Dear Carrie, My mother, who is in her 70s, has recently been advised by her banker to buy an annuity. I've heard that annuities can be costly and risky. What do you think? --A Reader
Annuities often seem to raise questions. That's probably because what was once a fairly straightforward way to secure income for retirement has evolved into a multitude of products with an array of possible features. As a result, the world of annuities has become incredibly complex and fraught with potential misunderstanding.
Annuities can be divided into two distinct categories: fixed and variable. Both are contracts with an insurance company; you pay a premium (or series of premiums), and then receive payments at regular intervals for a stated period of time.
There's no limit to the amount you can contribute to an annuity, however, contributions aren't tax deductible. Taxes on earnings are deferred until you withdraw the money, at which time you pay ordinary income taxes on your gains. There's a 10 percent penalty for withdrawing earnings before age 591/2, but there is no required starting age for withdrawals.
At a basic level, a fixed annuity may seem like a traditional pension plan, providing a predictable income stream. Provided the insurance company remains solvent, you can count on receiving payments for a set number of years, for life, or even for the life of a beneficiary.
With a variable annuity, however, you can invest your money in "subaccounts," which are comprised of stocks, bonds, or other vehicles -- and your return will vary depending on their performance. For that reason, payments aren't as safe or predictable as they are with a fixed annuity.
Adding another level of complexity, both fixed and variable annuities can be either deferred or immediate. With a deferred annuity, payments start at a future date. An immediate annuity will start to pay out right away, continuing for a specified period of time or for life.
Annuities can have hefty fees and commissions, whether variable or fixed, but that doesn't mean your mother should avoid them. In particular, an immediate fixed annuity, also known as a single premium immediate annuity (SPIA), could work well for someone your mother's age under the right circumstances.
With an SPIA, you invest a lump sum with an insurance company and immediately begin to receive guaranteed income for a set number of years or for life, depending on the annuity. It can be a viable way to supplement retirement income. With a life annuity, there's the added security that you'll never outlive the income.
Beyond the basics: Is an SPIA right for everyone?
On the surface, an SPIA sounds ideal. But it isn't for everyone. Whether it's right for your mother depends on her individual financial situation.
Here are a few things to focus on to help her decide:
(SET BOLD) Current savings. (END BOLD) The main benefit of an SPIA is reliable cash flow. This cash flow is generated by a combination of interest payments plus tax-free return of principal. If your mother has considerable assets and income, she may not need the security that this type of annuity offers and may be getting a better return on the investments she already has.
At the other end of the spectrum, if your mother has minimal savings, she may not be able to afford an SPIA. Once you buy one, you generally can't cancel and get your premium back in a lump sum. For someone with limited cash, this could create a bigger cash flow problem down the road.
The ideal candidate for an SPIA is someone with adequate retirement savings for basic needs who wants a convenient way to supplement income. If this is your mother's situation, she might consider investing a portion of her savings in an annuity. This would guarantee a certain amount of income, and still give her access to the balance of her assets.
(SET BOLD) Time horizon. (END BOLD) Your mother's life expectancy is also a consideration. According to the Social Security Administration's current actuarial tables, a 75-year-old woman, for example, can expect to live another 12.55 years. Let's say your mother decides to invest $200,000 in an SPIA for a payout of $16,000 per year for the rest of her life. On the surface, that may look like an 8 percent annual return, but once you strip away the return of principal, the real return is closer to 4.5 percent. The longer she lives, the higher the return. If there are no survivor benefits and she dies within a few years, the insurance company comes out ahead.
(SET BOLD) Survivor benefits. (END BOLD) Your mother can choose between a single-life annuity or an annuity that would make payments to beneficiaries upon her death, either for a set number of years or until the entire premium is returned. An annuity with beneficiary payments generally pays out less per month or requires a higher premium for the same monthly benefit. But at least your mother's annuity assets would be passed on should she die early.
What about today's interest rates?
With today's low interest rates on CDs and Treasuries, I can understand your mother's banker suggesting an annuity as an alternative. But annuities are also affected by prevailing rates, which influence the lump sum required to generate a certain level of income. Locking in an annuity at today's rates may not be the best move. An alternative would be to buy smaller annuities at various times to average out the rate of return.
If you and your mother decide that an annuity makes sense, help her shop around. The specifics are often complicated, and sometimes different insurance companies provide different payouts for the same investment. I'd suggest talking to an objective financial. Above all, remember that so-called guaranteed income is only as secure as the insurance company behind it -- so only work with the most highly rated companies.
Annuity guarantees are based on the financial strength and claims-paying ability of the issuing insurance company. Insurance company ratings do not extend to the performance of the variable annuity subaccounts and are subject to change. There is no guarantee that current ratings will be maintained.
Variable annuities are long-term investment vehicles designed for retirement purposes. The value of a variable annuity may be more or less than the premiums paid and it is possible to lose money.
Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER(tm), is president of Charles Schwab Foundation and author of "It Pays to Talk." You can e-mail Carrie at firstname.lastname@example.org. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.
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