Should I Buy an Annuity?

Annuities have been providing financial security for people for a millennium. As a financial instrument there is none older, and as savings vehicle there are few that more misunderstood. Still, people who are beginning to get serious about their retirement savings are turning to them in record numbers. Because, what many people do understand about annuities it that the can be a source of financial security unlike any other investment. But, clearly, they aren’t for everyone. To truly answer the question, “Should I buy an annuity?” you would have to first seriously consider your own financial situation to determine if it is the right solution for you.

Annuities are more than just financial products. They are financial solutions that fill a need or address a concern, whether it is for tax savings, guaranteed income for life, portfolio stability, guaranteed growth, or simply some peace-of-mind. But, they are also somewhat complex, which is, perhaps, why some people shy away from them. But once you more clearly understand your own needs, priorities and tolerance for risk, it is much easier to consider annuities as a solution, and as a way to fill a need or address a concern. And, that’s the only reason why you should buy an annuity.

What are Your Needs and Concerns

I am concerned about outliving my income: That’s not an uncommon concern. Recent studies reveal that the majority of the American public is extremely anxious about having enough money to last their lifetime. Annuities today offer the same promise as they did to Roman citizens 2000 years ago, and that is that the income generated from a cash deposit, is guaranteed to last as long as you do, regardless of how long you live. Your annuity contract with a life insurance company becomes an obligation, backed by the assets of the company, to make monthly payments based on a cash deposit and your life expectancy. If, as more and more people do, you live beyond your life expectancy, the company is still obligated to make the payments.

I’m concerned about keeping up with inflation in retirement:

This is a concern that many people haven’t really considered. The fact is that, if you do live for 20 or more years in retirement, your cost-of-living will likely double based on the current rate of inflation. It’s one thing to have enough income to last a lifetime, but, if it can’t keep up with your actual expenses, it can make life pretty difficult. Many people are relying up their retirement funds to keep growing in their retirement accounts. In order, for their income to increase over time, their retirement funds will have to be invested in growth investments which are risky.

Most annuities include an option that ties your income to an inflation index so it will automatically increase. Variable annuities offer an option that enables your income to increase in rising equity and bond markets, while protecting it from declines. While these options do cost extra, they can turn out to be priceless when the economy goes sour again.

Annuities Explained

I’m concerned with the safety of my principal:

As are millions of people who lost significant sums of money in the recent market crash. Even the people with money in the bank lost some sleep when hundreds of banks were closed during the financial crisis. Fewer people are feeling secure about the Federal Deposit Insurance Corporation (FDIC) which could actually run out of funds if too many banks fail at once. Annuities have always been considered among the safest of all savings vehicles. During the Great Depression when customers of failed banks were receiving cents on the dollar, life insurance companies were making their annuity customers whole.

Unlike banks, which are required to maintain a small fraction of reserves on hand to cover immediate obligations, life insurance companies are required to have nearly 100% of reserves on hand in the form of safe, liquid assets. Sure there have been a few life insurance companies that became insolvent, but the states ensure that their reserve requirements will be met by other life insurance companies. Annuities are sleep insurance. For an even better sleep, try to work with companies that have the highest ratings for safety and stability. There are plenty of annuities to choose from among the top 20 life insurers.

I’m concerned about paying too much in taxes from my savings and earnings:

Although tax rates have come down quite a bit in the last few decades, people are still heavily taxed, especially when you combine federal taxes with state and local taxes. The effective tax rate for many people can still reach as high as 50%. When that happens, 50 cents of every dollar of interest earned is lost, forever, to taxes. By keeping that 50 cents working in your investment account, compounding over many years, you can more than double your accumulation, and that will make a huge difference for people who are concerned with accumulating enough for a secure retirement.

Annuities are one of the very few individual financial instruments that allow your funds to accumulate without having to pay taxes on them. Your funds will eventually be taxed as ordinary income when they are withdrawn, however, for most people, the tax rate in retirement will be lower than during their working years. It is important to be aware of the penalty for withdrawing funds too early (prior to age 59 ½), however, if you are saving for retirement that may not be a concern.
I’m concerned with the low yields that my money is earning right now:

Current interest rates are still at historic lows. While that may be an advantage if you’re borrowing money, it makes accumulating money very difficult. Fixed annuities do offer yields that are higher than other safe savings vehicles, such as CDSs; however, if you want your money to work harder without much additional risk, then you could consider an indexed annuity or a variable annuity with optional guarantees. With an indexed annuity, your yield is linked to a stock market index, so if the market rises, your yield can rise. Although there is an upper cap on the yield (in the range of 5% to 8%), there is also a minimum rate guarantee, so, even if the market index declines, you will still earn a positive return. The funds in variable annuities are invested in stock and bond accounts, so there is market risk involved; however, many variable annuities offer an option that will guarantee a minimum rate or a minimum withdrawal amount based on your principal. These options do cost extra but they enable you to enjoy the upside without concern for the downside.

