An 8.3 percent return for life, guaranteed: real or imagined?
Lew Mandell returns to address readers’ questions about what he calls the best retirement deal on the market. Photo courtesy of Digital Vision via Getty Images. Lew Mandell, author of “What to Do When I Get Stupid,” recently graced this page with a highly-read post praising the return of Single Payment Immediate Annuities (SPIA), what he called, “the best retirement deal on the market.” As he explained, an SPIA can get a retiree a guaranteed cash flow of more than 8 percent — for life! Since that post, Mandell followed up with his number one recommendation for guaranteeing financial security in retirement: owning your own “age-in-place” home. But since that first post, we’ve been buffeted with questions and comments about Lew’s endorsement of annuities, and about annuities in general. Here we turn the page back over to Lew to respond. To set the stage, here’s his explanation of what an annuity is:
In finance, the word “annuity” refers to a series of payments made to a person (called the “annuitant”) for life or for a set number of periods. In this post we refer to a fixed, life annuity, a plain vanilla annuity that will guarantee a set income each month for the rest of your life, no matter how long you live or what dumb mistakes you make along the way. If this guarantee looks familiar, it should, since it is pretty much what we get from Social Security as well as from a traditional “defined benefit” pension — if we are lucky enough to have one. Both are forms of life annuities because both pay until you die.
Here now is some of the feedback to Lew and his responses.
@paulsolman Paul-the return quoted includes the principal. THATS YOUR OWN MONEY! See Bernie Madoff in prison. He can explain this to you.
— Tom Flaherty (@sloethrop) September 12, 2013
Lew Mandell: We don’t have to interrupt Bernie’s peaceful sojourn in North Carolina for this explanation. It is contained in the piece that I wrote when I said, “…most of the guaranteed monthly cash flow is due to return of principal (the amount you put in), not to earnings on the investment.” I strongly recommend that retired folks with a gap between income and needs (that cannot be made up with interest on a safe bond) consider a fixed annuity that can give them a guaranteed payment many times larger than the bond interest payment, for the rest of their lives. It is certainly far less risky than investing in stocks.
The return that you get from a fixed annuity is not the more familiar return on investment (ROI) on a bond which returns the money invested to you (or your heirs) at maturity. Rather, it is a cash flow payable to you for the rest of your life. In return for giving up the principal, you get guaranteed income for life, no matter how long you live. Therefore, an annuity is much more like an insurance policy, to keep you from running out of money if you live too long, than it is like a bond.
Bob S. — Guilford, Conn.: Can you give me your opinion on the MetLife deferred variable annuity with the Guaranteed Minimum Income Benefit (GMIB) option?
Lew Mandell: Without commenting on the specific policies offered by various insurance companies, including MetLife, a GMIB, offered by many insurance companies, is a hybrid between a fixed annuity, which offers the same guaranteed payment for life, and a variable annuity, whose payment is based on the performance of the securities in which they are invested, often a stock index.
The upside of a GMIB is that if you are lucky and the securities in which your annuity has invested do well, you can end up with higher lifetime payments than you would from a strict, guaranteed fixed annuity. The downside is that if the securities don’t do well, you may end up with only the guaranteed minimum investment benefit which will be less, often far less, than what you could have received with a guaranteed fixed annuity.
As I cover in my book, the costs of more complex variable annuity products, such as GMIBs, are generally higher than they are for plain vanilla fixed life annuities, in part because they require more of a salesperson’s time to explain and sell to a consumer. These costs reduce the size of the lifetime payment available to the buyer.
Of greater importance in making the decision to buy a variable rather than a fixed annuity is the amount of guaranteed income you need for life to close the gap between income and needs. If you will be dependent on the guaranteed income produced by an annuity and can’t take a chance on running short, you would probably be better off with the more secure fixed annuity. If some of the income will not be needed to cover your core retirement expenses and will be used for “luxuries,” you might want to gamble a little by choosing the guaranteed minimum income benefit necessary to cover your essential needs and take a chance that the variable portion might add a little zest to your life.
