Annuities can be valuable retirement and longevity planning tools- but they are complex financial products that can be misused. There are two kinds of annuities: variable and immediate. Variable annuities have gotten a bad reputation in recent years because they are often sold to people- especially seniors- for whom they are inappropriate. Immediate annuities- on the other hand- may be undersold.
Let’s start with an explanation of what an annuity is: It is a contract with an insurance company under which you- the consumer- pays a lump sum in exchange for certain benefits. In the case of a variable annuity- those benefits are based on an investment package. Often the insurance company will guarantee a minimum rate of return on the annuity even if the investments perform poorly. For instance- if you put $200-000 into an annuity with a guaranteed 5 percent rate of return- the annuity will pay you $10-000 a year even if the value of the investments dropped to $160-000- for which a 5 percent return normally would be just $8-000 a year. But if you chose to cash out the annuity- you could only withdraw $160-000. In addition- you might be hit with a penalty for early withdrawal. Typically- variable annuities charge penalties of up to 10 percent for withdrawal over the first few years of the investment- with the penalty gradually declining each year. In addition- you are not taxed on the investment earnings but are taxed on income when the annuity is withdrawn- whether in regular payments or as a lump sum.
Immediate annuities are fixed contracts under which the insurance company pays the consumer a fixed amount- usually on a monthly basis- and usually for life. For instance- you might pay the company $200-000 in exchange for a guaranteed income stream of $1-000 a month for the rest of your life. The amount of the payment and the cost of the annuity will depend on your age since the company- in determining these numbers- will be making an estimate of how long it will have to pay- or in other words what it thinks your life expectancy is.
In our example- if you live longer than 17 years- you will “win” because the insurance company will ultimately pay you back more than $200-000- but if you live for a shorter period of time- you will “lose” (in more ways than one) because you will receive back less than your investment. If the buyer of the annuity in our example passed away after just five years- she would have received only $60-000 in payments on her $200-000 investment. For this reason- many consumers purchase annuities with guaranteed terms of payment (“term certains”) meaning that if you were to pass away before the end of the term- payments would continue for your beneficiaries or they would receive a lump sum upon your death. For instance- if you were to buy the annuity in our example with a 10-year term certain and were to pass away after five years- the insurance company would still pay out an additional $60-000 to your heirs- either by continuing the monthly payments or in a lump sum. Of course- the length of the term certain will affect the amount of the monthly payments since the insurance company will be committing to pay for a longer period of time no matter how long you live. If you want a longer term certain- you will either have to pay more for the annuity or accept a smaller monthly payment.
The Rap on Variable Annuities
Variable annuities are extremely complex products and it is doubtful that very many consumers fully understand them when they purchase them. That doesn’t mean that these products are bad- just that they’re confusing. In addition- they pay generous premiums to the brokers who sell them- payments which many of the brokers don’t disclose. They also generally don’t disclose whether they are paid more or less by one insurance company than another or whether the annuity being sold is the best option for the consumer.
This relates to another debate going on in the financial services industry. Broker dealers are held to a “suitability” rather than to a “fiduciary” standard. This means that they need only sell products and give advice that is “suitable” for the client. A fiduciary standard would require them to act in the best interest of the client. (This article more fully explains the difference.) The Obama administration is working to adopt the higher fiduciary standard for retirement accounts.
All of this means that the purchaser of a variable annuity needs to be cautious and should seek a second opinion. Some people have been greatly helped by variable annuities- receiving higher retirement income due to the guaranteed rate of return even after the sharp drop in investment values and low interest rates after the recent recession. For others- however- variable annuities have been problematic. This is especially the case when a senior needs to access capital to pay for long-term care or accounts need to be transferred between spouses to qualify an ill spouse for Medicaid benefits. In either case- this may require withdrawal of funds after the underlying asset value has dropped and often means paying early-withdrawal penalties. For these reasons- older or sicker seniors should be wary of purchasing variable annuities. The products may not be in their best interest and may not even be suitable. It’s always important to get a second opinion from an advisor who will not benefit from the sale of the annuity.
The Benefits of Immediate Annuities
Immediate annuities- on the other hand- are much less complicated products. They are often used in Medicaid planning– but they can also be used to guarantee a retirement income no matter how long you live. Some people call this “longevity protection.” For instance- let’s assume you plan to retire at age 65 and you have calculated that with your Social Security income- savings and investments you have enough money to live comfortably for 20 years- taking into account likely inflation during that time. That’s fine if you only live to age 85- but what happens if live past that age?
A bit more than a fifth of men and a third of women who are 65 today will make it to age 90. Your own health and your family’s longevity may give you even more guidance as to whether you will need income past age 85. But based on these statistics- if you’re a woman (or are married to one) your planning should make sure that you have sufficient income until age 90. (You may not need to be as concerned after age 90 since only 13 percent of 65-year-old women and a measly 7 percent of 65-year-old men make it to age 95.) An immediate annuity can be a solution since it will continue paying for the rest of your life even if you run through your savings and even if you live to 100 or beyond.
Variations can enhance the usefulness of immediate annuities for this purpose. For instance- if you calculate that you can give up current income in exchange for more income in the future- insurance companies will pay you a higher monthly benefit. If at age 65 you were to purchase an annuity that did not begin paying until age 85- it would pay you far more than if it were to begin paying immediately. According to one on-line annuity calculator– a 65-year-old woman paying $100-000 for an immediate annuity that pays out for her life beginning now would receive $528 a month. If she postponed payments until age 85- she would receive $3-608 a month beginning then- almost seven times as much (and more than three times the $1-125 a month she would receive if she purchased the annuity at age 85). She would- of course- have given up both the income of $126-708 ($528 x 12 x 20) and the use of her capital- but it might be a good hedge against outliving her savings.
For both variable and immediate annuities- because the payments may have to last a lifetime- you want to be sure the insurance company you pick will still be around. Make certain that the insurer is rated in the top two categories by one of the services that rates insurance companies- such as A.M. Best– Moodys– Standard & Poor’s– or Weiss. And don’t put too much of your savings into any one type of investment- whether that be variable annuities- immediate annuities- stocks or bonds.
Note that not all immediate annuities will meet Medicaid’s stringent rules. If you are considering an annuity in a Medicaid planning context- you owe it to yourself to consult knowledgeable counsel before proceeding.
Your attorney can also help you decide whether any annuity is appropriate for your particular situation.
For more information, see this resource on retirement planning.