There’s much more to annuities that you will need to know – there are expenses, withdrawal provisions, different savings options, as well as the fact that there are hundreds from which to choose. However, your most important consideration in determining why you should buy one is how it will help you address your needs and concerns. If you share one or more of the concerns listed here, an annuity may be right for you.

How to Balance Your Variable Annuity

Retirement savers are starting to get serious. After years of saving at anemic levels, and then suffering through one of the worst economic downturns in our history, people of all generations are gearing up, and, as evidence, last year saw a record number of variable annuity purchases. The resurgence can be attributed to some of the new features that have been introduced over the last several years which make variable annuities extremely attractive to risk-oriented and risk-adverse investors alike. With new options available that can guarantee income, withdrawals and even principal, variable annuities are as close as any investment  to becoming the “best of all  worlds”.

Even with that, variable annuities are not for everyone. It is recommended that only those people with an understanding of how investments work and are familiar with market risk consider them.  As with any investment tied to the fluctuations of the markets, variable annuities are not the type of vehicle that you can set and then forget.  In order to maximize the long term return opportunities, and to optimize the product to best fit your needs, the investments within a variable annuity contract require at least a moderate level of management.  Establishing the proper diversification and balance to match your investment profile is the first, critical step. But, once the investment accounts go to work, they will almost certainly require ongoing management to maintain the proper level of diversification and balance.

Let’s consider an example of a variable annuity investment allocation.  The investor is in his late forties. With 20 years on his time horizon, he is able to accept a moderate level of risk in order to increase his potential return, so he creates a balance that is heavily tilted towards equities, but only 20% is allocated toward higher risk stocks. With his initial deposit of $100,000, he  allocates the funds among five different investment accounts: $30,000 in a large cap growth account; $20,000 in an international stock account; $20,000 in a balanced growth and income account;  $20,000 in a corporate bond account; $10,000 in a fixed income account.  It is well-balanced between growth potential investments and more stable income oriented investments – about 70/30 which is appropriate for his age.

During the course of the next year, the international markets flourish and the international stock account increases by 20% . The large cap fund also increased by 12%.  Because the stock and bond markets don’t always move in the same direction, his income oriented accounts, the balance account and the corporate bond account decreased by 6%. So, at the end the year, his allocation now looks like this: International stock account – $24,000; large cap growth account – $33, 600; balanced account – $18,800; corporate bond account – $18,800; fixed account – $10,400.  The balance between growth and income has changed to about 75/25.

While the increase in his growth accounts is a positive thing, the fact that his portfolio balance is more tilted towards growth means it no longer matched his investment profile.  If the same trend were to continue for the next couple of years, the portfolio can get further out of balance.  As long as the markets are working in his favor, there may be a temptation to leave well enough alone. However, should they turn against him, his portfolio has greater risk exposure than he may be willing to tolerate.  In order to ensure the portfolio matched his risk tolerance, he needs to re-balance his accounts by moving funds from his growth accounts into his income accounts to achieve the 70/30 balance.  It is also important to keep in mind that, as he gets older, he may want to adjust his balance for greater emphasis on the stable, income accounts, which may require more re-balancing.

The other reason to balance your accounts is to ensure that you lock in any gains. If, after that first year of gains in the growth accounts, the markets turned and declined by 20%, the prior year’s gains would be wiped out.  By adjusting the accounts, moving some of the gains into the stable accounts, he could minimize the losses or even achieve more gains if the stable accounts performed well.

Variable annuities are ideal, because they do allow you to transfer funds between the accounts several times a year without charge, and better yet, with no tax consequences which is not the case when transferring between mutual fund accounts.

It’s a Balancing Act

One of the main criticisms of variable annuities are their high expenses, sometimes averaging as much as 1.5% more than a mutual fund.  And, if you add any of the guarantee options, it can add another .05% to 1%. Investors who have been ravaged in the markets probably won’t mind paying the extra cost for the peace-of-mind of those guarantees.  But, it makes it all the more important to ensure that you are maximizing your investment returns while maintaining the proper balance in your portfolio. The race to retirement is not a sprint, it is a marathon which requires thoughtful pacing and steady progress. There is no need to take big risk if you are able to achieve consistent, stable returns.  And that is best achieved through a well-balanced portfolio.


