Annuities. Yes, you read that right. I am writing about one of the most hated words in all of retirement. For those of you who have had a bad experience with annuities in the past, or have misgivings towards them, I invite you to give me a chance to help you better understand why even many financial planners who have been against annuities for decades are finally changing their tune. And, I’ll give you a hint. It has a lot to do with the fact we’re all living longer than our ancestors did, and interest rates are in the toilet.
As a parent of six children, one of the fun experiences you have at times is trying to get your children to eat things. They’ve already built up some type of bias towards certain foods. My youngest son, Joshua, is definitely pickier than my other five children. We tend to have more of these food experiences with him than we’ve had with any of our other kids.
One of these experiences happened just a few months ago. I brought a food home from the grocery store, and after looking at it, Josh was just sure it was going to be nasty. It happened to be a food I really liked that I had been able to get during the last five years while we’ve been in Puerto Rico. Being the good dad that I am, I was completely fine letting him believe the food was going to be everything he expected—yucky and nasty—because that meant there would be more of it left for me.
However, then my wife stepped into the situation. She didn’t realize I was completely okay with Josh not trying this new food, so she insisted he try it. Yes, I’m sure you’ve guessed by now what happened?
He fell in love with the food and ate the rest of it, leaving not even a small sample for me. Now, why do I tell you this story? Because I believe there are a couple of great correlations to annuities.
Number one, you should never discount annuities without getting a full understanding about how they might help your retirement. Number two, know that there is a group of people out there who are hoping you won’t buy an annuity similar to how I didn’t want my son to try the food.
These people are those who already have annuities and are wanting to buy more. Because unlike so many other things in the world, there is a fixed amount of annuities that can be sold. The part of the annuity that makes it so great is that it has mortality credits. These are the extra credits you get because other people who have purchased an annuity die before they get all their benefits. Therefore, there is a finite number of these credits.
The best place I can start when talking about annuities is with a big picture overview of what they are. An annuity is a contract. You are often referred to as the annuitant to an insurance company. As with any other contract, there are promises that are being made by both parties.
You’re promising to make contributions to the insurance company, and the insurance company is promising to pay you a certain amount of money on a periodic basis or for a specific period of time. Maybe a different way to look at what annuities are would be to look at your Social Security.
You make contributions to the program throughout your working years, and then the federal government guarantees you a check on a monthly basis for the rest of your life. I always find it interesting that so many people can love Social Security and hate annuities when they’re both designed to accomplish the same thing, which is to provide you with a guaranteed stream of lifetime income.
Anyway, I will try not to digress on this topic. Many people will lead you to believe that an annuity is a tax advantaged investment. However, I think we need to look at this a lot closer today than people have in the past. The argument for annuities being a tax advantaged asset comes from the way the growth works inside of the annuity.
Most annuities are structured where the investment earnings grow tax free until you begin to withdraw the income and the power of zero paradigm. This is called the tax deferred income. The belief for most people has always been that tax rates are going to be lower in the future than they are today. So, take advantage of tax deferred growth, and then pay the tax at a period of time when taxes are surely going to be lower than they are now.
For those of you who lived in the 70s, this was a great plan because the highest marginal tax rate in the 70s was a whopping 70%. How could taxes ever be higher than this? Well, fast forward 50 years and what we find is we’re in a period of historically low tax rates.
What people are doing by deferring their taxes is compounding a problem they will have no ability to solve in the future. And that future is time in their life. They will have the least ability to replace income that is going to be lost at increased taxes. Now, there are three other misgivings many people have with annuities, and there are valid concerns that need to be addressed.
Number one is the lack of liquidity. Many annuities are structured to where you cannot pull any money out of them besides your annuity payment. Even if you can pull money out of these annuities, they’re designed primarily for retirement purposes, which means you’ll often be subject to fees.
Some of these fees come from the insurance companies and some of these fees come from the IRS if you pull the money out of a tax deferred annuity before you reach age 59 and a half. For those of you who are concerned with this liquidity issue, be aware there are many annuities out there now that will allow you to work around this misgiving.
Number two is the cost of an annuity, which is another big issue that needs to be taken into consideration when looking into annuities. This is one of the biggest problems many people have with annuities is they can have very high fees. What I found from my 20 plus years of experience in dealing with annuities, though, is that when you have exuberant fees, it’s because you have a bad advisor who is working for a bad insurance company.
When annuities are sold, commissions are paid, and unfortunately, that can be too much of a temptation for some bad advisors. So, they get what I call commission breath. They focus on their pocketbook rather than your success. They take high commissions and put the onus of paying for these commissions right back on you.
