Annuities have gotten a bad name because of the high-pressure, “free-lunch”, sales tactics many agents use to sell fixed-index annuities linked to stock market gains. (Check my recent column on the subject.) But annuities do have some important uses in financial planning, so here are some basics.
Every annuity is a contract with an insurance company. These contracts are backed by the company itself, and by state “guarantee funds” – but not by the Federal government. Those state guarantee funds are made up of “contributions” by other insurers doing business in the state.
So it’s important to deal with a highly-rated insurance company. Check A.M. Best insurance company ratings at A. M. Best
Insurance products can offer some enticing yields because of the provision in the federal tax laws that says money growing inside an insurance contract can compound tax-free. But don’t let yield blind you to facts.
Immediate vs. Deferred
An immediate annuity lets you place a lump sum of money into the contract and immediately start getting a monthly or annual check, promised for the rest of your life (or your life and your spouse’s life, which reduces the monthly amount). It’s an irrevocable decision. You can’t outlive this promised income, which gives you peace of mind. But, when you die (or you and your spouse die), the insurance company keeps the balance of the money – unless you structure the payments so that any money left in the policy goes to the beneficiary — which reduces your monthly payment
There’s one more problem with an immediate annuity: the impact of inflation on that fixed, guaranteed check. At only 3 percent annual inflation, the buying power of your money is cut in half in 25 years. A check that will nicely cover your expenses today, could be just a pittance later in your retirement. That’s why you won’t place all of your money into an immediate annuity.
A deferred annuity is a contract that allows your money to grow tax-deferred inside the annuity contract – either based on a promised interest rate, or on your choice of investment sub-accounts, or in a combination of the two (which is what a fixed index annuity promises). Each contract has restrictions on how and when you can withdraw money – either by annuitizing (taking that lifetime payment promise) or simply withdrawing cash from the contract or some other formula. Those restrictions are the least understood and most challenging part of the deal.
The insurance company offsets the risk that you might want to get out of your contract early by charging “surrender charges,” which can last a decade or more. Those charges protect the insurer, and help pay hefty commissions to sales agents.
A Smart Annuity Move
If you have money outside your retirement account, but want tax-deferred growth, you can purchase a short-term fixed rate annuity contract (MYGA – multi-year guaranteed annuity) in terms ranging from 3 year to 7 years or more. It’s the insurance industry’s version of a CD. The rate is higher than an FDIC-insured CD. Staggering maturities of these contracts (laddering) can ensure that if rates move higher, you’ll earn more as each MYGA matures and is rolled into a new, higher-yielding contract. At some point in the future you can withdraw the money paying taxes on the earnings – or even annuitize into a lifetime check.
To compare rates on these MYGAs, go to http://www.stantheannuityman.com/annuity-strategies/the-annuityman-steakhouse/fixed-rate-annuities-myga/#selectstate where this annuity guru Stan the Annuity Man has created an online database for current rates on short-term guaranteed annuities. Input your state, and the term of the annuity to see what companies are offering. There’s no sales pitch, because there’s no big commission involved, so you have to do the work yourself.
All annuities carry a slightly higher risk because there’s no Federal guarantee. But you can get tax-deferral, a higher return, and also have liquidity — if you understand annuities before you invest.
That’s the Savage Truth.