You own an annuity, you believe you were wise to buy one and, most important, you recently became a life insurance policy beneficiary and are thinking about buying an additional annuity to further ease financial stress. You can do so and still have sufficient liquidity.
Is this the right move?
If you’re a very conservative investor who would otherwise put most of the money in bank CDs, it probably is. Otherwise, there is no right answer unless your health is fading, which means you should avoid an annuity, or you did not purchase a lifetime rider with your first annuity or now think it isn’t big enough. In this case, you probably should purchase a second annuity. Barring either of these scenarios, however, your decision is probably a flip of the coin.
Should you decide to proceed, don’t be put off by the fact that interest rates today are probably lower than they were when you bought your first annuity. They are still better than you can get in most other investments. And, in fact, trying to buy an annuity with the maximum return possible really misses the point of your ultimate goal.
Why People Buy Annuities
Most people buy an annuity to provide a steam of cash during retirement, especially during the latter part of retirement. Essentially, it’s a hedge against outliving your savings. Since you don’t know how long you will live, transferring the risk of an unexpectedly long lifespan – i.e., longevity risk – to a third party (the insurance company) can be a good thing.
All forms of insurance are essentially a risk against some sort of catastrophe. It that risk doesn’t occur, it doesn’t mean insurance was a bad investment. And in the case of an annuity with a lifetime income guarantee, it’s pretty much the only type of insurance in which you can actually come out ahead – i.e., earn money – if you live long enough.
You shouldn’t get hung up by relatively high annuity fees, either, which are almost always the first thing skeptics jump on. These fees are not simply excessive overhead. They are charges for the transfer of longevity risk. They foot the bill for things like a lifetime income stream, which is unavailable elsewhere, and a death benefit.
Here are some additional thoughts for the prospective second-time annuity buyer:
If you didn’t learn your lesson the first time around, make sure you don’t get sucked in by internet ads promoting an 8% annuity, perhaps even higher. These are always misleading. Think about it: How can an annuity pay 8% when the benchmark 10-year U.S. Treasury note is barely paying more than 2%? The answer is that it cannot. These come-ons are generally linked to fixed indexed annuities (FIAs), which can be sold without a behavior-modifying securities license, and usually target FIA “rollups” – a means to increase annuity payouts if you delay taking them.
An 8% rollup, while relatively rare, exists, but it isn’t the same as an 8% annual return.
For a while, the income base – the figure that determines your actual payments – may rise 8% annually. This is nice, but it is not liquid money you can put in your pocket. That is the cash value of your annuity – and rollups do not impact that. Also noteworthy is that an insurance company offering such an annuity is often looking for a way to compensate for its higher-than-average rollup. The annuity’s annual payout percentage, for instance, may be lower than those of competitors.
If you’re not happy with your first annuity – perhaps because you didn’t know enough about annuities and didn’t buy a good one – resist the urge to hook up with a broker and swap it for a new one.
Those thinking about buying a second annuity may decide that this is also a good time to review your first annuity and see if you can improve upon it. Unfortunately, substantial barriers usually stand in the way. You’ll probably face stiff surrender penalties, which probably would erase any benefit you might otherwise receive in swapping annuities. You also have to pay an additional commission to buy the new annuity. And unless the annuity is reasonably old, it still may be better than what you can buy today because interest rates are lower and other annuity terms have generally deteriorated. This includes lower participation rates on fixed indexed annuities and a smaller array of variable annuity subaccounts.
As a second annuity, an ideal choice might be a deferred income annuity (DIA), a high-paying immediate annuity that delays payments until you elect to receive them – usually years down the road. This gives you a second pension in the future, when you’re no longer working even part-time, and one fatter than other annuities because the insurance company isn’t on the hook to make payments as long.
In addition to the basic FIA, you can also buy a tax-advantaged Qualified Longevity Contract, or QLAC, with funds in your traditional IRA. These defer the Require Minimum Distribution (RMD) requirement at age 70 ½ on a portion of our IRA until as late as age 85. You can defer the RMD on 25% of your IRA or $125,000, whichever is less.
To appreciate the allure of a DIA, consider, as an example, a man who buys an immediate annuity from New York Life at age 68 and starts collecting $1,000 a month for life. This cost about $170,000. But if the same man bought the annuity 10 years earlier, at 58, and waited 10 years to collect, he would pay only $120,000 for the same income of $1,000 monthly for life.
The one catch with a DIA is uncertainty about how long you will live. If you don’t live long, it’s a bad deal. Some DIA buyers sidestep this, however, by buying a cash refund policy, which reimburses all the principal to a beneficiary in the event of your premature death.
If you want a portion of the additional income today, rather than in the future, another option is to split your investment and buy two annuities – a DIA, plus a fixed immediate annuity, which pays more, partly because you sacrifice your principal.
Many annuity owners are unaware of split annuity strategies. If this appeals to you, make sure you are comfortable with sacrificing principal. And again, you need to have a reasonable expectation of living a normal lifespan to get your money’s worth. Both of these annuities require longevity to make sense.
As in all cases of a potential annuity purchase, make sure you do your homework, pick a good financial adviser, ask lots of questions and carefully read all the fine print when you get your paperwork. A second annuity, like your first one, is a sizable investment, and you want to get it right.
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