What I recommend if you’ve had this experience in the past or if you have it in the future, is that you don’t throw the baby out with the bathwater. Just because there are some bad advisors and bad insurance companies out there selling bad products, it doesn’t mean that all annuities are bad, and that they can’t play a very important part in your retirement that will be one of the longest self-imposed periods of unemployment most people are ever going to have. You need to remember annuities provide benefits other investments can’t, including mortality credits. Make sure you include all these benefits when looking into the fee structure of the annuity..
Number three is the Mack truck factor. The Mack truck factor is the risk that you take all of your retirement savings, convert them into an annuity, and then die the next day after being hit by a Mack truck, having received your guaranteed stream of lifetime income, although it was only for a day, but losing out on being able to transfer the remaining asset value of the annuity to your beneficiaries. Luckily, forward thinking annuity companies have made updates to their products, allowing you to eliminate the Mack truck factor from the equation.
Let’s now take a minute and talk about how annuities work.
When it comes to annuities, there are two main categories, and they’re different based upon when they begin to pay out. The first one is an immediate annuity, and the second is a deferred annuity. The immediate annuity is referred to as a single premium index annuity or what the industry often refers to as a SPIA. With a SPIA, you give the insurance company a lump sum of money, and then you start receiving payments right away.
When you start receiving these payments, they can be either a fixed amount or a variable amount, based upon the contract you choose to enter into. Typically you might choose a speed if you have a one time windfall such as an inheritance. People that are close to retirement may also take a portion of their retirement savings and buy an immediate annuity. This is a way to supplement their income from Social Security and other sources.
But you need to make sure you look at the paperwork because most spheres will be subject to the misgivings we talked about earlier—that deferred annuities are structured to allow you to accumulate capital over your working life, and then convert this capital into an income stream and retirement. The contributions you make to the annuity grow tax deferred until you take income from the account. This period of regular contributions and tax deferred growth is called the accumulation phase. You can purchase a deferred annuity with a lump sum, a series of periodic contributions, or a combination of the two.
There are some cool things deferred annuities offer that SPIAs often don’t. They can help you overcome the issue with lack of liquidity and the Mack truck factor by providing you with an alternative to take up to 10% of the account balance without penalty, and by allowing you to receive any remaining contribution balance if you die before the assets are liquidated.
Another option I recommend for those I work with is to include these annuities inside of their Roth IRA. That way they can also eliminate the future problems you will encounter with tax rate risk because now the annuity becomes tax free within the broad categories of immediate deferred annuities. There’s also several different types of annuities from which to choose. These include fixed, indexed, and variable annuities.
A fixed indexed provides a predictable source of retirement income with relatively low risk. With a fixed annuity, you will receive a specific amount of money every month for the rest of your life or another period of chosen time, such as five years, ten or even twenty years. Fixed annuities offer the security of a guaranteed rate of return regardless of whether the insurance company earns this affects efficient return on its own investments to support that rate.
In other words, the risk is on the insurance company, not you. That also means that you’re going to get a much lower rate of return, which can also be problematic when you go with an investment that should be safe and productive. The downside of a fixed annuity is that if the investment markets do unusually well, the insurance company, not you, will reap all the benefits. What’s more, in a period of serious inflation, the low paying fixed annuity can lose spending power year after year.
The next type of annuity is an indexed annuity. Indexed annuities, also called equity indexed or fixed indexed annuities combine the features of a fixed annuity, with the possibility of some additional investment growth, depending on how the financial markets perform. You’re guaranteed a certain minimum return plus a return pegged to any rise in the relevant market index such as the S&P 500. This is a type of annuity I recommend with most of my clients because you can alleviate all the misgivings of a spear but also get productive growth and be able to put it into the tax free environment of a Roth IRA.
The last type of annuity is a variable annuity. Rather than being tied to a market index, as indexed annuities are, variable annuities provide a return that’s based on the performance of a portfolio of mutual funds you’ve selected. The insurance company may also guarantee a certain minimum income stream if the contract includes a guaranteed minimum income benefit option. Because the volatility of a variable annuity, this type of annuity should generally only be used with very complex planning.
When it comes time to annuitize the annuity, there is a mathematical calculation performed. When it comes time to take money out of the annuity, the primary factors that go into the calculation are the current dollar value of the account, your current age, the longer wait before taking income the greater your monthly payment will be, the expected future inflation adjusted returns from the accounts assets, and your life expectancy based upon industry standard life expectancy tables.
Finally, if you have any spousal provisions included in the contract, they’ll be factored into the equation as well. Most annuitants choose to receive monthly payments for the rest of their lives and their spouses lives in case their spouse outlives them.
I hope I’ve accomplished two things: first, giving you a better understanding of annuities and how they work, and second, helping you realize that all the misgivings people have had in the past when it comes to annuities can be overcome by using annuity products provided by forward thinking insurance companies.