Belief: Variable annuity investors can lose much of their money.
Reality: This is not necessarily true because of the lifetime income guarantee* offered by many variable annuities (for an additional premium charge).
In variable annuities – whose returns are tied to the performance of underlying stock mutual funds (called sub-accounts) – stock market declines result in a decline in contract cash value but may not affect the withdrawal of income. This income provided by the rider, which is the primary reason why people buy annuities, is guaranteed,* regardless of market performance. A weak market will negatively impact the cash value of the contract, but that typically affects only the amount of money a beneficiary receives.
Belief: Annuity fees and commissions are high.
Reality: Additional fees pay for unique benefits in riders, such as guaranteed* lifetime income. Although the fund managers are still paid for their work, their commissions are often lower than they are in a traditional managed money account.
Annual annuity fees are higher – usually 2.5 to 3.5 percentage points annually, but this pays the freight for account management and the guaranteed* income stream, if purchased, among other benefits.
The one-time sales commission on most fixed annuities is 2 to 4 percent, and is paid by the insurance company, rather than the annuity-owner; on variable annuities, it is 5 to 7 percent and paid by the annuity-owner. By contrast, a fee-only financial planner generally charges 1 to 1.5 percent a year. So if you stay with your financial planner for 10 years, his total commission is 10 to 15 percent, typically on a growing account value.
In addition to the financial planner’s commission, the client typically pays a mutual fund management fee, usually 1 to 1.5 percent. A variable annuity charges about the same. But it also charges an annual guaranteed* income rider fee – generally 1 percent – and mortality/expense/administration fees – generally 1.25 percent. These fees pay for a guaranteed* income stream and death benefit** and the mutual fund expenses. A fixed annuity is typically less expensive than a variable annuity – and less than what a fee-only financial planner charges – because the one-time commission is lower (is paid by the insurer, not out of the annuity premium) and because there are no mutual fund management fees.
Belief: Given the uncertainty of life, especially in retirement, annuity surrender fees, typically pro-rated for the first 5-10 years of the contract, are a substantial negative.
Reality: The purchase of annuities is a long-term commitment, so a purchase should be well thought-out. However, because annuities typically allow additional withdrawals of up to 5-10 percent a year without penalty, the annuity-owner’s money is somewhat liquid. Many retirees feel the long-term benefits are worth the commitment.
Insurance companies need to keep an annuity-owner’s principal to make money on that principal. Hence they have surrender fees. But the 5-10 percent withdrawal feature – without penalty – materially eases the concern for liquidity. In addition, almost all insurance companies offer a variable annuity without a surrender charge, by purchasing a rider for this benefit. Annuity holders pay extra for this, but the charge comes solely out of the contract cash value, not from the amount of withdrawal payments. Terms and limitations will vary among products and among insurance companies. Read the contract carefully before committing to purchase.
Belief: Unlike capital gains paid on variable annuity earnings, annuity withdrawals are taxed at a higher ordinary income rate, which makes them less tax-efficient.
Reality: Many retirees with annuities are in the 15 percent marginal tax bracket, which means they pay the same tax as the capital gains rate.
A married couple filing jointly can earn $74,900 annually after deductions and still be in the 15 percent marginal tax bracket. A single person can earn up to $37,450 after deductions. Many typical retirees do not have more income than this, even including investment withdrawals. According to the AARP, the average annual income of a single retired American in 2012, the latest figure available, was $31,742 – below the 15 percent threshold.1 This information is not intended to provide tax advice, however. See your tax professional about how an annuity might impact your tax situation.
Belief: Annuities pay lower rates than a decade ago, making them a bad choice.
Reality: You can’t look at interest rates in a vacuum. All interest rates are lower.
