Thursday, December 31, 2015

Annuities 101 ... The More We Know About How Things Really Work, The Better Our Decisions Will Be

Occasionally I am asked about annuities.

I always answer that there is no free lunch (despite what the sales people or politicians may say), and that knowledge is the prerequisite to power when making individual financial choices.

So with that as background, Annuities in retirement: a true guarantee? is informative as well as appropriately subtitled --- 'Before plunking down money, know the fees and risks:'

"After the economic downturn in 2008, the annuity industry started to gain attention from investors looking for a way to secure investment returns during retirement. New income riders and guarantees were enticing to people who had just witnessed a sharp decline in their portfolios, and annuity companies offered a safety net for fearful consumers.

Although this may have seemed like an attractive option at the time, expenses associated with annuities can sometimes take away from a retiree’s earning potential . . . .

Annuities can be a valuable wealth accumulation tool if used properly, but it’s important for investors to do the proper research before jumping into them with their hard-earned investment dollars.

Annuities 101

There are two basic types of annuities: immediate and deferred.

With an immediate annuity, you begin to receive payments very shortly after the initial investment. For example, you might consider purchasing an immediate annuity if you determine that you want an additional income stream when you retire.

With a deferred annuity, you invest for a period until you decide to start taking withdrawals. A deferred annuity accumulates money for an indefinite amount of time, unlike the immediate annuity which pays out right away. Deferred annuities can be converted into immediate annuities if, and when, the owners decide to begin collecting payments.

Within these two categories, annuities can also be fixed or variable, depending on whether the payout is a set sum (fixed) or tied to the performance of the investments within the contract (variable).

Despite the additional income benefits that annuities offer, investors should always evaluate the associated risks before purchasing one for their investment portfolio.

The downside of annuities

Many investors are unaware of the potential fees that come with purchasing an annuity. The high expenses are often not worth the return. Here’s a rundown of the various annuity fees.

Commissions: Most annuities are sold by insurance brokers or other salespeople who collect a commission as high as 7% from the products they sell. . . .

Surrender charges: Many annuity contracts contain steep surrender charges for pulling money out during the first several years after you buy them. The surrender charge typically costs about 7% of your account value if you leave after one year and then declines by one percentage point every year until it gets to zero.

High internal fees: If you invest in a variable annuity, you’ll encounter a certain amount of annual expenses built into the contract. You will have an annual insurance charge that can be 1% or more.

Annual investment management fees will add 0.5 to 2% and fees for various insurance riders can add 0.5 to 1.75% or more. Add them up, and you could be paying 2 to 3% a year, if not more. That can take a big bite out of your retirement nest egg, and in some cases, even cancel out some of the benefits of an annuity.

Regular investment account vs. annuity

If we were to compare the return of a regular investment account which charges an average of 1.5% a year to an annuity contract which charges 2.5% a year, the difference can be staggering.

Let’s assume we have two identical IRA rollover accounts with an initial value of $1 million. Since we don’t have to worry about taxes until we start taking money out of the IRA, let’s see what higher internal costs can mean over 20 years.

We’ll assume both portfolios are invested the same way, earning the same rate of return (7%, for our example). At the end of 20 years, that additional 1% cost would yield a final value of $2.7 million versus $3.3 million — a whopping $600,000 in internal expenses that would have been paid inside of the annuity. (Calculation assumes growth rate of 7% over 20 years with a 1% variable of internal expenses.) {MY NOTE: Making that referenced annual variable investment expense 0.5% instead of 2.5% would yield a final value of $3,900,000, or $1,200,000 more than the example. Costs matter!}

If you decide to pay extra for a guaranteed benefit, or an income rider, this is a perfectly acceptable expense. The problem is many people don’t understand the cost that comes along with that peace of mind.

When considering an annuity, it’s important to know your options and understand why you may or may not be the right candidate.

How to know if you’re a fit

Annuities can be appealing to investors because they offer the ability to build tax-deferred savings on investments that would be taxable if left in a personal investment account. . . . You don’t have to be an investment professional to understand that tax-deferred money will grow faster than money that is subject to being taxed every year.

If you’re only looking for tax deferrals, however, you don’t need an annuity within an existing retirement account.

An IRA is already tax-deferred, so holding an annuity in an IRA is redundant. If you’re looking for a particular insurance benefit (income rider, death protection, etc.), you may want to keep the annuity, but you should still be aware that the additional expenses could potentially eat away at your investment return.

Annuities have many income riders or benefits available to consumers, and they are often a good fit for anyone who wishes to include a guaranteed income stream in his or her household budget. This model tends to work well for cautious investors, and if you’re willing to give up control of your investments, it might be right for your lifestyle.

But if you decide to keep your investment portfolio and establish a monthly distribution to be paid directly to your bank account, the returns are likely to be much higher than an annuity. Managing your portfolio allows you to choose from the entire world of investment possibilities that can be allocated and diversified in whatever way you see fit. You can still have total control over the investments, create your own income stream and even change the amount of income you get from month to month and year to year.

The trade-off for all this flexibility is that none of it comes with a guarantee."

Summing Up

Risk is. And that's an inescapable fact of life.

Accordingly, managing risk is all about making informed tradeoffs.

And that definitely applies to a decision to purchase annuities or stick with individual investing.

In the example above, the annuity buyer would elect to trade $600,000 for the security of an annuity. In fact, the trade would be $1,200,000 if the person paid an adviser 0.5% annually instead of the referenced 1.5%. And that $1,2000 difference would be even greater if over time a well managed portfolio exceeded the assumed 7% annual rate of return.}

When it comes to buying anything (including college, cars, credit card purchases and homes), knowing the costs and tradeoffs is a necessary prerequisite to reaching appropriately informed decisions.

Accordingly, when evaluating the pros and cons of purchasing an annuity, the rule of Caveat emptor, aka Let the Buyer Beware, should be front and center.

That's my take.

Thanks. Bob.

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