Unlike their parents, baby boomers can't count on employer-sponsored pensions to support upon retirement. Boomers will have to come up with another way to ensure financial security. With 76 million boomers forecast to reach the age of retirement (65) in the next 10 years, brokers need to become more fully aware of every retirement savings product and strategy, including annuities. “Customers and clients want to talk about retirement income, but registered reps and brokers haven't gotten educated,” says Lorry Stensrud, executive vice president of Lincoln National Life Insurance.
Three basic features of annuities can aid retirement planners: Their income stream, which is guaranteed to last as long as the contract holder lives; their ability to function as a long-term savings plan in which investments grow tax-free; and their higher level of protection against investment losses (see page 53). These advantages, however, come at a cost, and many financial planners believe clients can do as well or better with ordinary mutual funds. Still, with retirement accounts battered by the bear market, guaranteed income from a fixed annuity now has more appeal, especially for clients who may be too close to retirement to count on a rebound from equity markets alone. Certainly, a guarantee of a 3 or 4 percent return is better than the prospect of a 20 percent loss in the market. Either way, brokers can't afford not to know about annuities and how they work.
Annuities, first and foremost, are insurance products and, secondarily, savings vehicles. That said, annuities do “make sense for someone who's already maxed out in qualified plans and is looking for a way to defer taxes on additional investments,” says Matt Sharp, a vice president at GE Capital.
The term annuity means simply a stream of payments. An annuity contract is an instrument designed to convert a sum of money into a drawn out series of payments so clients can pace their use of income over time. The buyer of an annuity hands over a lump sum or series of premiums to an insurance company, which uses actuarial tables and projected investment returns to repay the account value — plus potential appreciation — over a set period of time.
Annuities can be either deferred or immediate. Deferred annuities are invested over an “accumulation period” of often at least 10 years, giving the premiums time to appreciate. At some point in the future, the account value is repaid to the client either via a lump sum, via systematic or periodic withdrawals designed to last a given period of time or via lifelong payments. If the purchaser chooses a single life annuity, income will flow for life, even after the account value is depleted. Insurers can afford to do this in the same manner as they can afford to pay life insurance to people who die young — from the pools of premiums paid by those who don't.
Immediate annuities have no accumulation phase. Rather, the investor purchases a contract for a lump sum and starts to receive payments within a year. “Many are sold to retirees who would like to have a portion of their income guaranteed,” says Sharp. “A lot of planners use immediate annuities for a small portion of a portfolio.” For example, if a 60-year-old making $5,000 a month wanted to keep working but cut back her hours, she could buy an immediate annuity which would provide $1,000 a month and make up the shortfall. It also could be helpful to a couple looking to buy a retirement home and prefer to know that the mortgage payments will be coming from a steady, reliable source.
There are two investing styles of annuities: fixed and variable. A fixed annuity pays a set interest rate during the accumulation phase and a predetermined amount during the annuitization, or withdrawal, period. “Fixed annuities are good for anyone seeking an easy-to-identify stream of income down the line,” says Sharp. These annuities have the same basic pros and cons as bonds: a predictable income stream but a vulnerability to rising inflation. Norman Chiodras, founder of Retirement Planners Inc. in Oakbrook, Ill., occasionally uses fixed annuities for clients as an alternative to CDs. “They often pay a premium over CDs, and they're safer than bonds because their value doesn't fluctuate,” he says.
The more common variety of annuity is a variable annuity, which lets investors diversify their premiums through a range of stock and bond mutual funds called subaccounts. Earnings fluctuate with the stock market, as do the eventual payouts. “The payments may vary in amount on a variable annuity, but they are payable for life,” says Richard Austin, former head of Templeton Funds Annuity Co. “You have to start with the premise that the retiree should be in the stock market. Then ask: Should he be in a mutual fund where he'll just spend down the money, or in a variable annuity where it will provide income for life, no matter how long that is?”
Like IRAs, annuities have favored tax status that allows them to grow tax-free until withdrawal, and investors can switch among subaccounts without incurring adverse tax consequences. In fact, certain institutional retirement plans, like 403(b)s used by public employees, are annuities. These plans, like 401(k)s, let employees contribute pretax dollars to the annuity.
But brokers need to understand that most individually sold annuities are nonqualified, that is, premiums must be paid with after-tax dollars. Other qualified plan rules apply as well; for example, any funds withdrawn before age 59½ are subject to a 10 percent penalty tax, and earnings withdrawn from an annuity are taxed as ordinary income — not as capital gains.
All annuities come with a price tag, of course. Besides fees to the insurer and the administrator, upfront sales and back-end surrender charges often apply, which usually start as a 7 percent penalty for withdrawing money in the first year and then decline each year thereafter. These fees and charges make annuities less desirable than qualified retirement plans or even investments in taxable mutual funds to some reps. “Most variable annuities have such high costs built into them that they're generally bad investments,” says Larry Elkin, founder of Palisades Hudson Management in White Plains, N.Y. “When all is said and done, you're generally paying 1.5 percent to 2.5 percent more in avoidable expenses.” Even the annual expense ratio paid to managers of the subaccounts is higher on average than expense ratios on the same mutual fund outside an annuity (1.98 percent vs. 1.45 percent for a U.S. stock market fund). According to Peter Di Teresa, senior analyst at mutual fund tracker Morningstar, “That [charge] compounds over time, so you're not just lagging by 53 basis points.”
And the high fees can make the tax benefit of annuities less compelling. “The extra expense ratio charge diminishes the tax benefits,” says Di Teresa. “If you were in the 28 percent tax bracket and had a variable annuity with an average expense ratio, you would need to own it for at least 10 to 15 years for the tax advantages to even make it competitive — and that's assuming you own just an average mutual fund, not a fund managed to minimize taxes.”
But Elkin concedes that one insurance feature is worthwhile. “The key purpose in a classic annuity is transferring the risk of longevity to an insurer who's better equipped to bear it,” he says. “If you're worried about outliving your income, this is the key annuity benefit not matched by anything else.” The best bet, Elkin says, is a fixed lifetime annuity when interest rates are high. “One reason they're so unpopular is that if you buy one today you're locking very low interest rates for the rest of your life. This is a bad time for that good thing,” he says.