Are Annuities Right for Your Retirement?
Because of this, for many, annuities have never looked more tempting. Just read the American Council of Life Insurer's brochure, The Individual Annuity A Resource in Your Retirement, "An annuity can provide a steady stream of income for life, shifting the burden of managing savings from you to your life insurance company. No other personal financial product offers this guarantee of lifetime income." That's the pitch. It's not surprising then that Beacon Research reports that U.S. sales of individual fixed annuities rose to about $19 billion in the first quarter of this year, up 6% from the same period in 2010.
If you're like many people, you wouldn't consider yourself an expert on annuities. Apparently, that's not stopping shell-shocked people -- especially baby boomers -- from seeking low-yield, but stable investments, according to Allianz Life's 2011 Reclaiming the Future study. When asked which is more attractive, a financial product providing 4% return that is guaranteed not to lose value, or one with 8% return that is subject to market risk and loss of principal, 76% of people chose the guaranteed product. And 81% of boomers say their most important goal is having a "stable, predictable standard of living throughout retirement," according to Allianz's study.
Prudential's new survey, The Next Chapter: Meeting Investment & Retirement Challenges, confirms this run to safety narrative: 58% said they've lost faith in the stock market and 44% said they are not likely to ever put more money into stocks. And 40% said they have a conservative portfolio today, compared with 33% pre-recession.
This change in mindset has not been lost on the 401(k) industry: There are retirement income or guaranteed income solutions in many 401(k) plans. An annuity or annuity-type product may be coming to your 401(k), or it may already be there, which is all the more reason to give them a closer look. ACLI's brochure is a good starting point.
You can carefully analyze the costs, product features and guarantees, but fair warning: "You may never understand everything you need to make a good decision. You will be at the mercy of the person selling you the annuity," says Barbara Roper, director of investor protection for the Consumer Federation of America. "Given the often astronomical costs and potentially harmful features -- such as lengthy surrender periods with high penalties for early withdrawal, consider buying an annuity from someone with a legal obligation and a firm commitment to act in your best interest," says Roper.
"This is not your parent's annuity. The product suite is new, innovative and customizable, a lot different than products available even a few years ago," says Mark Fitzgerald National Sales Manager for Saybrus Partners, a consultancy firm.
Annuities can be quite complicated, and there's plenty an investor can get wrong. The word "annuity" describes at least five different kinds of products that have little in common besides the name, the fact that they are issued by insurance companies, and give the owner the option to convert his or her money to a guaranteed income stream at some future date, says Kerry Pechter, editor and publisher of RetirementIncomeJournal.com and author of Annuities for Dummies. Annuities can be fixed, variable, immediate, indexed, and more.
"There is a big difference between the products and their costs," says Roper. "The person selling you the annuity probably doesn't conduct the analysis to determine which is best for you, and instead is likely to sell you whatever their company sells, or the one that pays them the most."
Know the Differences
The main difference between variable annuities and fixed annuities is that a fixed annuity protects your principal from stock market losses, while a variable annuity can lose value when the stock market declines, explains William Smith, president of W.A. Smith Financial Group. A fixed indexed annuity offers a guaranteed minimum rate of return or the return based on an underlying stock index such as the S&P 500, whichever is higher, says Smith. Fixed indexed annuities also provide the contractual promise of guaranteed lifetime income much like a good-old fashioned pension. An immediate annuity provides an immediate income stream with no access to principal in the future.
Be clear on what you're buying and whether it aligns with your goals.
Some annuities have up to 10-year surrender periods, and high penalties if you want to get out of the investment sooner.
Do They Belong in Your Portfolio?
How might annuities fit into your retirement plan? "They should not be used as an equity alternative, since they are not designed to compete with the stock market or to have tremendous gains," says Ryan Peterson, president at Wisdom & Wealth Solutions. "They should be a long-term vehicle to provide a base guarantee of return and lifetime income in retirement above CDs or other guaranteed income products."
In other words, while perhaps they should be a part of the plan, they definitely shouldn't be the entire plan.
