Annuity Advice

The recent worldwide financial crisis and accompanying recession have wreaked havoc on the portfolios of countless investors. In addition to the visible changes, this steep and prolonged downturn has also changed the attitudes of investors. First-hand experience with the volatility of equity markets has renewed appreciation for safety and security as investment attributes. This has stimulated interest in annuities, which offer the prospect of guaranteed lifetime income and the possibility of lower volatility in portfolio value.

Investments are like medicine – the right choices for some people are absolutely wrong for others. Annuities have figured in some well-publicized recent investment abuses. The best way to avoid costly mistakes is to learn the basic makeup of an investment – its “active ingredients,” as it were – and see how that dovetails with your own goals and attitudes.

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The following five pieces of annuity advice should help you find out if annuities are the right medicine for you.

1. Annuities Are a Retirement-Oriented Asset

The structure of annuities – whether immediate or deferred – is clearly oriented toward retirement. The option to annuitize – take income in the form of periodic level payments for the remainder of life – will be exercised at retirement, when earned income ceases and you begin to live off your assets. The insurance features associated with annuities – not merely the death benefit, but also the rate-of-return and income guarantees available with many products – match up well with pre-retirement and retirement-investment goals. The tax-deferral benefits of annuities are most valuable for those in the highest tax brackets who have already met contribution limits in tax-advantaged retirement accounts. On average, these are middle-aged people approaching retirement.

The laws governing annuities reinforce this retirement orientation. Investment gains accruing inside an annuity enjoy the privilege of tax deferral, just as do investments in tax-advantaged retirement plans. Withdrawals from annuities prior to age 59 ½, i.e., prior to retirement, are subject not just to ordinary income tax, but also incur a 10% tax penalty.

The cost structure of annuities also implicitly favors retirement investment. Most annuities carry surrender charges, which vary in size and duration. The charges may be 7-9% for the first two years after purchase, then decline steadily over the remaining term of the surrender charges. Duration may exceed ten years but usually does not. Variable annuities add a second layer of insurance-and-administrative costs on top of the investment costs of its subaccounts. This makes them competitive with non-annuity investments only over very long holding periods – still another predisposing factor in favor of retirement investment.

Many of these retirement-oriented characteristics make annuities a doubtful choice for young investors. Beginning investors often have intermediate saving-and-investment goals, such as liquidating mortgages, funding children’s education, and purchasing big-ticket consumer durables. Their income is typically at its lowest point since they are just acquiring job skills and proficiency in their chosen field. This limits their retirement saving to whatever they can afford to contribute to tax-advantages plans such as IRAs and 401k plans. They also have a need for liquidity to cope with the inevitable emergencies of life.

There is a solid case for annuity investment by individuals or couples in middle age and older, all the way into retirement itself. There is an equally solid case against annuity investment by twenty- and thirty-somethings. One possible exception to these rules of thumb might be young professionals and business owners who require a shield against liability judgments. Many states exempt life-insurance assets from seizure in tort cases, which provides a role for variable annuities as a growth investment. In addition to their standard tax-deferral advantages, variable annuities may provide insurance against the loss of assets to legal judgments.

2. Match the Annuity to Your Degree of Risk-aversion

Academic studies find that the value of annuitization increases as investor risk aversion increases. Thus, an immediate annuity is an excellent way to neutralize the risk of outliving one’s income. Deferred fixed annuities and CD annuities are appropriate for investors who want to eschew the risk of equity markets. Indexed annuities provide the opportunity for somewhat larger returns at the risk of more volatility; they are also an alternative to equity investment. Deferred variable annuities combine the potential high returns of mutual funds with tax deferral; they are ideal for high earners in middle age who need more growth but have used up their allowable tax-advantaged contributions.

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3. Check Out the Guarantor As Well As the Guarantee

Most annuities are issued by insurance companies, which offer both investment- and income-related guarantees. The financial condition of the issuing insurance company underwrites the guarantees, which makes it advisable for an annuity purchaser to limit purchases to products of financially-sound insurance companies. The four major rating agencies provide ratings for life-insurance companies. It behooves a prospective annuity purchaser to choose only highly-rated companies. Each rating system is slightly different than the others, but all of them explain their ratings coherently.

This step is vitally important. A highly risk-averse investor who annuitized most wealth, only to see the value of the annuity decimated when the insurance company went bust, would suffer a crushing loss. It is true that insurance companies seldom declare insolvency and that a measure of backup is provided by the state guarantee funds, as well as by the acquisition of sick companies by healthy ones. Nonetheless, there is no reason not to solidify your position by checking on the financial-soundness rating of any company whose annuity you are contemplating.

4. Shop Around

Financial soundness is not the only reason to review competing annuity products before purchase. Annuities are famous for the number and complexity of their features. Payouts, death benefits, rate-of-return and income guarantees, number and variety of sub-accounts, ability to transfer funds between alternative investments, withdrawal provisions, and surrender-charge waivers are among the annuity benefits that vary across, and within, insurance companies.

Shopping can pay even bigger dividends on the cost side. Surrender charges are a traditional drawback of annuities, but today it is even possible to find annuities that have no surrender charges. High costs and fees are another traditional bugbear, but low-cost and no-load annuities have increased in number.

How does the careful shopper proceed? Not surprisingly, rule number one of annuity shopping is to read the annuity contract carefully and thoroughly.

5. Remember the Meaning of the Word “Annuity”

Research suggests that only a very small fraction of annuities are actually annuitized. For the most part, Americans use annuities to accumulate and grow investment funds rather than to provide lifetime income.

This is highly ironic, since the original annuities were used to deliver level payments that were guaranteed for life. The word “annuity” itself referred to the lifetime stream of level payments rather than to the investment vehicle that funded it. (Today, this original form is called an “immediate” annuity to distinguish it from the more-common deferred annuities.) The reasons for this low rate of annuitization are open to debate. Part of the solution seems to be the fact that a large chunk of retirement-directed wealth is already “annuitized” by the Social Security system and private pensions. Another reason seems to be the loss of control involved in surrendering wealth to the annuitization process.

Two factors should cause Americans to reevaluate their position on annuitization. First, life expectancies have been steadily increasing over the last half of the 20th century and first decade of the 21st century. This exacerbates “longevity risk” – the danger of running out of money before running out of life. Retirement investors are increasingly contemplating the necessity of increasing their exposure to equity investment in order to increase their rate of return, so as to accumulate sufficient wealth to last for a longer lifetime. Moreover, the realized rate of return on an annuity increases the longer one lives, which makes annuities a better bet in an era of increasing life expectancies.

This highlights the role played by the second factor. The recent economic cataclysm has apparently awakened the inner conservative in many investors, driving them to less volatile, more secure investments. This suggests that simple asset reallocation in favor of equities will not solve the problem of longevity risk for those people who have become more risk averse.

Annuities can be one solution to both of the foregoing problems – provided that investors take good annuity advice. Follow the general principles outlined above and you’ll be doing just that.

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