Your Finances: Focusing on Annuities

Navigating the ins and outs of today’s investment alternatives requires a little homework.

An annuity makes sure your cash flow doesn’t kick off before you do. In other words, an annuity provides a guaranteed retirement income for life. That makes it unique compared to other investments, which end when the money in the account is depleted.

However, annuities have always been one of the most complex investment vehicles, even more so in recent years. So if you’re thinking about purchasing an annuity, definitely do your homework thoroughly and enlist the help of a trusted advisor as well.

Only insurance companies can issue annuity contracts because your payout is not just based on how much money is invested and the rate of return, but your estimated lifespan, too.

Right now, annuities are something more people are looking at, says David Stoeffel, vice president of investment products for the Northwestern Mutual Financial Network of Milwaukee. According to its annual report, in 2007 the company received $1.3 billion in new premiums and deposits for annuity contracts, an 11 percent increase over the previous year.

“Annuities are a ‘paycheck for life,’” Stoeffel says. “I think annuities address a need, in an environment where corporate, defined benefit plans are things of the past and the Social Security system is changing and may not be adequate to meet lifestyle needs for most Americans.”

Alvin Schulz retired at age 68 from Dana Corporation’s Indianapolis plant without qualifying for a pension. He faced a choice about what to do with his company-funded Cash Plus account: receive a lump sum of money reduced by income taxes owed, or buy an immediate annuity—a type of annuity funded by a single deposit with the payments to begin immediately—and receive the money spread out over his lifetime with taxes taken out as he received payments.

Schulz and his wife, Mary Ann, chose the immediate annuity, electing a lower monthly payment to make his wife a joint annuitant. Under this arrangement, if one person died, the other would continue receiving an income for life. He calculated they would break even at 10 years. If one of them lived beyond ten years, they would exceed what they put in.

Many of his coworkers also opted for an annuity, while others disagreed, thinking they could make more money by taking lump sums and investing them.

“We thought about putting it in CDs (certificate of deposits),” adds Schulz. “But when we looked at the taxes and the return, the annuity was a better deal, if you lived long enough. A lot of people said, ‘You’re crazy to buy an annuity.’”

Schulz, 74, speculates that if he were in his 20s or 30s, he might have taken the lump sum and invested in the stock market. But having seen the market “skyrocket” and “plunge,” he likes that this relatively small piece of his retirement planning remains stable. Sadly, Mary Ann died unexpectedly last year at age 71 after 53 years of marriage.

Matthew Tuttle, president of Tuttle Wealth Management, LLC in Stamford, Connecticut, however, isn’t a fan of annuities. He thinks there are too many fees associated with them.

In fact, the fees vary widely among companies, so a cost comparison is critical.

If you choose a variable annuity, you can select from a wide variety of accounts that offer numerous investment choices, similar to mutual funds. The fees are based, in part, on what investments are selected. Because the money in an annuity grows tax deferred, you can make changes in the investment choices without incurring taxes. In comparison, with mutual funds, unless they are invested in an individual retirement account making the growth tax deferred, you may pay on capital gains if you change investment choices.

If you want to keep things simple and have an absolutely stable investment, both immediate annuities and deferred annuities include options that offer a fixed return on the money. While rates are lower, you no longer need to worry about the fluctuations in an annuity invested in the market.

However, deferred variable annuities contain a clause that guarantees a death benefit equal to at least what the investor put in, even if the market goes down and the annuity account loses money. Tuttle says the fees for the death benefits and the cost of commissions paid to financial representatives to sell annuities are reasons to steer clear of annuities.

“Very rarely do I put someone into an annuity,” Tuttle says.

Tuttle especially cautions investors about some variable annuity riders that emerged in the past several years. The riders sometimes charge one percent of the total contract to offer living benefits, which guarantee a certain minimum amount of income can be taken out yearly, before you have chosen the retirement income option. How much a person can take out under these riders is based on a complex formula.

Whether you invest in an annuity or another investment vehicle, there are always some fees associated with investing. Mutual funds charge an array of fees, and personal investment advisors are compensated in a variety of different ways.

After considering the pros and cons, Michael Havens and his wife, Suzanne (not their real names), purchased a variable annuity. They elected a rider that provides living benefits. If they meet certain criteria, they can take out a guaranteed minimum amount annually.

