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Six Things You Need To Know Before You Buy Annuities

Last update on: Dec 27 2018
Topics:
buying-annuities

Fixed annuities are popular and getting more popular. Beaten down by the bear market, many investors suddenly like the safety of fixed annuities. A tax-deferred yield of 5% looks good compared to recent stock market returns. Fixed annuities can be a valuable of any portfolio, as I’ve said for years.

Years ago most retirees could rely on a fixed pension from an employer to cover a large part of their retirement expenses. Those defined benefit retirement plans largely are disappearing, and retirees are on their own for funding retirement. A good replacement for these plans is an annuity. Shifting part of your retirement nest egg into an annuity gives you that safe, guaranteed lifetime income. A price is that you give up some potential stock market returns in exchange for reducing risk.

A recent study shows that a fixed annuity also can make your wealth last longer. An article in the December 2001 Journal of Financial Planning examined the odds of different portfolio combinations lasting at least 30 years of retirement. The study examined four portfolio combinations, from conservative to aggressive. The conservative portfolio was 20% stocks, while the aggressive was 85% stocks. Using a technique known as a Monte Carlo simulation, the study found that for each type of portfolio, putting 25% or 50% of the fund into a fixed annuity increased the odds of success.

The greatest improvement was in the conservative portfolio. While the annuity also improved the odds of success for the aggressive portfolio, the existence of a lot of stocks in that portfolio already gave it over a 90% probability of surviving. Adding the annuity increased the survival odds only a bit. The odds of survival for the conservative portfolio, however, were 32.6% with no annuity. They improved to 53.3% when 25% of the portfolio was moved into an annuity, and to 81.3% when the portfolio was 50% in a fixed annuity.

An annuity offers advantages you won’t get from bonds. The payout on the annuity is fixed once you start regular payouts. Bond yields can decline as interest rates decline, or the bond principal can decline as interest rates rise. A bond acts like an annuity only if interest rates are fairly stable for 30 years.

Probability Portfolio Will Last 30 Years

Portfolio Type No Annuity 25% Annuity 50% Annuity
Conservative 32.6% 53.3% 81.3%
Balanced 76.3% 85.1% 94.5%
Growth 87.4% 92.2% 96.7%
Aggressive 91.6% 94.6% 97.5%

The lesson seems to be that if you are not prepared to invest aggressively all through retirement, consider adding an annuity to your portfolio.

But the strategy won’t help you if you buy the wrong annuity. There are many insurers offering annuities with many different terms. You need to know how to compare them and get a good deal.

In this visit I’m going to show you how to buy a fixed deferred annuity. The fixed deferred annuity will earn interest on your account each year. The interest income will compound tax-deferred until you withdraw it. At retirement, you can begin a payout schedule (annuitize the annuity), withdraw money as you need it, take the entire annuity as a lump sum, or transfer the account tax free to another insurer to buy an immediate annuity. (I covered immediate annuities in the December 2001 visit.). Here are the factors to consider when shopping for a deferred fixed annuity.

  • First consider the financial stability of the insurer. Earning a high yield doesn’t do much good if the insurer goes bankrupt. Annuities are not federally insured. Most states have a modest insurance guarantee fund, but they don’t amount to much.  Your only real guarantee for the annuity is the financial stability of the insurer. Insurers with the lower safety ratings generally offer higher yields. While few insurers go bankrupt and many perk along profitably despite low safety ratings, it is not a risk I want to take with my retirement money. Examine ratings from all four rating agencies. The Weiss ratings tend to give lower scores than the others. Stick with insurers in the top groups of ratings from at least a couple of the raters. Any insurance broker or web site selling annuities should have the ratings.
  • Find out about interest rate changes. How often will it change and how is the change determined? A fixed annuity usually guarantees a rate for a year. After that, the rate will change, usually annually. Some insurers say the yield will be determined by their investment experience. If so, you’ll want to see the yields the insurer has credited to accounts for at least the last 10 years. Compare these with intermediate bond yields. While the history is no guarantee that you’ll get competitive yields in the future, it does indicate the insurer’s investment record and style.A more reliable system is for the yield to be determined in reference to market interest rates. You should get a yield that is close to that for intermediate bonds, not money market fund or CD yields.
  • Find out the net yield that will be credited to the account. Insurers deduct various fees and expenses before the interest finally is credited to your account. Be sure you see the difference between the “gross yield” that is the starting point and the “net yield” that actually will be credited. Sometimes it is tough, but you want to know all the expenses that will be deducted from the gross yield.
  • Don’t be fooled by high teaser first year yields. Many insurers sell annuities by promising an above-market yield. But the yield usually is guaranteed for only six months or one year. After that, the insurer is likely to credit the account with below-market yields while continuing to offer above-market yields to new buyers. Don’t be overly concerned with the yield you’ll receive now. Pay more attention to how long that yield will last and to how future yields will be determined.
  • Learn about penalties. Most annuities impose a penalty if you want some or all of the principal back in the early years. The standard penalty is 7% of the account value for withdrawals within one year. The penalty drops by one percentage point each year until it disappears after seven years. In addition, you should be allowed to withdraw 10% to 15% of the principal in any year without paying a penalty. You should look for alternatives to any annuity that imposes higher penalties.
  • Check for payout restrictions. Your ultimate goal is to get a reasonable income from the annuity during retirement. Some annuities offer attractive terms during the pre-retirement accumulation phase then take the advantage away during the distribution phase. You want a policy that does not require you to “annuitize” at distribution time or that otherwise limits your payout options. You also want to be able to transfer the account as a lump sum to another insurer without penalty in a tax-free exchange.

Annuity Sources

Web Sites
annuityscout.com  immediateannuity.com
brkdirect.com   tiaa-cref.org
fidelity.com   troweprice.com
topannuities.com  masterquote.com
quotesmith.com quickquote.com
annuityshopper.com vanguard.com

National Brokers
Annuity & Life Insurance Shopper 800-872-6684
Quotesmith 800-556-9393

At payout time, your best option might be to use the annuity balance to buy an immediate annuity from another insurer. This move might increase your yield by 20% or more. I’ve covered this strategy in the past, and it is included in the article on immediate annuities in the December 2001 issue. Be sure you have maximum flexibility when it is time to take distributions.

There are hundreds, perhaps thousands, of insurers offering annuities. Get quotes from several sources before you make a decision. I’ve listed some national annuity sources in the box.

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