Now that traditional pensions are fading into history, Americans are scrambling for a source of lifetime retirement income. New twists on an old investment — annuities — can sometimes fit the bill.
Here’s this week’s question:
I have a question regarding fixed annuities with an income rider. I’m looking to provide some future security for my wife (11 years younger than me), and I’m being told that these are guaranteed, can’t-lose, programs. I’m always concerned when anyone tells me something is a guaranteed. Are these annuities really can’t-lose investments? What’s the catch?
I wrote about annuities a couple of years ago, but let’s go over them again, including the kind John is interested in, a fixed annuity with an income rider.
Investing with an insurance company
As you’ll soon see, there are various types of annuities. But they all have one thing in common: They’re offered by insurance companies.
Insurance companies offer advantages over bank accounts, mutual funds and other types of investments, because insurance companies are treated differently under the law.
The two chief advantages? Tax deferral and the ability to bypass probate.
- Tax deferral. If you have an IRA or 401(k), you know you don’t pay income taxes on the earnings until you take them out. Annuities offer the same advantage. As long as you leave the earnings alone, you don’t pay taxes on them. As with a retirement account, however, if you take the money before age 59½, you’ll face a tax penalty.
- Bypassing probate. When you set up an IRA or 401(k), you’re allowed to name a beneficiary. If you die, the beneficiary gets the money without the hassle and expense of probate. This, too, is true with an annuity, as well as with another common insurance product, life insurance.
So here are two reasons annuities are popular: They let you postpone a tax bill, and they allow you to leave money directly to your heirs.
Now, let’s explore various types of annuities.
Fixed annuities: Certificates of deposit from an insurance company instead of a bank
Back in my investment adviser days, I’d use the exact words in the heading above to explain single premium deferred annuities, also known as fixed annuities, to clients. Because when you boil it down, that’s what they are — insurance company CDs.
Like a certificate of deposit from a bank, when you take out a single premium deferred annuity, you agree to deposit a lump sum for a fixed amount of time, and the insurance company agrees to pay you a fixed amount of interest. Unlike a certificate of deposit from a bank, however, the annuity is guaranteed only by the insurance company. There’s no FDIC insurance. And, as I mentioned above, as long as you let the interest accumulate, you won’t pay taxes on it.
Immediate annuities: Deposit a lump sum, get monthly income
This is what many people think of when they hear the word “annuity.”
With an immediate annuity, you give the insurance company a lump sum of cash, and it pays you a monthly income. The income can be doled out in any number of ways. For example, it could last for a fixed number of years, or the rest of your life. Or it could last for the rest of your life, then your surviving spouse’s. It could last for life, but for a minimum of 10 years. There are any number of possibilities.Obviously, the amount you’ll get monthly will depend on how much you deposit, as well as the length of time you expect to receive it. But if you’re looking for a predictable income in your retirement years — a pension substitute — this is where you might find it.
Fixed annuities with an income rider
This is what John is asking about. Think of these as a hybrid between fixed and immediate annuities. As with a fixed annuity, you deposit a lump sum and let it accumulate. But as with an immediate annuity, it can also pay an income later.
This type of annuity could make sense for someone in John’s position, because he can deposit a lump sum now, let it accumulate, then convert it to a monthly income years from now that will offer his younger wife additional security.
Unfortunately, income riders aren’t free and are confusing. For example, income riders will offer a rate called the roll-up rate. This rate, often between 5 and 8 percent, applies only with the income portion of the annuity — not the lump-sum accumulation part. The rate will be guaranteed for a certain period of time, known as the rate guarantee period. Then there’s the actuarial payout rate, which describes the percentage that will be paid out depending on the person’s age at which the income is turned on.
Income riders come with fees attached, and rates and terms vary widely from company to company. Because these are complicated contracts, get the details before committing and not from a commissioned salesperson, rather from an objective expert (think fee-based financial planner or accountant).
There’s lots of information online about this type of annuity. One article I found helpful was this one from Marketwatch.
Variable annuities: mutual funds from an insurance company
A single premium deferred annuity is a CD clone. Its variable cousin is the insurance company clone of a mutual fund. Think of it as a mutual fund wrapped in an insurance contract.
Like many mutual funds, you’ll often have various fund options, including growth (stocks), income (bonds) and balanced (both stocks and bonds). You can switch among various options without tax implications as long as you don’t take the money out.
Variable annuities also offer something mutual funds don’t: a death benefit that guarantees that no matter how the funds perform, the beneficiary can’t receive less than the original investment.
Potential problems with annuities
Thus far, I’ve highlighted the advantages of annuities. Unfortunately, however, it’s not all wine and roses.In a CNNMoney article called “Immediate Annuities: When Guaranteed Income Is a Bad Bet.” The author suggests that an immediate annuity might not be ideal for some retirees because once invested, your money is tied up. There’s no unwinding the contract if a health care or other crisis creates a need for cash.
Another potential problem with virtually all kinds of annuities is excessive fees. And as with mutual funds, fees are often not apparent or disclosed. For example, single premium and variable annuities routinely have back-end surrender fees lasting up to a decade. Variable annuities often have annual management and other fees in excess of 2.5 percent, 10 times more than some low-cost mutual funds. There’s also a charge for the death benefit offered by variable annuities.
For more on variable annuities, check out the Financial Industry Regulatory Authority’s “Variable Annuities: Beyond the Hard Sell.”
Are annuities for you?
There are situations where annuities can fit into your financial plan. As with any investment, however, annuities aren’t all created equal, so comparison shopping is a must.
If you’re looking for an immediate annuity, or a fixed annuity with an income rider, compare monthly income and options. If you’re looking at fixed annuities, compare rates and surrender fees. With variable annuities, you’ll want to look at all the fees, plus the performance. And remember, guarantees are only as solid as the company making them.
Finally, as with all investments, the more a salesman is trying to jam something down your throat, the more cautious you should be. Avoid commission-based financial advisers. Rule of thumb: If you’re not paying them by the hour, you’re probably paying them in ways you’re not aware of.
Got a money-related question you’d like answered?
You can ask a question simply by hitting “reply” to our email newsletter. If you’re not subscribed, fix that right now by clicking here.
The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.
Got any words of wisdom you can offer for this week’s question? Share your knowledge and experiences on our Facebook page. And share this article with your Facebook network.
I founded Money Talks News in 1991. I’ve earned a CPA (currently inactive), and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. Got some time to kill? You can learn more about me here.
Got more money questions? Browse lots more Ask Stacy answers here.
Learn everything you need to plan your dream retirement
The Only Retirement Guide You'll Ever Need gives you the knowledge you need to retire on your own terms. Sure, you can pay a financial adviser, but this online course gives you total control to create a custom retirement plan around the things that make you happy.
You're going to get expert, personalized advice. You'll have access to the latest tools. And when it's complete, you'll be able to approach your retirement confidently and with peace of mind.
It's time to plan the best years of your life. Let's get started.