Think twice about a deferred variable annuity unless you're confident you won't need the money for at least 10 years, says Steven Weisman, professor at Bentley University and author, The Truth About Buying Annuities. And don't consider an annuity until you've maxed out your IRAs and 401(k)s, he says. "Tax deferral is good. Paying no taxes is better. A Roth IRA always beats an annuity."
Figure Out the Fee Structure
Then there are the fees -- some clear, others hidden. The cost of a variable annuity, for example, varies from 2% to 4% of the investment, according to Pamela Green, an annuity specialist at Sapient Financial Group.
There are mortality and expense charges which cover the life insurance component of the annuity; investment management fees, contract maintenance fees and more. These fees can drastically eat into the value of the annuity. There are some companies, like Vanguard that sell annuities with low fees," says Weisman.
Beware of bonus annuities. "It sounds nice to get an upfront bonus, but those bonuses come with additional fees," says Carole Peck, a certified annuity specialist. "Ask to see the cost of an annuity without the bonus option. Each company has a different fee schedule, so it's important to ask."
In fairness, John McCarthy, CPA and product manager, Advisor Software, Annuity Solutions for Morningstar (MORN), says there are misunderstandings about fees. Most people compare a variable annuity to a mutual fund, he says, but that is only half the picture, because a mutual fund does not offer guaranteed living or death benefits. The actual fees of the sub-account investments (mutual funds) are typicallylower than their stand-alone mutual fund counterparts. As for the guarantee, that's where the extra cost comes in. There are two types of guarantees: first, a death benefit which gives your estate the ability to recover any lost investment value should you pass away while the account value is below your initial investment value; and second, a living benefit guarantee, which commonly offers payments for life, regardless of whether the investment completely tanks, he explains.
The bottom line: "Ask yourself if the benefits are worth the cost? The answer depends in part on your risk tolerance, portfolio size relative to cash flow needs, and proximity to retirement," says Mitch Kauffman, a certified financial planner with Kauffman Wealth Services.
Know Who You're Getting in Bed With
Annuities are only as safe and conservative as the company issuing them, says Weisman. Always research the strength of the company and its rating with the major rating services like A.M.Best Co., before buying an annuity. "They will let you sleep at night. By investing in an annuity, you may be able to invest more aggressively in other parts of your portfolio," he says.
Annuities are not FDIC insured. "They are backed by the underlying insurance company. Understand insurance protection limits if the company fails. Coverage amounts vary depending on where you live. Coverage is at least $100,000 in most states," says Roman Ciosek, managing director and partner at HighTower Advisors' Strata Wealth Management.
Is a 401(k) the Place for an Annuity?
Eleanor Blaney, consumer advocate for the Certified Financial Planning Board, is blunt, "This is categorically a bad idea." For one, if 401(k) plan loans are an attractive feature, realize that you may not be able to use your annuity benefit to provide a loan, says Thomas White, a partner and member of the employee benefits practice group with Arnstein & Lehr. It may also be impossible to move the annuity to another plan or to an IRA upon termination of employment.
Pechter's view is more nuanced. Much depends on the precise kind of annuity the 401(k) offers, he says: They may be cheaper than retail annuities, because there are often group rates. But McCarthy suggests that a variable annuity inside a 401k can replicate a defined benefit pension,
Consider the Advantages
Mike Terrio, president of The Terrio Group, says annuities' lifetime income guarantees and upside growth potential are real benefits. But the biggest advantage of annuities is that they allow you to save money on a tax deferred basis, says Weisman. Unlike other tax deferred investments, such as IRAs and 401(k)s, there are no annual contribution limits.
Laddering fixed immediate annuities can be an effective strategy to take advantage of rising interest rates and obtain a higher monthly annuity payout, says Weisman. Because annuities have beneficiaries tied to them, they are free of any probate fees or delays passing the funds to beneficiaries, which is another plus.
Insurers are seizing the moment to promote annuities. For example, this month, New York Life is launching its Guaranteed Future Income Annuity, a deferred income annuity which offers consumers an opportunity to create their own personal pension.
Annuities aren't the simplest solution, but worth a second look. Shaky-kneed investors, study up.