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| The Basics | Consider annuities -- but as a last resort
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When you've exhausted your traditional retirement choices, consider this tax-deferred vehicle. You can get a regular check, but the costs can be high.
By Terry Savage
Mention the word annuity and eyes start to glaze over. People tend to think of the old check a month for life type of annuity payment. Or they wince at trying to comprehend a tax-deferred insurance/investment contract that limits their financial flexibility.
We need to talk about annuities because people are trying to sell them all the time. They may make sense for some people, but only if you understand the costs as well as the enticement of tax-deferral.
So, heres the truth: Both tax-deferred and immediate annuities can have a place in your portfolio, but do some homework to get the best deal.
Tax-deferred annuities can be a useful place to invest money only if youve used up allof your other tax-deferred retirement plan options, such as 401(k)s, Keoghs and IRAs. Yes, this implies the core audience is fairly affluent. But there are plenty of people who have money set aside for retirement outside their IRAs or 40l(k) plans. Investing in a fixed-rate instrument that pays competitive rates and also offers tax deferral could be a good solution if youre willing to park part of an inheritance or other windfall at least until youre ready to retire. And if youre willing to take more risk, look at tax-deferred annuities that offer a variable return, based on the performance of mutual fund-like sub-accounts inside the annuity.
Retirees may find that immediate annuities -- that "check-a-month for life" -- can also be a smart use for at least a portion of their retirement funds. An immediate annuity guarantees youll have money coming in, every month, as long as you and your spouse are alive.
But dont be mesmerized solely by the promise of deferring taxes. Despite years of criticism, some companies insist on marketing annuity products that are so costly in terms of fees and penalties that youll be financing the insurance salespersons retirement, not your own. Shamefully, some agents even recommend purchasing annuities to grow inside an IRA. Its crazy to pay extra to defer taxes on an account that already is tax-deferred.
If youre thinking at all about annuities, learn how they work and learn how to buy them from cost-competitive providers.
The basics
An annuity in its simplest form is a contract between you and an insurance company. (This can also be the insurance subsidiary of a mutual fund or brokerage company.) Because the federal tax code lets cash deposited in insurance contracts grow tax-deferred, you can essentially create your own pension fund. The tax-deferred annuities come in two types: fixed rate or variable. Or you can choose the more traditional immediate annuity to get a guaranteed, but fixed income for life.
A tax-deferred annuity. In this type of annuity, you invest your money, and the earnings on that cash build up, deferring taxes until you start to take the money out. When you take money out, all earnings are taxed as ordinary income. There are two types of tax-deferred annuities: fixed rate or variable. The fixed rate annuity works like a CD inside the insurance company contract -- although theres no federal guarantee on the product. The variable rate tax-deferred annuity offers you a choice of sub-accounts into which you allocate your money much as you would allocate money among mutual funds. You can switch between these accounts with few restrictions. The build-up of your account value depends on your investment skills.
An immediate annuity. This annuity pays you immediately a guaranteed sum each month until you die (or your spouse dies). The payment is based on your age and your spouses (if applicable) and how much money you deposit. Payouts vary among insurance companies sometimes by as much as 50%. So shop around. When you die (or after your spouses death), the insurance company keeps the balance. An immediate annuity locks you into a fixed monthly payment that might not keep up with future inflation. Nonetheless, the product has some fans who are interested in the security of the income stream in the face of a dismal stock market. There are now ways to purchase an immediate annuity with some upside, as well as downside, variation in the monthly amount.
Watch the risks
Annuities come with their own set of risks, including:
Income taxes when you take the money out. All the growth in your account must be withdrawn as ordinary income. There are no capital gains in annuities even in those variable fund accounts. Only the portion that represents a return of your original invested capital is not subject to taxes. And if you havent withdrawn the money from your account when you die, it is considered a part of your estate and may be subject to estate taxes.
No tax deduction on contributions. Any money that you invest in a deferred annuity is after-tax money. That makes an IRA, Keogh, 401(k) or SEP-IRA your first stop for retirement savings.
Big tax penalties for early withdrawal. As with IRAs, 401(k)s and related accounts, if you withdraw money before age 59 1/2, youre subject to a 10% federal tax penalty plus income taxes on the money you withdraw. If you dont like the performance of your annuity, the only way to avoid penalties is to roll your annuity into another annuity -- a so-called 1035 exchange.
After age 59 1/2, you have several choices on how to withdraw money. You can take a lump sum or withdraw differing amounts at any time. Or you can annuitize -- take a regular stream of income for the rest of your life or the lives of both yourself and your spouse. A warning: if you decide to annuitize, you can never change your mind. And, if you choose to annuitize, the insurance company retains the balance of your account when you die -- or the surviving spouse dies.
Fees and surrender charges. Fees on tax-deferred annuity accounts can be huge and hard to understand. So you should read the contract very carefully before you sign. On fixed-rate annuities, the fees work to reduce the yields. So compare yields before buying. Also make sure that the guarantee period the time the rate is promised matches the surrender period. That way you wont get stuck with an annuity that has dropped its rate, while you still would pay surrender charges to get out.
Fees on variable annuities can run 2% a year or more. These include the fund management fees and the M&E (mortality and expenses) charges. The latter pays for a death benefit -- either your original investment, or a higher value set under the contract terms -- and other expenses, including marketing and commissions.
Surrender charges, or penalties for early withdrawal, can start at 5% to 8% and decline to zero over a period of time, usually five or six years. Some surrender periods last as long as eight years. But many variable annuities are sold with no surrender charges.
Bottom line: All the fees in an annuity can be a high price to pay for tax deferral, but well show you how to find those with the least costly fees and charges.
Security. An insurance contract is basically only as good as the financial strength of the insurance company that stands behind it. Unlike a bank deposit, an annuity does not come with federal deposit insurance. It may get some backing from state insurance guaranty programs. So, very carefully check the companys ratings from Moodys, Standard & Poors or A.M. Best before investing any money.
Performance. This mostly applies to variable annuities. The money an investor puts into a variable annuity is subject to market risk. If you expect to withdraw the money during your retirement, you could have a loss of principal in spite of the guaranteed death benefit provided by the mortality charge. The volatility has, in fact, begun to depress variable annuity sales in the last six months. To get a handle on performance as well as fees and penalties, however, I recommend you look at the variable annuity performance tool at Insure.com, which is a partner of MSN Money. (See link at left.) The tool was developed with Morningstar, the Chicago investment research firm.
New choices
The annuity companies are still trying to make their products more competitive and have offered some new wrinkles in recent years, including:
Immediate variable annuities. Essentially, you invest a lump sum. It starts to pay immediately, but its invested to try to capitalize on financial market performance. Two companies that have actively marketed the product are T. Rowe Price and Fidelity Investments. With the T. Rowe Price annuity, you invest a minimum of $25,000 in any combination of nine managed investment portfolios. You can move money among the funds up to six times a year. T. Rowe Price calculates an initial monthly payment to you and recalculates it once a year thereafter, based on investment performance. The payment will be at least 80% of your initial monthly payment for as long as you live. But if your investments do well, your payment should rise with no cap. The downside: fees for the annuity total 2.2% of assets.
In Fidelitys Income Advantage annuity, you pick from three benchmark returns at purchase -- 3.5%, 5%, and 7% -- and invest in any of 28 different Fidelity and non-Fidelity fund choices. You may switch fairly freely between them. The amount by which your return exceeds the benchmark determines your monthly payout. The downside is big: theres no floor to your monthly payment. (Fidelity recommends pairing this annuity with an immediate fixed-rate annuity to reduce risk.)
Choosing an annuity
As I said, annuities may have a place in your retirement planning.
The tax-deferred annuities, whether fixed or variable, can help your retirement planning once youve used up all other opportunities for tax-deferral, such as your company 401(K) retirement plan, IRAs and Keogh or SEP-IRA plans
The immediate annuity can really help someone who worries about his ability to invest successfully or wants to guarantee an income stream to a surviving spouse. Used in combination with other retirement investments, it can take some of the worry out of those later years.
The costs remain the big stumbling block. Traditionally, an annuity is sold by insurance agents, and theyre well compensated for helping you out. The cost of their commissions (6% to 8% of the money invested) is paid out of ongoing expense fees and from surrender charges.
Some companies including Fidelity, Vanguard, T. Rowe Price, Ameritas Life and TIAA-CREF offer low-cost annuities. They not only have low management fees on the mutual fund sub-accounts in variable annuities, but keep other expenses low since they dont pay commissions to salespeople.
Some traditional insurance companies offer similar products to those sold by their agents, with lower costs and charges, if you buy through a fee-based planner. And there are online services that will help you compare traditional products, including the projected costs and charges, while acting as independent agents for multiple insurance companies.
Always remember that commissions or fees on annuity products are built into the costs of the product. Any commissions paid to agents are taken out of this annual fee. Youll find the fees in your contract, and remember: they go on for the life of the contract. So compare, compare, compare.
Where to find more information
The Internet offers a lot of information to help you make good decisions about annuities. Here are some of the resources available to you:
Insure.com. A partner of MSN Money, Insure.com is an independent site that offers a wide variety of information on annuities and other insurance products.
AnnuityScout.com. This site offers annuities from 59 carriers. The sites comparisons on fixed-rate annuities include not only rates but surrender periods and company ratings. You can get a prospectus and performance record for each of the investment sub-accounts (funds). In May, youll be able to buy an annuity here. The site only presents variable annuities with no surrender charges. Their offerings of fixed-rate annuities feature products where the guarantee period is matched to the surrender period.
AnnuityNet.com. This Web site offers annuity products from six major companies, including GE, Lincoln National, John Hancock and Keyport. This site also offers software to track purchases, manage client portfolios and track data on the sub-accounts.
ImmediateAnnuity.com. This site specializes in comparing the payouts on immediate fixed annuities. You can click on the home page to get an estimate of what your monthly payout on a fixed sum would be, or fill out a form and receive next-day quotes from 15 different immediate annuity sources.
Quickquote.com. Working your way through this site to get free annuity quotes can be a chore, but the instant quote feature is worth it. It asks for your e-mail address, but no other personally identifying characteristics, when you fill out the online form.
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