Updated: May 3, 2013 12:14PM
Originally published: August 1, 2007
Would you like a check a month for life or the next 30 years? You don’t have to win the lottery to get this kind of reliable income stream, but chances are your broker or financial planner won’t be anxious to tell you how it can be accomplished.
A brief mention of annuities in last week’s column brought this reminder from my long-time annuities expert Jerome Alexander (847-564-9371). Alexander, who runs a financial planning service, says this is an opportune time to consider purchasing an immediate annuity, which will pay out fixed monthly checks for 20 or 30 years.
Immediate annuities have gone out of style in recent years.
People would rather speculate in the stock market than accept a lower, guaranteed return. With an immediate annuity you give the insurance company a chunk of after-tax cash to invest and it immediately starts paying you that regular check. The amount of that check depends on the period of time guaranteed - or your life expectancy if you choose an annuity guaranteed to last as long as you do. It also depends on the current level of interest rates, so the insurance company can hedge its promise to continue paying you.
Many planners caution that tying up a chunk of cash in return for the promise of a fixed monthly check limits your ability to make investment changes to keep up with future inflation or lifestyle changes. And they warn that part of the monthly check you’ll be receiving is a return of your own capital. At the end of the immediate annuity period, whether 20 or 30 years, you’ll have completely depleted your cash.
Alexander counters that a bit of searching will turn up immediate annuities with an internal rate of return greater than 7.5 percent. He says those monthly payouts, which are partially a tax-free return of capital, offer substantial security against all but the most devastating inflation. And he advises choosing an annuity term that covers your life expectancy so you won’t worry about running out of assets - or just to annuitize part of your retirement funds. The real reason planners don’t recommend immediate annuities, he says, is that commissions on these products are in the range of 2 percent, compared to 4 percent or even more on mutual funds or life insurance products.
Although immediate annuities seem to be almost a secret, many people have heard a lot about tax-deferred annuities lately. With a tax-deferred annuity, you give the insurance company a lump sum of cash (or monthly installments) of after-tax dollars. Money invested in these deferred annuity contracts grows tax-deferred in either a fixed rate investment or in mutual fund ``separate accounts.’’ When you withdraw the cash from the annuity in the future, the gains come out as ordinary income. Even with today’s low capital gains rates, and in spite of high costs and surrender charges, these tax-deferred annuities are attracting about $100 billion a year in new investments.
But relatively little money is put into immediate annuities.
Those individuals who do opt for a monthly check are typically retirees who accept whatever monthly deal is being offered by the financial services provider at their company. That could be their biggest mistake. Not all companies offer the same size check for the same initial deposit. Alexander points out that shopping around for the best immediate annuity deal from top-rated companies could result in a 30 percent difference in the amount of the monthly check.
For example, a 65-year-old man or woman could deposit $100,000 into an immediate annuity with a guaranteed period of 30 years, and receive a monthly check of $654.96. A portion of that check - 42 percent - is considered a tax-free return of capital. That totals $7,859 a year - or a total of $235,785 over the next 30 years. The implied interest rate is 7.6 percent.
But other companies have quoted monthly checks as low as $458 a month for the same deposit and the same term. The difference of nearly $200 a month could make a big impact on your retirement lifestyle. That’s why it pays to compare offerings from different insurance companies - of course using only sound financial institutions. And by the way, you don’t have to have $100,000 to purchase an immediate annuity. Most companies will start with as little as $20,000.
Here are a few things to consider when purchasing an immediate annuity: If you purchase a life-only annuity, you can never run out of money - even if you live far longer than the actuarial statistics predict.
But if you die early, the insurance company gets to keep the balance in your account.
That’s why you’ll probably be better off purchasing a term-certain annuity for a period of 20 to 30 years. If you die during this period, your heir will continue to receive the promised monthly check for the balance of the period. Perhaps your spouse will be your heir. Then when your spouse dies, your child will continue to receive the monthly check.
Ordinarily you’d never want to put a tax-sheltered retirement account into an annuity. After all, retirement money is already tax-sheltered, so why pay for an annuity contract? But there is an exception. You might want to put a portion of your IRA rollover into an immediate annuity contract, and get a monthly check that will cover the regular withdrawals that will be required once you reach age 70 1/2.
Since all of the IRA money is pretax, all of the monthly check will be taxable income - as with all IRA withdrawals. But you won’t have to worry about calculating withdrawals - and the balance of your cash can continue to grow in other investments in your rollover IRA.
Check with an actuary to make sure the monthly annuity distributions will cover your withdrawal requirements.
There are some drawbacks to an immediate annuity. Once you’ve started on such a plan, you can never change your mind. Whether interest rates rise, or life circumstances change, you’ll have to stick with the deal you’ve made. And there are some estate tax implications. Your heirs will have to pay ordinary income taxes on the same portion of the monthly checks that is considered income, as opposed to a return of capital. If you had invested in a mutual fund, heirs would inherit shares income tax-free, and at a new stepped-up cost basis as of the date of your death.
For all these reasons, you should get professional advice about how an immediate annuity will apply in your situation. Perhaps only a portion of your cash belongs in an immediate annuity, and the balance could then be invested with more opportunity for growth of principal. Just don’t overlook the peace of mind seniors may buy when they opt for that regular monthly check.
Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil Co. You can send her questions via e-mail at firstname.lastname@example.org. Her second book, published by HarperCollins, is Terry Savage’s New Money Strategies for the ‘90s. Copyright Terry Savage Productions.