Next, let’s look at guaranteed income in more detail.
Immediate Annuities
These contracts exchange principal permanently for income—only income. Because of this “goodbye to principal,” they pay higher payouts than any other annuity (unless you annuitized a variable annuity or an EIA). They are shopped for strictly for payouts and soundness of the carrier. If you cannot defer income to cover necessities, you need to get an immediate annuity or else go back to work. Deferred annuities give you the best eventual income, but immediate ones create income within thirty days to a year after deposit—for life or your chosen payout arrangement. If you must get an immediate annuity, try to do it with nonqualified money (as long as you still keep an adequate cash reserve). That way, you get the best tax treatment: the exclusion ratio helps (earnings in the contract divided by the basis is the percentage of payments that are taxable until you recover your basis). So, well over 99% will be deemed recovery of basis until that basis total has eventually been received. For married couples, the joint-and-survivor payout option causes the same income to keep coming to a surviving spouse that had come to the contract owner(s) and a ten- or twenty-year period certain pays for life but, if briefer than the years guaranteed, it pays the designated beneficiary for the remainder of those years after the annuitant’s death. Life-only causes payments to stop at death, but pays the highest income. Get these quoted if unsure.
Variable Annuities to Fund Your Basic Income Need
We have discussed the drawbacks and costs of variable annuities and the restrictions regarding the aggressiveness you’re allowed to reach (the carrier restricts this, especially after starting income, because it locks in the high water mark for the guaranteed lifetime income/withdrawals rider). They might even remove this rider and pay you back only your rider fees. So, on the surface, they seem to be a perfect tax-deferral mechanism and/or income mechanism (qualified money or not). One might argue that a retiree in a continuing high tax bracket who annuitizes a VA and picks a variable payout rather than its fixed option has realistic potential to get more income in a long-life, decent market return scenario. Back-testing of these has proved this to be true for aggressive investors maxing out on allowable equities exposure. That particular option captures maximum tax benefit from the exclusion ratio and the income payments. If the “decent market” assumption holds, the contract will produce an income that is higher than any other annuity. But living briefly loses the money (annuitization, remember?) or restricts the payout to, say, twenty years certain, which may not be enough to capture the best stock market cycles—one cannot invest mostly in equities anyway; these contracts restrict the aggressiveness!
A 1997 Harvard study and a more recent USAA-sponsored recheck (Hegstrom, 2008) found that even with the internal expenses around 4%, nonqualified variable annuity portfolios beat a taxable, discounted A-share mutual fund portfolio. The VA separate accounts are clones or near-clones of those mutual funds. The studies back-tested results over twenty-year and longer time frames, and examined income streams after that accumulation of another twenty years.
The reason is simple: The mutual funds were assumed to have liquidations for income taxation along the way (they are not tax-deferred, but the VAs are). Money that would have gone to pay taxes on the VA earnings did not get withdrawn but instead earned more money. The study has not been repeated but, despite its age, it was revealing and still applicable. VAs also produced income for life after accumulation, whereas the mutual fund portfolio exhausted late in retirement for the same income draw. Also, a taxable portfolio can be tax-limited per the advice in the tax management chapter; most reallocations/rebalances are best done tax-free inside your qualified or IRA plans.
Annuities for Retirement Income
There are three ways to get money out of annuities, each with distinct implications.
The first way to get money out is on demand. If this is in the first year of ownership, you will likely have a steep surrender charge. See the annuity’s marketing brochure. After the first year, though, you can typically take one withdrawal that is up to 10% of the investment amount or market value (see its brochure, because these two numbers are not the same) without the carrier assessing a surrender charge. You can also see from the brochure that the surrender charge diminishes with time. This diminishing is for a given deposit, by the way; if you make subsequent deposits, each deposit has its own surrender charge start and end points. All annuities are tax-deferred, so Uncle Sam penalizes owners under 59.5 a 10% penalty, plus income is recognized to the extent that there was gain in the contract. In the case of an IRA annuity, all money taken out is ordinary income. Avoid pre-retirement withdrawals because you will compromise both guarantees in the product, possibly sacrificing a long-hold incentive of bonus interest if the product has this feature; early withdrawals obviously diminish the income you could draw. So if you get an annuity, be sure you have other more liquid assets to use for unexpected needs. Annuities are not cash reserves; they are personally owned pensions.
The second way to get money out is by annuitizing. Annuitizing can be done at any age. It is a no-going-back trade (at the owner’s option) of all or part of your annuity account value in return for the highest possible payout for life. Most carriers treat a given annuity account as a whole, and will not split your money; you must annuitize an entire contract if you annuitize any part. Check with the agent before you buy if this bothers you; the work-around is to buy two contracts. You consult with your agent or planner whether you want life-only (maximum income but no income to a survivor) or survivor income, or payouts for life that will continue for a period of years even if you die early; each gets you differing income, so examine these options carefully when you annuitize. This option is seldom used because people do not like to say goodbye to their principal just to get an extra 5% to 8% higher income compared to the next method (guaranteed withdrawals). But it does give you maximum possible income and it does have significant tax benefits (see the tax management chapter). Your retirement budget might push you into this, but it is quite rare for people to use it. Here are the poorly known strategies, though: As people live longer (medical advances, better nutrition, etc.), insurers guarantee lower and lower payout rates in newly marketed annuities. You can read the income guarantee in the contract; compare these rates (convert to bottom-line income) before replacing an annuity. Older contracts may be worth keeping, provided you intend to annuitize. A footnote of sorts: variable annuities offer fixed (unchanging income for life, like other annuities) as well as a variable income. That variable income is complex, but can be illustrated if you ask. The starting income is dismally low, but if two things both happen, you will win the bet and it will pay you more than any fixed or equity-indexed annuity will. Provided you live a long life and provided you also experience (especially early on after annuitizing) great stock market returns, your income will rise very nicely. Variable annuitization income will always be subject to adjustments downward, too, but a “dampening” formula is applied to cushion this irritating bad news. Again, get this illustrated with at least a decade of past performance projected as your account’s future performance to see whether this is an attractive option.
The third way is a hybrid of the first two: Lifelong guaranteed withdrawal riders. These are available to anyone at least 45 years of age, 50 for many carriers. This is because the carriers would have to have a too-long set of guarantees if they issued these special features to younger owners. You can buy annuities at very young ages, but the guaranteed withdrawal benefits are not available and neither are long-term interest rate guarantees. So, really, these are for ages 45 and older, and are most often designed to have premium contributions only in the first year.
This excerpt is taken from “The Secrets of Successful Financial Planning: Inside Tips From an Expert,” by Dan Gallagher. To read other articles of this book, click here. To buy this book, click here.
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