Are annuities the greatest thing since sliced bread? Well, no, but they do make sense for some investors as part of their portfolio. However, we have to shop wisely and not allow sales agents to push us into the wrong products just to fatten their own wallets. Unfortunately, that makes some folks shy away from something that could help them make their money really last a lifetime… or longer.
After we published both a Money Forever premium issue on annuities and a special report (The Annuity Guide) last November, our team received an outpouring of emails, some sharing happy stories and others with sad tales; but most folks were just thankful for our objectivity and eager for more information.
So I decided to go back to Stan the Annuity Man, who helped us with the issue, for more input. We have no financial arrangement with Stan; he is just a really smart guy with years of experience in the industry, but I guess his name probably gives that away. We appreciate Stan taking the time to make sure we all understand annuities and how to shop smart.
Take it away, Stan…
Use Portion Control With Annuities
By Stan the Annuity Man
Assuming that an annuity is appropriate for you (more on that in a bit), the first question you should ask yourself is: How much should I allocate to any one, specific annuity? A word of advice: "how much" is not a question you want to ask an agent, because most live in a fantasy world of "one size fits all" and "let's put it all in the annuity." Common sense would tell you that, like every other investment, annuities should only be a portion of your portfolio.
As Dennis has mentioned before, if it sounds too good to be true, it is. Annuities are no exception to this rule, and you should own or consider owning an annuity for its contractual guarantees only. Do not let an agent show you hypothetical or projected returns and try to sell you a dream.
I created an easy to remember acronym – "PILL" – that tells you if an annuity might be right for you. In my world, if you don't need to find solutions for the issues below, then you probably don't need an annuity.
- P is for principal protection
- I is for income for life
- L is for legacy
- L is for long-term care
Notice that growth is not one of the issues an annuity addresses. Even though 75% of all annuities sold annually (over $200 billion worth) are high-fee variable annuities, I am a firm believer that annuities are not growth products. Indexed or hybrid annuities offer such limited growth that it's comical. Load variable annuities offer limited investment choices in most cases, with an average annual fee of over 3%. No load, no fee variable annuities are growing in popularity because of tax-deferred growth, but you have to be able to properly manage the funds yourself… or hire someone to do it for you.
"P" Is for Principal Protection
The majority of annuities I recommend address the risk of outliving your money. No one wants to outlive their money, and annuities are the only product that will pay you regardless of how long you live. Most people I talk to think that if you die early, the insurance company will keep the balance. That is not true, and it is not how you should structure a policy. I always recommend the contract pay for life and leave 100% of any unused money to your listed beneficiaries.
With this lifetime income plan, you have no money at risk, and you are literally making a bet with the insurance carrier that you will live longer than they project you will. If you live to 125, the carrier will have to pay you. If you die early in the contract, all of the money will go to your family, and the insurance company doesn't keep a penny. It's really that simple.
"I" Is for Income for Life
I can give the insurance company the premium, and it will pay me for the rest of my life. Should I die before my monthly payments have exceeded the premium, the balance is returned to my beneficiaries. As Dennis mentioned in The Annuity Guide, in the worst-case scenario you end up lending your money to the insurance company interest-free for the period over which you collect payments. That is the tradeoff for knowing you have income for the rest of your life.
There are two ways to use annuities for lifetime income: You either need income now or income later. Income now is only solved with a single premium immediate annuity. Don't let an agent try to convince you otherwise by recommending a variable annuity or indexed annuity, because they are factually and mathematically incorrect and only thinking about the commission.
Immediate annuities provide the highest contractual payout of all annuities, and can be set up jointly with your spouse. You also can add an annual cost-of-living percentage increase to the policy as well, even though this decreases the initial payout. If your family has a history of longevity, this contractual cost of living increase might be worth considering.
Immediate annuities used within your IRA can provide a lifetime income stream while offsetting your required minimum distributions (RMDs). When used outside of an IRA, an immediate annuity will provide tax advantages because a portion of your income stream will be excluded from taxes. Single premium immediate annuities have no annual fees and pay the lowest commission to the agent. That combination translates into "good for the client."
If you need income later, there are two strategies to consider: longevity annuities; and income riders that are attached to deferred annuities. Longevity annuities are actually deferred immediate annuities with an enhanced payout at the time you declare the income to start. Longevity annuities can be structured exactly like an immediate annuity as described in the paragraphs above.
Income riders provide the same type of income later, but with a little more flexibility. This attached benefit provides a guaranteed percentage of growth during the deferral years that you can use for lifetime income down the road. The key point to remember with an income rider is that you can only use it for income, and you cannot access the money and that high percentage of growth in a lump sum. Agents tend to blur the line with this fact in the hope that you will believe you are receiving yield that just isn't there.