Consider, for example, the benchmark 10-year U.S. Treasury bond. It currently yields 2.13 percent, down from 4.12 percent a decade ago.2 And once an annuity-owner owns an annuity beyond its surrender period, he or she can withdraw all the principal without penalty and purchase an annuity with higher interest rates, if available. In the interim, the annuity-owner can commonly withdraw 5-10 percent annually, without a penalty. In addition to looking at the interest rates paid by a particular annuity, you will want to consider the potential monthly payout and the benefits provided for your premium dollars. All of these factors help determine which annuity might be a fit for your situation.
Belief: Annuities offer no protection against inflation.
Reality: You can buy a “ladder” of fixed annuities*** to help hedge against inflation or help provide increasing income.****
You can, for example, buy several annuities with one each expiring in three, four, five and six years. If you think inflation and interest rates will rise but don’t know when, this laddering is a way to buy annuities that mature at different points in the future, allowing you to place your assets in annuities with better terms for the benefits you want, should interest rates rise, to help hedge against inflation.
Belief: Annuities are bad because they are irrevocable.
Reality: Most annuities are only totally irreversible during the surrender period. Even during the surrender period, you can cash an annuity out or replace it with another, but you will pay a percentage of your assets in the penalty fee.
After the end of the surrender period, it costs an annuity-owner nothing to liquidate the annuity. Purchasing an immediate annuity, where you begin monthly withdrawals immediately is not reversible. However, any remaining funds will serve as a death benefit for your heirs upon your death.
This aside, the creation of a stable retirement income stream often requires commitment to a long-term strategy. You may choose to eschew annuities and invest solely in a balanced fund (stocks and bonds). If a huge market downturn happens just as you are ready to begin withdrawing the money, you may not have time for your assets to recover to provide the amount you are counting on for income.
Belief: There is too much risk putting your assets in the hands of an insurance company.
Reality: Most insurance companies are financially strong, with a long history of paying customer claims, including annuity income streams.
During the Great Depression, not one insurance company failed to pay on any of its policies, including annuities, according to Bob MacDonald on Business.1 Far fewer insurance companies than banks failed. When one did, others stepped in and bought it, to sidestep possible industry wide panic.
Insurance companies are naturally conservative because they are not run by investors, and invest their funds principally in low-risk, fixed return assets. Their primary goal is to protect assets and increase them conservatively. One way you can check a company’s strength is to look for their industry rating, with a company like A.M. Best. (Note that a rating refers only to the financial overview of the company and is not a recommendation of specific policy provisions, rates or practices of the insuring company.) Ratings of A, A+ or A++ are the highest from that rating organization, for instance.
Belief: Doesn’t the government bailout of American International Group (AIG) undermine the above contention?
Reality: No. AIG is not an insurance company, but owned a number of financially strong insurance businesses at the time of the credit default crash. The underlying strength was one reason it received the bailout, and it has now managed to repay that debt
AIG was bailed out by the U.S. government, but it paid back $205 billion on a $182 billion loan. It ran into trouble because a London-based subsidiary got mired in the sub-prime mortgage crisis. The government, in large part, bailed out the company because of confidence inspired by the steady cash flow of its insurance businesses.
Large insurance companies are here for the duration. Consider the age of leading life insurance players: We are aware of a number of top insurance companies that have been in business more than 100 years.
Belief: Annuity salespeople may not clearly spell out variable annuity (VA) fees.
Reality: This is true, but VA fees are always disclosed in the prospectus. Fixed annuity fees are disclosed in the terms of the contract.
There are Mortality, Expense and Administration contract charges, variable annuity subaccount fees, and living benefit and death benefit rider fees (if they are selected for purchase). Subaccount fees should be roughly 1 percent or less, rider fees a total of 1 percent and M&E&A fees 1.25 percent. An annual fee is also charged for changes in funds, just as they would be in any non-annuity investment account. This amount can’t really be shown in a prospectus, and may vary from year to year. Annuity buyers need to comparison-shop. Ask for everything in writing to ensure you understand the fees you are paying and how they may change.
For these reasons, read the contract (and prospectus for a VA) carefully to understand all terms and conditions before purchasing.
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