Retirement dream fading? Annuities can help cash
For millions of Americans the dream of retirement may look more like an approaching
nightmare. With people retiring earlier and living longer, you could live in retirement
for 20 years or more without receiving a paycheck. And while experts say you'll
need 80 percent of your annual salary to live comfortably, a shaky Social Security
system offers little hope -- paying the average worker just $804 a month in 2000.
No wonder you're losing sleep over whether you'll have enough cash to last through
your twilight years.
One answer to this cash crunch at retirement time may be an annuity.
"You now have a greater responsibility to create your retirement
income," says Erin Watford, a senior financial consultant with A.G.
Edwards & Sons Inc., in Lake Mary, Fla. "An annuity can help you
meet that responsibility by generating income for life."
Simply put, an annuity is an agreement between an insurance company
and an individual, designed to pay the buyer a steady retirement income. The
buyer agrees to deposit a sum of money with the insurance company, which agrees
to return a certain income for a specified period. If the money is deposited
in one lump sum it's called an immediate annuity. If paid over time it's called
a deferred annuity.
With an immediate annuity, once the lump sum is paid, the payouts
begin. In the deferred annuity, payouts begin once the accumulation period expires.
The most powerful advantage of an annuity is that your money can
accumulate tax-deferred, so you pay no taxes on your earnings until you withdraw
money. At that point you will be taxed on the accumulated interest and capital
gains, but by then most retirees are in a lower tax bracket. Also, part of each
payment is considered interest and is taxed, while another part is considered
return of principal and is not taxed.
Currently, annuities are providing a higher return than most traditional
savings accounts and CDs. However, buying an annuity is a complex investment
process and not one to jump into without careful research. This Bankrate story
four factors your insurance agent may not want to bring up when explaining annuities.
Generally speaking, there are three kinds of annuities:
Fixed annuities: Think of
these as reverse life insurance policies, protecting you not against death but
from longevity, or outliving your retirement fund.
Fixed annuities guarantee a fixed rate of return for a specific
period of time. The company invests your money in a fixed-rate product like
a bond or mortgage in order to guarantee you this return on investment at low
risk. While the money accumulates, the issuing insurance company guarantees
the interest and your principal against loss. At the end of the accumulation
period, typically one year to 10 years, the company may offer you a new interest
rate for a set number of years. Or, you can begin to receive regular payments
at the guaranteed specific amount.
"If you buy an annuity for $100,000 and the money earns 5
percent interest per year, your $100,000 would be worth $127,628 after five
years," explains Watford, who has more than two decades of experience with
annuities. In the past, people with fixed annuities could earn 6 percent or
7 percent interest on their investments. But right now, returns are lower because
interest rates are down.
"Every time Alan Greenspan and the Federal Reserve lowers
rates, it hits the fixed annuities," Watford says. "Still, you know
what you're getting, know exactly what it's worth when, and there's no market
risk. People who buy fixed annuities are generally those that are scared of
the market and those that want better rates than what CDs offer. They are popular
with retirees, but very few young people go for the fixed annuity."
The drawback of a fixed annuity is that there's limited potential
for growth. "If the equities market gets hot, you've missed it," Watford
says. "A fixed annuity is like buying a tax-deferred CD."
Variable rate annuities: Variable
rate annuities are like an insurance contract joined at the hip to an investment
product. They allow you to invest in products like stock, bond and money market
funds to see your money grow faster. You can switch investments with no brokerage
fees or tax implications. But there's more risk. If the investments you choose
tank, you could lose not only earnings, but a big chunk of your principal as
well. The fees are higher, too, including mortality and expense-risk charges
and administrative costs.
Investors who want to avoid the risks of a variable annuity can opt for equity-indexed
annuities. This puts part of your investment in a fixed account, and the rest
in an index fund, which could be a growth and income fund, a bond fund or a
stock fund, among others, says Debra Amicarelli, owner of Florida Benefits Inc.
in Winter Park, Fla.
The major advantage of this type of annuity is that if the stock
market tumbles, your investment does not decline in value, she says.
"It offers you the safety of a fixed annuity, but you also
get the opportunity to enjoy the growth of the stock market," says Amicarelli.
