Financial Advice for Retirement, Social Security, IRAs and Estate Planning

Annuities As Classic Investment Vehicles

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There’s at least one good effect of the 18-month bear market we’ve endured. Investors are taking a new look at some classic investment vehicles. For example, sales of fixed annuities are rising while sales of variable annuities are declining. I’ve long argued that most variable annuities are sold to the wrong people, and I’ve pointed out that fixed annuities can have a place in a balanced portfolio as a bond substitute.

A variable annuity allows you to invest in a selection of mutual funds, and all gains compound tax-deferred until withdrawn. That’s the good news. The main disadvantages of variable annuities are the high fees and expenses. It can take 10 to 15 years, sometimes longer, for the advantage of tax deferral to overcome the fees. In addition, all distributions from a variable annuity are ordinary income. In effect, you convert tax-favored long-term capital gains into ordinary income. For those reasons, variable annuities are most appropriate for younger investors who can let the gains compound tax-deferred for many years to overcome the disadvantages.

Older investors can use variable annuities for money they don’t expect to need during their lifetimes. But there also is an estate planning disadvantage. Unlike most other assets, the tax basis of a variable annuity is not increased to its fair market value when it is inherited. That’ why there can be better vehicles for an emergency fund that you’d like to leave for heirs.

The neglected investment of recent years, which is coming back into favor, is the immediate annuity. Close behind it is the fixed deferred annuity.

In an immediate annuity, you pay a lump sum to an insurance company. The insurer then begins making regular payments to you. The payments can be monthly or less frequently, depending on the insurer and the option you choose. You select how long the payments last. They can continue for your lifetime, the joint life of you and your spouse, or for a period of years. The longer the payments, the lower each payment will be.

When the payment period ends, there is no money left for you or your heirs. If you choose payments for life and die before your life expectancy, the insurance company will profit and your heirs will lose. That’s why a popular payment option is life with a guaranteed minimum period of years. If you die before the minimum period ends, payments continue to your heirs for the balance of the minimum payment period.

There are tax benefits to an immediate annuity. Income earned by your account is tax deferred as long as it remains in the annuity. Also, part of each payment is a tax-free return of your principal and part is taxable interest. Another benefit is creditor protection. In most states, creditors of you and your heirs cannot reach the annuity with their claims.

You could get the same income effect as an immediate annuity by withdrawing both income and principal from your investment accounts on a fixed schedule. But the annuity protects you from the two greatest fears of retirees. The insurer has to make up the difference if you live longer than expected or if investment returns are below projections. That means you cannot outlive the income or assets unless the insurer goes out of business. Another advantage the annuity has over other fixed income investments is that your yield is locked in once a distribution schedule begins. You won’t be in the classic position of having bonds or CDs redeemed then reinvesting the principal to earn a lower yield.

There are potential disadvantages to the immediate annuity. The prime disadvantage is that your income from the annuity is fixed. That means it will lose purchasing power to inflation each year. An immediate annuity also lacks liquidity. Your ability to get additional cash that exceeds the periodic payments usually is limited or non-existent.

The immediate annuity can be used anytime after retirement. It provides a floor for your income for the payment period you select. You can pay cash for the annuity. Or an existing variable annuity or fixed annuity can be converted into an immediate annuity tax free. If you use an existing investment account to buy the annuity, you might owe taxes, because you’ll have to sell the investments in the account and pay taxes on any gains before using the after-tax cash to buy the annuity.

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An immediate annuity can be a valuable part of your retirement portfolio. It can put a floor on your income by taking some money that you would have put in bonds or more conservative investments and use it to buy an immediate annuity. Most people shouldn’t have their entire portfolios in annuities, because the income is fixed. You’ll need growth in the portfolio from stocks and real estate investment trusts to keep up with inflation.

A related option is called the split annuity, though it really is two annuities. You purchase one immediate annuity to give you that floor of steady, dependable income. At the same time, purchase a fixed, deferred annuity. This second annuity will earn interest that will compound tax-deferred. When the first annuity runs out, or you need a supplement to make up for lost purchasing power, convert the deferred annuity to an immediate annuity.

If you decide to buy an immediate annuity, shop around. Even if you plan to convert an existing variable annuity or fixed annuity into an immediate annuity, check out competing offers. Don’t automatically select one of the payout options offered by your current insurer. Each insurer uses its own assumptions about life expectancy and interest rates to determine payouts. Each also has its own level of expenses. Those factors affect the payouts.

Every year or so I get quotes from different insurers. Each time, despite a very competitive insurance market, there are vast differences in payouts. Insurers with comparable safety ratings have payouts that vary as much as 20%. That is a substantial difference. Remember that is a 20% difference in your income every month for life.

That’s why the most important part of buying annuities wisely is to shop around. Contact your local agents and brokers to see what they offer. A national annuity broker that deals with a number of insurers is Annuity & Life Insurance Shopper (800-872-6684).

The Internet also has a number of sites that offer comparisons. Links to good sites, such as quotesmith.com, are at the members-only web site. In addition to those on the web site, you might want to check insure.com and annuityscout.com. These two sites generally don’t give you a quote online. You enter the information and wait for someone to call you with quotes.

You’ll want to talk to several brokers and visit several web sites. Everyone who sells insurance products has relationships with a limited number of insurers at any time. The relationships have to be established before a sale, and an insurer generally terminates the relationship if the broker doesn’t generate a certain amount of sales. That’s even true of the web sites. No web site deals with all insurers. You have to get quotes from more than one source to be confident of getting a good deal.

Don’t go for the highest payout. Safety counts with insurance companies. You might remember that in the 1980s and early 1990s several prominent insurers went bankrupt because of risky investments. Many people had their annuity payments eliminated or reduced when the insurers went under. A broker or web site should give you the safety ratings from the leading rating firms. It’s a good idea not to buy an insurer below the “A” rating.

If you buy a deferred annuity, don’t focus on the current yield. Even on a “fixed” annuity, the yield is fixed only for a year. You might be offered a teaser rate that will drop sharply after the first year. Ask to see the insurer’s history of yields actually credited to the same or similar annuities.

A deferred or immediate annuity can fit into your portfolio as a bond substitute. You won’t get capital gains when interest rates fall or suffer losses when rates rise, as you would with a bond fund. The annuity offers steadiness and predictability that aren’t available from other investments.

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