Annuities as retirement savings options: The good, the bad and the ugly
Although annuities have been getting terrible press of late, the products themselves are not inherently evil. (To borrow a saying from the National Rifle Association: "Annuities don't kill finances, salespeople do.")
However, having formerly been in the insurance/annuity business for many years, I can attest to the fact that the large (5 percent to 10 percent) upfront commissions and corporate pressure (as in, "Sell 10 of these by the end of the year and the company will send you and your wife to Jamaica for a week") are huge sales inducements for folks whose compensation is, for the most part, commission-based.
This tends to lead to a sales process in which the positive aspects of annuities are stressed while the downside is, for the most part, ignored. Here is a brief annuity primer that covers the good, the bad and the ugly of annuities.
1. Single-premium fixed immediate/deferred annuities. These products are purchased with a lump sum of money and offer a guaranteed source of income for retirement, but once purchased, they have substantial surrender fees for liquidation.
An immediate annuity, also known as a single-premium immediate annuity (SPIA), begins paying out income immediately after you have purchased it with a single, lump-sum investment. A deferred immediate annuity, also known as a single premium deferred annuity (SPDA), provides an accumulation period until it begins paying out income at a future date after you have purchased it with a single, lump-sum investment.
Individuals approaching retirement age may choose these types of annuities because they allow seniors to supplement Social Security income and pension plans that might not provide enough income to cover basic retirement-living expenses.
Immediate annuities can provide periodic lifetime payments or payments for a fixed period of time or for you (and your spouse if you wish), depending on which options you choose. If the immediate annuity is nonqualified, meaning you have purchased it with after-tax dollars, only the earnings will be subject to income tax, which you must pay each year at your ordinary rate. It is rarely a good idea to use qualified — individual retirement account or 401(k) plan — money to purchase a fixed annuity.
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Pros:
Safety: As with any annuity, your risk can be transferred to the insurance company. If the immediate annuity is fixed, your premium goes into the company's general fund to be invested in bonds and stocks, and the interest rate cannot go below a certain minimum. Also, every state has an insurance guaranty association that offers backup protection in the unlikely event the insurance company that sold you your annuity cannot honor its obligations.
Tax-deferred growth: The income payments for non-qualified immediate annuities are based on a combination of principal returns, which are not taxed, and payout of income, which is taxed at income tax rates.
Mortality credits: Risk pooling, or the spreading of risk across many accounts, allows premiums from annuity owners who die prematurely to be used to pay benefits for those who live beyond their life expectancy. These mortality credits can help increase your returns above those of other investment options and, by choosing a lifetime benefit option, you can hedge against ever outliving your available assets. In fact, depending upon how long you live, your annuity can actually pay you more money than you originally invested plus what your account has earned in interest or capital gains.
Cons:
Loss of control: The most significant drawback is that immediate annuities are irrevocable. Once your lump-sum payment has been exchanged for periodic distributions, you no longer have control of or access to your money. That means funds may not be available for emergencies or any other use.
Loss of purchasing power: If your annuity has a fixed rate of interest that is lower than the rate of inflation, your money is not working for your benefit.
Expenses: All annuities carry fees, commissions and administrative charges that are usually higher than those that accompany other investments.
You should always make sure the insurance company that issues your annuity is highly rated by any of the financial institution rating agencies, such as Moody's, Fitch, Standard & Poor's or A.M. Best.
2. Deferred variable annuities: A deferred variable annuity is a long-term, tax-deferred investment product in which money is invested into the account with a single premium, multiple premiums or regular contributions. The annuitant decides if and when they want to convert the accumulated value into periodic payments as supplemental income during retirement. It is rarely a good idea to use qualified — individual retirement account or 401(k) plan — money to purchase a variable annuity.
Deferred annuities have two main phases: accumulation and income. During the accumulation phase, your premiums are invested in mutual funds that invest in stocks, bonds and other short-term money market products called subaccounts. Your rate of return is linked to the performance of your sub-accounts.
The income phase, which is also known as the distribution phase, begins after the money has accumulated for a certain time period. During the income phase, you will receive regular payments from your annuity. Even with non-qualified money, annuitants must wait until age 59½ before withdrawing funds from these accounts or face income tax and a 10 percent penalty for taking out money before that age. The distribution stage can start at any time after age 59½.
Pros:
Tax-deferred investment: You only pay taxes once the distribution stage begins, generally after the age of 59½. In a non-qualified annuity, only the earnings are taxed as ordinary income at your current tax rate. Again, it is rarely a good idea to use qualified (IRA or 401[k] plan) money to purchase any annuity.
Safety: Annuities can only be sold by insurance companies. Unless the company goes bankrupt, there is little chance of losing your money. Also, every state has an insurance guaranty association that offers backup protection in the unlikely event the insurance company that sold you your annuity cannot honor its obligations.
Bypassing probate: Since an annuity is an insurance product, it can be left to heirs without going through the probate process.
Death benefits: A death benefit rider to your annuity contract ensures that if you die before the distribution phase begins, your survivors can still receive the premium payments less withdrawals.
No contribution limits: Unlike with IRAs, the Internal Revenue Service places no upper limits on the amount you can contribute to your deferred annuity.
Cons:
Lack of liquidity: Withdrawals during the contract's first several years will incur a surrender charge for withdrawals over a certain percentage of the account balance. In addition, if you are under age 59½, you will owe the IRS a 10 percent penalty for any withdrawal you make.
Risk: If you have a variable annuity, your principal is subject to market risk.
High tax rates on earnings: Unlike the lower capital gains rates that apply to investments in stocks, bonds and mutual funds that are held for more than one year, earnings from your deferred annuity are taxed at your ordinary income rate, which may be higher.
No step-up basis: Other types of investments such as stocks, bonds and mutual funds receive a step-up in cost basis when you die; proceeds from most deferred variable annuities do not receive the same treatment.
High cost: Variable annuities can be expensive because of mortality and expense charges, administrative fees, funding expenses, subaccount expense ratios, charges for special features and riders and high commissions for salespeople.
Again, you should always make sure the insurance company that issues your annuity is highly rated by any of the financial institution rating agencies, such as Moody's, Fitch, Standard & Poor's or A.M. Best.
(Editor's note: This guest column originally appeared on Investopedia.)
— By Gary Brand, vice president of client services, The Goff Financial Group
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