, as with a company 401(k) or the like, the VA owner has the option of taking a lump-sum payout of his entire account value or a lifetime annuity based on that value.

Now things are going to get a little more complicated. These are the variable annuities that not only have the basic death benefit guarantee mentioned above, but also have additional “living benefits,” including guaranteed growth rates in the accumulation phase and a feature called a “guaranteed withdrawal benefit.”

These investments are very complicated because they accomplish a lot in one package. While it’s critical that you avoid investing in something you don’t understand, the best advice I can give is to take the time to learn about these investments rather than rejecting them offhandedly.

There are hundreds of interesting VA’s on the market, and there is no way to explain them in one short article. What I can do is give you a flavor for the genre.

The deferred VA with guaranteed growth rates and guaranteed lifetime withdrawal benefits

These investments are a great solution for someone who is near or just entering retirement, who wants to stay invested in the stock market just in case it rockets up again, but who doesn’t want to risk losing any of the retirement income his investments are intended to generate.

Guaranteed growth rates mean that even if your variable account value (see above) goes down because of stock market performance, a separately calculated “protected” value will always go up by a given annual percentage and/or will ratchet up, but never down, as the stock market goes up. This “protected value” assures that even if your investment portfolio tanks, you will still have the basic retirement income you were relying on.

Guaranteed lifetime withdrawal benefits mean that when you are ready to start collecting income for retirement, you will be entitled, as with any variable annuity, to take your separate account value in a lump sum or a lifetime annuity. However, with a guaranteed lifetime withdrawal benefit, you have a third option: Keep your VA going, but begin to withdraw a percentage of the “protected” value out of your account every year for life (and your spouse’s life in a joint product). This withdrawal amount—typically five percent of the “protected” value at the time you begin withdrawals—does comes out of your separate account, but it is guaranteed for life even if your separate account value goes to zero.

An example: A 60-year-old with a million-dollar portfolio that he is counting on to fund his retirement beginning at age 65 is worried that another disastrous period in the stock market might reduce or even half his portfolio in the next five years. He purchases a typical VA with guaranteed growth rates and guaranteed withdrawal benefits. Now, no matter what happens to the value of his portfolio, he has locked in a retirement income stream from his one million dollars of at least $50,000 per year, or five percent of his original investment. Depending on the minimum growth guarantee of his particular VA and/or the performance of the stock market, his retirement income stream may go higher, but, in any event, his safety net is in place in case the market tumbles.

Which is better, an SPIA or a VA with “living benefits”? Depends. In general, the SPIA will generate more income, but, except for the “period certain,” once you die, the money is gone. The VA with “living benefits” will pay income out at a lower rate, but you can always decide to stop taking withdrawals and take the remaining value of your separate account in a lump sum. When you die, if any value is left in your separate account, it will go to your heirs.

Consult a professional. Take your time. Money is a serious business and never more so than with annuities. These are illiquid long-term investments, so before you lock up a sizable chunk of your assets, do your “due diligence.”

Fortunately, no one can sell an SPIA without an insurance license, and no one can sell a VA without both an insurance license and a securities license. This fact doesn’t guarantee perfect advice, but at least you know you’ll be dealing with someone who’s had some training and is operating in a highly regulated environment.

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