Mary — Sun Valley, Idaho: I’m 55 with an 8-year-old adopted son. My greatest asset is my home, worth $1 million. Should I take a second mortgage and pay into an annuity, and if so, for how much and what kind of annuity? I was thinking $100,000 on the loan to finance the annuity?
Lew Mandell: Without knowing a great deal more about your specific situation in terms of your income, job benefits and other sources of income, it is hard to answer your question. In general, however, an older parent with a very young dependent really needs to be sure that the child will be provided for in the event of the parent’s death, so adequate life insurance would be my first concern. Term insurance is the least expensive way of providing that protection. An annuity, with guaranteed payments to a survivor, is a far more expensive way to provide a similar dollar amount of protection to the child.
I cannot really see any value to taking out a second mortgage to fund an annuity. It will just increase monthly mortgage costs without providing much, if any, added protection to a dependent.
M.F. Bell — Dana Point, Calif.: I have a variable annuity. Can I change it to a fixed annuity?
Lew Mandell: The answer is “yes.” You can generally cash in a variable annuity and use the proceeds to purchase a fixed annuity, but when you finish reading this, you may not want to!
When you cash in or “surrender” a variable annuity, you may be hit with up to three sizable charges. Most annuities have a surrender charge, which can be considerable for a recently-purchased policy. In general, the surrender charge decreases each year you have owned your policy. A typical surrender charge begins at 10 percent the first year and declines to 9 percent the second year, and so on, until it disappears after 10 years.
In addition to the surrender charge, you will owe income taxes on any profits that you have made on your variable annuity. And, to add insult to injury, if you surrender a variable annuity before you hit age 59-and-a-half, you will owe the IRS an additional 10 percent penalty on your profits. It may be possible to avoid paying these taxes if you do a tax-free “1035 exchange.” This refers to an IRS provision that allows you to exchange an asset for a similar one on an untaxed basis as long as the funds pass directly from one asset (the variable annuity) to the other (the fixed annuity). This has to be done very carefully, preferably with the help of an attorney.
The Securities and Exchange Commission has a booklet that explains the basics of variable annuities, with some warnings about their costs and the ways in which they can be surrendered..
Nancy P. — Crystal River, Fla.: Can you give the names of a couple of insurance companies that are known to have the best offerings for a Single Payment Immediate Annuity (SPIA)?
Lew Mandell: The Single Payment Immediate Annuity market tends to be very competitive with a number of companies offering similarly-priced products. This site will enable you to find the company that best meets your annuity needs. It allows you to enter the type of immediate annuity you want, including a single life annuity that pays only one person or a joint annuity that will also pay a survivor, as well as the amount of money you have to invest in an annuity. It then gives you the insurance companies that will pay you the most money per year (for life) for your investment.
All of this is done on an anonymous basis. No one knows who you are unless and until you decide you are interested in a particular annuity and want to contact the agent who operates the site.
Vernon E. — Reno, Nev.: Do I need a stockbroker to buy annuities? Where do I buy?
Lew Mandell: You can buy annuities through stockbrokers who are licensed to sell them but you can also buy them from many insurance salespersons and financial planners. It is also possible to buy annuities directly from some insurance or no-load mutual fund companies. The difference between buying through a salesperson and buying directly relates to both the level of sales service that you are getting and to the commission (often called the “load”) you will pay for that service. Total sales commissions for annuities that are not purchased directly can be large, often 5 percent or more of the purchase price up front plus a surrender charge of as much as 9 or 10 percent for a policy that is not held for a long time. The sales load can really cut into your rate of return.
In spite of the high sales commission, relatively few annuities are sold directly because they can be complex and few people feel that they understand them well enough to go out and shop for annuities themselves. In addition, like most insurance policies that are not on the top of consumers’ want lists, they are products that are “sold” rather than “bought,” and the time of a talented salesperson is very valuable!
If consumers feel that they are up to the task of buying “direct-sold” variable annuities to save the commissions, they may want to contact companies such as TIAA-CREF, Vanguard, Fidelity, Schwab or T. Rowe Price, all of whom sell no-load mutual funds directly to consumers as well. If they are more interested in the simplicity and security of fixed annuities, they should check out immediateannuities.com.