Determining the Best Annuity Product for You

In the wake of the recent financial crisis, retirement concerns are mounting for all generations. As people’s focus turn to shoring up their retirement future, all savings options are, once again, on the table, and the one option that is garnering the most attention, by savers of all ages, are annuities.  Anxious savers are discovering, or re-discovering, the advantages of annuities for savings flexibility, tax benefits, safety of principal, growth guarantees, and income guarantees.  To their chagrin, they are also discovering that the choice of annuity products is not that simple based purely on the number of different annuity products that have proliferated in the last decade.  As with any critical purchase, determining the best annuity product for you should come down to what’s most important to you.

Narrowing Your Choices

Getting past massive confusion of the myriad of annuity products on the market, the one thing the annuity providers have done right is to create an annuity product for just about everyone.  Those seeking absolute safety can select fixed annuities with guaranteed rates and safety of principal. Those who understand market risk and want to make their money work as hard as possible can allocate their funds among several different types of investment accounts within a variable annuity. And, for those who have a low tolerance for risk, but want to do better than low fixed yields, an indexed annuity is an ideal choice.  For those seeking the ultimate balance in risk and growth, the best solution may be some combination of the three.

Before you begin your search for the best annuity product, it is vitally important to spend the time to fully understand your situation and objectives.  All deferred annuity products offer tax deferral, guaranteed death benefits, guaranteed minimum growth (this may only be offered as an option in some variable annuities), and, ultimately guaranteed income.  Beyond that, the different products vary greatly in their savings options, withdrawal flexibility, expenses, and their level of safety.  The only way to quickly narrow down your choices is to conduct a thorough assessment of your needs, your concerns, your risk tolerance and your priorities.  While your particular situation will vary from the next person, this investment profile guide can give you an idea of how to go about narrowing your selection.

Investment Profiles

Zero risk tolerance:

If you can’t stomach the possibility of getting back one dime less of your principal, and you are willing to except lower returns on your investment, then a fixed annuity with guaranteed rates is your best bet.   Fixed annuities are considered to be among the safest of all savings vehicles, but it couldn’t hurt to look at products from only the strongest and most financially stable life insurance companies. Stick with an A+ rated company and you’ll have the ultimate peace-of-mind.

Moderate risk tolerance/Need for higher returns:

With the introduction of indexed annuities, life insurers have provided one of the best solutions for people who don’t mind some fluctuation in their account balance if it comes with the potential for higher returns.  Indexed annuities actually, go one step better by locking in your principal while applying rates that are tied to a stock market index. Because they cap the maximum rate you can earn, you won’t capture the total return of the index. But, you also won’t incur any losses in years when the index declines.  Essentially, index annuities are all gain with no pain.  You can expect moderately higher yields than those on fixed annuities. Again, the guarantees available in indexed annuities are as secure as the company that backs them – stay with highly rated insurance companies.

Moderate to high risk tolerance/Seeking high returns:

If you are a stock or mutual fund investor, and you understand the risk-reward equation, variable annuities can give you the same opportunity for growth with the added benefit of tax deferral. As with any mutual fund, performance varies from one annuity provider to the next as do the investment choices that are available.  Variable annuities offer the same opportunity for achieving portfolio diversification and balance among different asset classes for optimizing long term growth potential.

Some variable annuities also offer options (at an additional cost) that provide principal guarantees, minimum growth guarantees and even minimum income guarantees, any of which virtually eliminates the risk of investing in the markets. Expenses can be somewhat higher than other types of investments, as much as 2% annually over mutual funds depending on how many guarantee options you add, but, for many investors who suffered through two steep market declines within 10 years, the peace-of-mind could be priceless.

Investment flexibility:

The one certainty in life is change. Through time, needs change, risk tolerance changes, priorities change.  While annuities are long term investments, they do offer some flexibility.  All annuities offer investors the opportunity to access their funds through withdrawal provisions. If the annuity is held long enough, this can be done without incurring any charges (not including a possible IRS penalty of 10% for withdrawal prior to 59 ½). In the early years of the contract, a fee may be applied if the withdrawal exceeds 10% of the account balance during the surrender period which can last as many as 10 to 12 years.

The highest level of flexibility can be achieved by taking a portfolio approach to annuity selection. By combining annuities with different investment characteristics, you can more achieve a closer match to your investment profile. A combination of fixed, indexed and variable annuities can be arranged to match your risk tolerance while optimizing your opportunities for growth.  The only way to truly counter all of the risks, including market risk, inflation risk, and interest rate risk, is to achieve optimal diversification and balance with all of your assets.