These strategies for income now and income later – in conjunction with your other sources of income – should solve your basic overhead and expense problems. I call this "stacking income." Along with Social Security payments, pension payments (if you are so lucky), dividends, rental income, and/or RMDs, etc., annuities can help fill in the gap right now or down the road.
For example, if your monthly expenses are $7,000 and your current income can only cover $5,000, then you can make up the $2,000 difference for the rest of your life with a single premium immediate annuity. Or you could project rising costs in the future and allocate money to a longevity annuity and have the income start at a specific date down the road. Because these strategies for income now and income later are contractual, you can plan to the penny how much your lifetime income stream will be.
Because interest rates are at historically low levels, you do have to factor this in to any current allocation decision involving annuities. Just like you probably have done with bonds or CDs, consider laddering your annuities – what I call "lifetime income laddering." For example, if you wanted to allocate $500,000 to a lifetime income strategy, it might make sense to buy an immediate annuity in $100,000 increments over a five-year time period. Even if rates don't move, the contractually guaranteed payouts will be higher each year because you will be older and your life expectancy will be shorter. If interest rates rise as you age, you will get even more bang for your buck and a higher payout.
"L" Is for Legacy, and Long-Term Care
The "transfer of risk" aspect of annuities works the same if you're planning for long-term care or to leave legacy gifts to your beneficiaries. Long-term care annuities should only be used as a supplement to – not a replacement for – traditional long-term care policies. Legacy annuities provide protection of principal while guaranteeing an annual growth (5-6%) that can be left to your listed beneficiaries. Remember that annuities should always solve specific problems.
There are a few important questions you need to ask when considering annuities as part of your portfolio:
- How much risk am I willing to shoulder myself?
- How much risk do I want to transfer?
- What specific problem am I trying to solve? Lifetime income? Legacy giving? Long-term care?
- What is the specific dollar amount that I want contractually guaranteed?
When I worked with Dennis' team on the November issue of Miller's Money Forever and The Annuity Guide, we put together great tools for smart annuity shopping. A prudent buyer will always read the fine print, do the math, and understand exactly what he's buying before he signs on the dotted line.
A good agent will help you run the numbers and understand the exact costs of what you are buying. Don't let any agent push you into a buying something you don't understand. I am a strong believer that an investor is better off with no annuity than with one not specifically tailored to his needs.
As Dennis mentioned earlier, annuities are not the greatest thing since sliced bread, so to speak. They are, however, pure transfer-of-risk contracts. Adding the right annuity to your portfolio can be a good step toward achieving your retirement goals.
Annuities, when allocated properly, can be just that simple.
Hi folks, it's Dennis here again. If you'd like to check out the November issue of Miller's Money Forever – which focuses on annuities – and The Annuity Guide, but you are not already a subscriber, I urge you to take advantage of our 90-day trial subscription. This no-risk offer gives you access to the current issue of Money Forever, our archives, special reports, and my book, Retirement Reboot. If you decide it's not what you're looking for, just call or email within 90 days and receive 100% of your money back, no questions asked. We aim to earn our keep by passing along actionable ideas that pay for your subscription many times over.
On the Lighter Side
While certainly not a light note, our hearts and prayers go out to everyone in Boston. There are certain parts of the world where attacks of terror are constant. I cannot imagine having to look over your shoulder in fear day in and day out. Let's hope that is not in store for our nation.
A friend recently commented that he also fears overreaction by the government trying to do "the right thing." I have undergone extensive security checks at football and baseball games, and I don't believe that is what America is all about.
Now for something a bit lighter: my beloved Chicago Cubs are off to a terrible start. It isn't the fact that they are losing, it is how they are losing that is so frustrating. Too many unnecessary mistakes cost them several games early in the season. There is an old saying, "You never win the pennant in April, but you can lose it in April." Teams can dig themselves into a hole, and it becomes very difficult to overcome.
The new owner promised that they would win the World Series if the city of Chicago would only allow them to run their business without interference. I have met the owner, Tom Ricketts, on several occasions, and he is truly committed to winning. At 73 years old, I just wish they would hurry up and get on with the job.
Our dear friend Toots is always good for some humor. She sent me some funny questions:
- Is it good if a vacuum really sucks?
- Why do we say something is out of whack? What is a whack?
- Why do tugboats push barges?
- Why are they called "stands" when they are made for sitting?
- Why is phonics not spelled the way it sounds?
- Why do you press harder on the buttons of a remote control when you know the batteries are dead?
And my personal favorite:
- Why do we sing "Take me out to the ball game" when we are already there?
Until next week…