David Shobe — Cullowhee, N.C.: How are annuities taxed if purchased in an IRA? Do you have to withdraw funds from the IRA in order to purchase it or can you buy it in the IRA and pay taxes only as you withdraw the amounts for living expenses?
Lew Mandell: Since both annuities and IRAs enable holders to tax-defer income, there would be no additional tax benefit to purchasing an annuity within an IRA. If you want to use funds in your IRA to purchase an annuity, you can avoid paying taxes on your IRA distribution in two ways. You can either withdraw money from your IRA and use all the proceeds to buy an annuity within 60 days, or you can move the assets directly from your IRA to the annuity.
If taxes have never been paid on income in the IRA used to fund the annuity, they must be paid on the full amount of annuity payments that you receive. When you turn 70-and-a-half and have to start making required minimum distributions (RMDs) each year, your annuity payments will count toward your RMDs. In fact, if all of your untaxed retirement money is in an IRA and you use all of those IRA funds to purchase a single payment immediate annuity, the IRS has a special provision that allows you to count your annuity payments as the full amount of your RMD for life, no matter how old you become. Since the size of your RMD changes every year, this can save some accounting complexity.
Paul Solman: On Fridays, I try to answer some of the questions readers and viewers submit to the Business Desk.
Robert M. — Oradell, N.J.: In response to your report on older workers and paying taxes, what is the impact of the taxes paid on withdrawals from 401(k) accounts and IRAs?
Paul Solman: If you mean the impact on federal revenues, it could be substantial. The latest figure I’ve seen for the total in tax-deferred pension accounts in this country is $10 trillion. That money must be withdrawn, with taxes paid on the withdrawals, starting on or before April 1 the year after you turn 70 1/2. If we assume, for ease of calculation, an average income tax rate of 20 percent — federal and state — governments can expect an extra $2 trillion dollars in taxes.
How much per year? According to the Social Security Administration’s actuarial tables, a 70-year-old American can expect to live until 85. So divide $2 trillion by 15 years and you get a tax take of $135 billion or so a year, more than $100 billion of it to Uncle Sam.
Please, dear readers, correct me if I’m wrong on my calculations, but if I’m right, $100 billion a year would go at least a fair way toward closing a budget deficit estimated to come in at $760 billion this year.
Rich Cooper — Hemet, Calif.: Will there be inflation or deflation when the Fed slows its “printing” quantitative easing projects? How soon?
Paul Solman: Since “quantitative easing” (QE) — is, as you suggest, the creation of money, any slowing would lessen the likelihood of inflation, all else equal, since a common definition of inflation is “too much money chasing too few goods.”
By the standard measure — the Consumer Price Index (CPI) — there already is inflation, running at about 1.5 percent a year. By recent historical standards, that’s curiously low. On the other hand, it means every dollar you have loses 1.5 percent of its value every 12 months. If you’re getting less than that in interest from the bank, say, you’re losing money on whatever you’re saving.
By another measure, however — the personal consumption expenditures price index — there is actually deflation, as Justin Wolfers explained on Bloomberg Thursday.
So the honest answer to your question is itself a question: Who knows? My favorite rendition of the problem is friend Merle Hazard’s country classic, “Inflation or Deflation?”, featured in a story of ours in 2010.
The Fed’s dilemma back then remains the Fed’s dilemma today.
Dale L. — North Andover, Mass.: Isn’t the idea of government spending to be a stimulus and not a permanent fix? Once the economy does get rolling again, and demand picks up, private industry starts hiring again to supply the demand.
Paul Solman: Or does it? Manufacturing is picking up in America these days, for example, but manufacturing employment is not. Have you ever seen “Baxter” in action?
Suppose private industry can provide what we are willing to buy at profitable prices using fewer and fewer Americans? Then what do we do? See my ruminations on government spending in an interview earlier this year or, more recently, Mariana Mazzucato’s discussion of the “entrepreneurial state.”
This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions