Last Week’s Question of the Week: According to a Harris Poll in 2017, what percent of Americans have NOT made a will? ANSWER: According to a recent Harris Poll, 64 percent of Americans have not made a will.
HOST: I know that when people start talking about retirement, the word annuities often comes up. Today your going to give us a summary about these products and enlighten us. But first, when did annuities even start in the U.S.?
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: When I hear there are so many TYPES of annuities, can you describe these?
KLAAS FINANCIAL: Yes, now for the education part: There are two basic types of annuities:
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 different 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.
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.
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.
- For starters, most 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.
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: According to the Centers for Disease Control, people who were 65 years old in 2014 will likely live into their 80s. After reaching 65, men can expect to live another 18 years and women an additional 20.5 years. With life expectancies continuing to rise, annuities sometimes can make sense.
To Take Control Over Too Much Spending: This is sometimes suggested as a reason to have an annuity, but we would argue that someone who needs their money, regardless of a contract, will pay surrender fees to get it out anyways.
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.
Catch C.J. Klaas and Maleeah Cuevas on Money in Motion every Thursday on Madison's 1310 WIBA from 8:05-8:35am.
