Annuities, Like Rome, Weren’t Built in a Day
June 7, 2018 by Troy Bender
Annuities have been around for centuries – since Roman times. In Ancient Rome, people would make a single payment in return for annual lifetime payments. Even back then, retirement planning was a concern.
The first annuities were available to the public in America in 1912. But the popularity of annuities really started during the Great Depression. Concerns as to the risks that were inherent in investing in the stock market motivated more and more people to buy annuities from well-established, large and stable insurance companies to provide for their retirement.
According to an October 1987 Sports Illustrated article, Babe Ruth weathered the storm of the stock market crash of 1929 because his agent Christy Walsh steered the Babe into annuities. Franklin Delano Roosevelt’s famous message to Congress on Social Security in January 1935 imparted the government’s goal of providing half the cost of the old-age pension plan (retirement). The other half, according to the Social Security website, was to come from compulsory contributory annuities and voluntary contributory annuities.
Most people don’t realize that their Social Security benefits are really an annuity. Social Security, according to investment basics at The Wall Street Journal, has even been called a “social annuity.” When we start our benefits, our monthly amount is paid to us for the rest of our lives. And for those who have a pension, they also have an annuity; these pensions are designed to provide us monthly income the rest of our lives.
How do they work?
Early 20th-century annuity laws were made to encourage more people to own an annuity as the accounts grew “tax-deferred.” Receiving the choice of when to pay taxes on gains earned became valuable to those who didn’t want to pay taxes over and over on mutual funds that spin off short-term and long-term capital gains, as well as dividend tax yearly on a person’s 1099. Choices and diversification grew, and today’s annuities allow everyone to tailor their goals to their specific needs in retirement.
Annuities work by giving you limited access to your funds yearly – much like Social Security or a pension. All companies give you access to at least the interest, with many allowing you access after 12 months to either 10 percent of your original premium deposited, or 10 percent of your account value. Just like an IRA or 401(k), withdrawals made before age 59½ are generally subject to a 10 percent early withdrawal “federal tax penalty.”
Different types
- Immediate annuities: These are purchased with a lump-sum payment. They begin to make payments to you right away and provide security and simplicity. A fixed immediate annuity works best if you think you will outlive what the insurance company actuaries think you will. This is because you are paid by the insurance company for as long as you live, or for a specified period.
- Variable Annuity: With a variable annuity, you get to choose how the money will be invested, and it grows tax-deferred like fixed annuities. In a variable annuity, the returns will vary depending on the underlying performance of the investments you choose. It is often stated that they offer the potential for higher gains that can be made as the performance is tied directly to mutual funds, called sub-accounts. With this, though, comes the distinct possibility of losses to your account balance when the stock market experiences volatility.
In addition, fees on a variable annuity are often quite high. There are mortality and expense charges that typically average 1.1 percent of the value of your annuity. According to 2012 Morningstar figures, the average mortality and expense for a variable annuity was 1.25 percent, the average management fee (expense ratio for the sub-accounts) was .97 percent, and the typical administrative fee and other standard costs came to .28 percent. That comes to a total of 2.50 percent. If you add a living benefit writer, the average cost becomes approximately 3.4 percent yearly.
The bottom line with a variable annuity is that the costs and fees can have a serious effect on how much you ultimately profit from the purchase. Remember, you will pay these fees in a down market, in addition to any losses. Look for low fees, but also concentrate on a variable annuity that offers you the potential to have a fixed rate option.
Of key importance is whether you have a variable annuity in an IRA account. There are 3 potential problems. These include when volatility in the stock market occurs and high multiple fees are often charged quarterly or yearly. The third important component in an IRA account is you must take out money once you turn 70½, and by law the percentages as you get older for your Required Minimum Distributions increase for the rest of your life. This is a recipe for potential disaster.
- Fixed annuities: Unlike CD’s, which are taxed each year interest is earned, fixed annuities grow tax-deferred, as you receive the choice of when to pay taxes on your gains. Rates can be fixed for as short as one year, so look for companies that will pay the guaranteed rate for multiple years, with rates guaranteed for five to 10 years. The attraction of the fixed rate deferred annuity is in its safety, security and guarantee.
- Fixed indexed annuities: Just like fixed annuities, fixed indexed annuities also are tax-deferred, which may help your savings accumulate faster. In fact, deferred annuities are bought for retirement. These annuities offer principal protection and potential interest to help you accumulate money for your retirement.
For many people, these annuities represent the umbrella to protect themselves from the rainy days that come after retirement. There are many unknowns in what Social Security will pay in the future. Planning on our own becomes paramount for success. The longer you keep the money in the annuity, the more it grows without being taxed.
Fixed Indexed annuities are tied to an index. You have the potential to earn interest based on changes in an external market index. This is different from traditional fixed annuities, which credit interest calculated at a fixed rate set in the contract.
According to a USA Today article, “Stressed by retirement and doing little to prepare for it,” we should all determine what our essential expenses will be and try to make sure we have enough sources of guaranteed income – such as Social Security, a pension, and/or an income annuity – to cover those costs. The article also recommends identifying the risks you could face during retirement, including long-term care costs and inflation, and to plan in order to manage and mitigate them.
A deferred income annuity can address longevity and the risks of outliving your money. Social Security isn’t enough alone to help fund retirement. It is our job To fund additional sources to provide the needs we will have for paying our bills, but also living our lifestyles the way we want.
Are you planning for your future correctly?
Troy Bender, President and CEO at Asset Retention Insurance Services Inc., has more than 30 years of experience in the insurance and annuity industry.