The Havenses lost their middle-management jobs while still in their 50s because the plant where they’d worked for decades closed down. With their former employer’s future uncertain, the couple worried whether their pensions were secure. They elected to take their pensions in lump sums and immediately invested a portion in a tax-deferred variable annuity, while the majority of their retirement savings is spread over a variety of investments.

“To me, the whole key is diversification,” Michael Havens says. “You have to hedge your bets everywhere. We wanted something with the lowest risk possible, which could still have that upside potential. The bottom rate is guaranteed. Do you pay for that? Sure. You always pay for security. There are a lot of annuities around that are charging fees that are pretty outrageous.”

Stoeffel advises people considering annuities to look at individual needs. Then, he says, sit down with a knowledgeable advisor to explain the complexities and determine which annuity riders warrant the costs.

“It’s like when you buy a car,” Stoeffel explains. “Do you want a GPS (Global Positioning System)? I don’t want one and don’t want to pay for one. I like to read maps. But my wife wouldn’t have a car without one. She loves her GPS.”

Choosing the income plan is another important decision. You’ll get the highest monthly payment if you select to have the annuity pay you until you die, then stop and pay no one else. But there are other options that may serve you better. Ask for calculations on several income options. Depending on your situation, you may find you’re willing to take a reduction in the amount you receive in order to provide for your loved ones. For example, Northwestern Mutual and other companies offer a “Single Life with Refund” income option. There is also “Single Life with Period Certain,” so if you die before the specified period of time, payments continue to your beneficiary.

State insurance commissioners are on the front lines of regulating advisors who sell annuities. And consumer complaints about annuities, especially from seniors, have increased. Officials became so concerned that the Wisconsin insurance commissioner’s office, for one, put together a committee to address the problems. The National Association of Insurance Commissioners has followed their lead and created a committee to come up with ways to be sure the public, as well as advisors, become educated on annuities. The Wisconsin panel originally addressed issues regarding seniors, but the topic has since been expanded to consumers of all ages.

“We continue to see various problems in the sales of annuities to senior consumers,” says Kimberly Shaul, deputy insurance commissioner. “Sometimes, there were misrepresentations made in the sale. In some cases it appeared the producers selling the products did not clearly understand them.”

In June of 2005 the National Association of Securities Dealers—a self-regulatory organization of the investment industry—issued an investor alert for equity-indexed annuities. It warned to pay close attention when considering that type of annuity.

Checking the financial ratings of the insurance company issuing the contract is also important. An annuity contract may possibly be an investment you own longer than any other. Depending on your age, you may buy a deferred annuity and let the money accumulate for decades. Then you’ll select an income plan, which will last the rest of your life. You don’t want the insurer to get into financial trouble along the way. If the insurance company that issued your annuity contract becomes insolvent, an organization called a state guarantee association may cover part or all of your fixed-rate contract. But the provisions vary by state and the process to get your money can take time. However, the protections don’t usually provide full benefits, and getting what is owed you can be difficult and time-consuming.

Insurance officials say surrender fees for annuities are higher than other investments because they’re meant to be a lifetime investment. However, sometimes the same company will offer several choices in how surrender fees are structured. So be sure to ask and to also compare among companies. But aim to make a selection you’re happy with and can stay with. That way you will avoid having to pay surrender fees.

Tuttle says one client brought him an annuity with surrender fees of 15 percent. If you decide you’ve made a mistake, you can do something called a 1035 exchange, but you may have to ask about it and there is extensive paperwork involved. If you experience buyer’s remorse immediately or see that the contract isn’t what you wanted, there is an option. Annuities offer a ten-day free look period after receiving the contract, in which time the investor can return the contract without penalty: this review option may not be available in all states.

Because an annuity is for retirement and grows tax-deferred, there is a 10 percent penalty if someone takes out money before age 59½, plus unpaid taxes would be due.

One unusual legal consideration with annuities may be important to you. In some states, annuities receive special status and are sheltered if you are sued in a malpractice case or in other legal trouble. However, you can’t just run and invest in one when a lawsuit is imminent. It would need to be a legitimate purchase that fit with your overall financial plans at the time.

Despite the daunting complexities, annuities are the only way to guarantee a retirement income that lasts as long as you do. If outliving your money is a concern, they are worth exploring.

“I think you have to be careful what you select, and you have to know what you’re paying,” Havens says. “I know what I have and what I’m paying for it. I’m satisfied.”

“I think annuities address a need, in an environment where corporate, defined benefit plans are things of the past and the Social Security system is changing and may not be adequate to meet lifestyle needs for most Americans.”