Annuities: Weigh them carefully, and scrutinize the details
The search for secure lifetime retirement income, along with promises of higher interest rates than CDs, has created increased interest in annuities. But, while many annuities are sold with attractive promises, these products have major differences, some of which can be costly or actually detrimental to your investment and retirement goals.
In the interest of full disclosure, I personally own some annuities. They have performed well over the years, and I plan to use them to generate a stream of lifetime income. So I have no personal complaints. But I do want to make sure my readers understand the pitfalls as well as the benefits of tax-deferred annuities.
A tax-deferred annuity with a guaranteed lifetime withdrawal benefit rider gives you the chance to create your own “personal pension fund.” You give the insurance company a lump sum of money, which can grow tax deferred inside the annuity contract. Typically that growth comes as a return tied to a portion of a stock market index, or a choice of mutual fund-like sub-accounts.
How well your money grows inside this tax-deferred annuity depends on your choice of investments. But most also have a minimum guaranteed rate of return, and some have a floor on the downside. You pay fees to get all these attractive guarantees. And with some, you must make some choices about how your money will be invested.
You must also understand that there may be a period of years called the “surrender period” during which you can take only a limited amount of money out of this contract without paying a steep penalty. Annuities are designed to be a long-term investment and most lack 100 percent liquidity.
The real attraction for these annuities is far more than tax deferral. It’s that promise to pay an income over your lifetime, based on the terms of that guaranteed lifetime withdrawal benefit rider. It does not lock you into a fixed monthly payment, but it does offer lifetime payments — with any remaining balance in your account going to your designated heir after your death.
It’s the details of the rider, along with your account growth and your age at withdrawal, that determine your guaranteed withdrawals. Your annuity statement is likely to show you two different “values.” One is the “income base amount” on which they will calculate a promise to give you a guaranteed lifetime income. The other is your “cash value” — the amount you could withdraw in cash. They are not the same.
By the way, if you choose a “guaranteed lifetime withdrawal” plan, you can always withdraw more money if needed (cutting into your income base), and at your death your heirs receive the balance in the “investment account,” less the withdrawals you’ve already taken.
So far, this concept of tax-deferred growth and guaranteed lifetime withdrawals looks terrific to those approaching retirement. You get upside potential, downside protection — and income for life. Who could complain? And that’s how these products are sold to eager investors.
But the devil is in the details, and these details can be very expensive!
Choices, costs and risks
There are significant sales commissions, at least 4 percent, built into most annuity products. All your money goes into the annuity investment account, because the insurance company knows it will make money on the cash you have invested. But they put in those surrender charges to make sure you stick around long enough for them to recoup the commissions they paid to the salesperson.
The insurance companies are experts at creating products to entice you, but you are always paying for those promises.
Let’s start with indexed tax-deferred annuities. They tell you that your return is tied to a stock market index on the upside, but that you have no risk of loss if the market goes down, and no investment management fees.
But with these indexed annuities, you don’t get the total upside return of the stock market in good years. There is likely a “cap” on the return — maybe 5 percent — or a “participation rate,” so you get less than the full return of the index. Or they may not include the dividend component of the index, historically about 40 percent of the total return of the S&P 500. Plus, surrender charges are typically high and extensive.
You might also consider variable tax-deferred annuities. These products give you several choices, called sub-accounts, which can grow your money inside the plan. They look and act like mutual funds, with both upside and downside possibilities. There are always fees and costs for both the annuity itself, and the investment accounts, which eat into the growth you get on your investments, even though the returns are shown “net” of fees.
When you buy a variable annuity with a “rider” that gives you guaranteed lifetime withdrawal benefits (sometimes called living benefits), your statement will show two account values: a guaranteed benefit base growing at a promised rate of return, and another reflecting your investment gains (or losses) on the actual cash value in your account — the amount you can withdraw, subject to any surrender charges.
Some variable annuities may offer attractive promises, such as a “high-water” mark or a yearly high anniversary value of your investments – a guarantee that your investment base for future income withdrawals can never go below that point -- even if your investment accounts subsequently fall in value.
And, if your investment account is worth more than that base account, you can lock it in and take your guaranteed lifetime income off the higher amount, or withdraw the cash.
What to do
These tax-deferred annuities are tempting primarily because of the higher interest rates they promise to credit to your withdrawal base. But you need time to make that money grow. If you are older than age 75, and need income immediately, there is no sense in paying all these annuity fees and creating illiquidity with your money. You may be better off just withdrawing cash on a regular basis — unless you plan to live far longer than average.
But if you’re nearing retirement and searching for the security of lifetime income, tax-deferred annuities with the appropriate guaranteed lifetime income benefit might make sense for a portion of your retirement assets — if you buy the right product.
It’s tough to compare annuities on our own. For advice I trust on this subject, I have always turned to Jeffrey Oster, annuities specialist at Raymond James (Jeffrey.Oster@RaymondJames.com.) Remember, it’s not just the interest rates that matter; it’s the terms and restrictions that make or break the annuity deal.
And that’s the Savage Truth.