SHOW NOTES: 2019-08-22 MiM

Last Week’s Question of the Week: How much does the average American spend on nonessential expenses? Is it $1,000 per year, or $5,000 per year?

ANSWER: The average American spends $5,339 a year on nonessential expenses like restaurant and takeout meals, coffee, rideshares, and leisure events.

HOST: I know that when people start talking about retirement, the word annuities often comes up. Today you are going to give us a summary about these products and enlighten us.

KLAAS FINANCIAL: Yes, so first a couple of interesting facts: annuities first came to America in 1759 in the form of a retirement pool for church pastors in Pennsylvania. Since then, they have continued to grow as a potential tool for retirees. Today, annuities of all types account for 10% of U.S. Retirement assets ($25 Trillion) in 2017.

While we are insurance licensed and can offer to sell annuities, and sometimes utilize them in ways to help our clients defer gains on old annuities, we should start out by saying that we are not always fans of annuities. Like everything in life, there is the A-Z world of annuities. Some over time have done well for people, and others have internal charges that really take away from overall performance.

So, what is an annuity?
Annuities are long-term investments specifically designed for retirement. Remember that word “for retirement.” If you take money out of an annuity prior to age 59 ½, you will pay a penalty.

An annuity can basically offer a paycheck with predictable income. The income—paid either through optional living benefits for an additional cost or through annuitization, converts your assets into an income stream—is backed by the claims-paying ability of the issuing insurance company. For many people, buying an annuity offers the reassurance that they won’t outlive their investments.

Many annuities sound like great moneymakers, but there are often hidden fees that can cut into any profits the annuity pays out, so buyers beware. We will discuss further in a minute.

HOST: There are so many types of annuities, can you describe them?

KLAAS FINANCIAL: There are two basic types of annuities:

  • Immediate annuities go directly into the distribution phase. There is no accumulation phase. Immediate annuities offer owners a choice of income options in exchange for the premium payment.
  • Deferred annuities begin in the accumulation phase. The owner pays premiums into the annuity and chooses from the available investment options. During this phase, earnings typically accumulate on a tax-deferred basis. The owner has the flexibility to start the distribution, or income, phase at a later date, often coinciding with a retirement date.

There are two kinds of deferred annuities:

  • Fixed annuities offer a fixed rate of return for a specified period of time. You can select the time period that may be right for you based on your investment horizon and retirement income needs.
  • Variable annuities offer a wide range of professionally managed investment options. The value of the annuity contract fluctuates based on the performance of the underlying investment options (also called subaccounts) chosen by the owner. Optional living benefit riders are available at an additional cost and can provide guaranteed lifetime income, regardless of how the annuity’s investments perform.

HOST: So you mentioned that there are costs and sometimes hidden fees for annuities?

KLAAS FINANCIAL: Yes, so there can be some disadvantages, such as high fees and limited liquidity. In addition, these products are often complex and can be hard to understand, even for a well-educated business professional.

Things to be aware of:

  • Commissions: Annuities are sold by insurance brokers or other sales people who collect a commission that can be steep – as much as 10% or so. You don’t see this directly come out of your investment when you write the check, but you should be aware of some of the incentive in this being sold to you.
    • Surrender charges: If you opt to pull your money out of an annuity within the first several years after you buy it, you’ll pay dearly. Surrender charge typically runs about 7% of your account value if you leave after one year, and the fee generally declines by one percentage point a year until it gets to zero after year seven or eight. Note that some annuities come with even heftier surrender charges – up to 20% in the first year.
      High annual fees: If you invest in a variable annuity you’ll also encounter high annual expenses. You will have an annual insurance charge that can run 1.25% or more; annual investment management fees, which range anywhere from 0.5% to more than 2%; and fees for various insurance riders, which can add another 0.6% or more.

    Add them up, and you could be paying 2% to 3% a year or more. That could take a huge bite out of your retirement investments and in some cases even cancel out some of the benefits of an annuity. Compare that to a regular mutual fund that charges an average of 1.5% a year, or index funds that charge less than 0.50% a year.

    HOST: What about taxes and annuities? What happens to deferred growth?

    KLAAS FINANCIAL: The tax rules vary based on the type of annuity and how you take the money.
    You can buy an annuity with funds in your IRA, and if you use pretax money from an IRA or a 401(k) to purchase the annuity, then all payouts will be fully taxed.

    If you use after-tax dollars to buy the annuity, however, then a portion of the payouts will be a tax-free return of your principal. Either way, you’ll have to pay any taxes that you owe on the annuity at your ordinary income-tax rate, not the preferable capital-gains rate. If you don’t need money from your annuity in your lifetime, your beneficiaries will be the ones to pay income taxes on the deferred growth, which can become a big problem for those beneficiaries.

    Be careful of cashing out annuities; consider completing a 1035 exchange on non-qualified annuities or face paying taxes.

    HOST: Shifting gears, we’ve come to our Money in Motion Listener Question Corner, one of your listeners, George, submitted this question: “The majority of my retirement funds are currently sitting in my 401k. Should I be considering converting a portion over to a Roth account?”

    KLAAS FINANCIAL: Thanks, George, for the question! As always it depends. It depends on your age, your current tax bracket, your future tax bracket and how much additional in taxes you want to pay in the year you decide to begin the conversions. It would be best to consult both your tax accountant and your financial advisor to see if this makes sense in your case!

    HOST: So, when can an annuity makes sense?

    KLAAS FINANCIAL: Recent studies showing the average life spans of men and women increasing, people without pensions are often left with a gap in their retirement plans. Annuities can provide some clients, the peace of mind in knowing they have a stable, reliable income in retirement. So the positives include:

    • To Provide a Hedge Against Longer Life Spans
    • To Take Control Over Too Much Spending
    • To Have Peace of Mind Over Stock Market Gyrations: For people who have absolutely no stomach for bear markets or stock market volatility, annuities can help prevent them from making “the big mistake”—selling stocks during a big market pullback. If you panic and sell a large chunk of your portfolio in a down market, it’s hard to recover especially if you delay reinvesting.