"This allows you to make more than the 1 or 2 percent interest that you
might make from a fixed annuity."
"All annuities have death benefits in them, but they apply only while you
are still making payments into the annuity. In that case, the issuing company
guarantees that your beneficiary will get back no less than what you put in
or the market value of your investment -- less any withdrawals -- whichever
is higher," Watford says. Even if the market value is down, your heirs
Graeme Wright, an investment adviser with 20 years of experience
in Florida, New York and London adds, "If your $100,000 variable annuity
goes down to zero and you pass away, your beneficiary would receive at least
$100,000, assuming there have been no withdrawals. If you, instead, had invested
your money in a regular mutual fund and that went down to zero, you would end
up with nothing," says Wright of AXA
Advisors in Orlando, Fla, "This benefit is really important, especially
if there is not adequate life insurance in the family."
Withdraw and surrender
Most annuity contracts -- fixed and variable -- let you make withdrawals during
the accumulation period. You can usually access 10 percent to 15 percent of
the contract value or premiums paid once each contract year. These withdrawals
are fully taxable and, if taken before the age of 59 1/2, are subject to a 10-percent
IRS penalty, much like withdrawals from an IRA.
Surrender charges can last up to nine years. If you need to surrender
part of the contract or the entire contract to access your funds, any accumulated
earnings are taxable at the time of the surrender. In addition to paying income
taxes, you may also be required to pay a surrender charge.
"Many insurance companies, however, will let you make withdrawals
with no surrender charges if you're confined to a nursing home or suffer from
a terminal illness," explains Watford. Also, while there are no fees to
buy an annuity, you'll have to pay if you sell within the first few years.
Many strategies for income
When the time comes to start taking income, you can choose "income for
life," a guaranteed income, or you may prefer "systematic withdrawals."
- "Income for life"
gives you a guaranteed stream of income. It can be for a fixed amount, a certain
period of time or for as long as you live or for as long as you and another
person, usually your spouse, live. This option is called annuitization. Annuitize
means to begin a series of payments from the capital that has built up in
an annuity. Under this category you also have a choice of "fixed income
for life" or "variable income for life." Fixed income for life
is best if you want to know exactly how much you're going to get with each
payment and if you need the money for things such as mortgages or car payments.
The variable income for life option gives you the possibility the payments
you receive might increase over time, perhaps enabling you to keep up with
inflation. How much you get paid depends on how well your investment options
- "Systematic withdrawals"
let you withdraw a specific dollar amount on a monthly, quarterly, semiannual
or annual basis. You can take out the amount you need when you need it. But
for that flexibility you lose your guarantee of income and if you withdraw
more than you earn, you run the risk of depleting your annuity assets and
potentially outliving your income.
Here are some other popular options that can be built in to your
Straight life -- a
guaranteed fixed payment each month as long as you live. The amount you receive
is based on factors such as your age and investment amount. The downside to
this approach is when you die no more payments will be made to beneficiaries,
even if you did not get back all the money you paid in. This annuity provides
the highest monthly payments, but is not a good choice if you want your spouse
and children to receive income after you die.
Joint and survivor annuity -- This
is a guaranteed income stream for as long as you live or as long as another
beneficiary lives. The payments would not be as great as the straight-life approach
because the insurance company has to pay benefits for a longer time.
Variable income for life -- This lets you tie your income
to the potential returns of the stock market, so your income may increase over
time and keep pace with inflation. The payment amount is based on the performance
of the investments you choose.
Blended income -- Another option is to take a blend of
fixed and variable payments. This gives you a stable base income while still
having part of your income invested in the market.
Life income with refund annuity -- If you die before receiving
all the money you paid in, your beneficiary will receive the amount you did
Life annuity with period certain -- You receive payments
for a certain number of years, but if you die before that period is over, your
beneficiary receives the payments for the remainder of the period.
"Variable annuities are the hottest thing on the market because
people want the guarantees -- the death benefit and the living benefit,"
says Watford. "In the roaring 1990s, people didn't want to pay extra for
the guarantees. But now, after a brutal, three-year bear market, people are
jumping into them."
Prakash Gandhi is a freelance writer
based in Florida.
-- Posted: Sept. 23, 2003