31 July 2008
Whenever a bear market raises its ugly head, fear causes many to make decisions that have lasting ramifications. In the last year I am starting to see a lot of salesmen pushing a specific annuity as the answer to every fear about protecting retirement dollars, but understanding who the winners are is important if playing the annuity game.
Before I get into the annuity, I do want to acknowledge that I believe annuities have a place in retirement. If you think about it, your corporate pension is simply an annuity – I believe immediate annuities where you put a lump sum into an annuity and it starts paying out the next month for your lifetime can be helpful to any portfolio. An immediate annuity can act like an anchor, the fixed piece, to a long-term portfolio. Yet very few of our clients ever use them because it is an irrevocable decision.
Today’s hot product is the variable annuity (variable meaning the cash is invested in stock market funds instead of in a fixed account paying a steady interest rate) with a twist. Retirement income is becoming a big topic as more baby boomers decide it is time to move on to the next phase of life. Since many of these baby boomers might not have saved enough money to retire outright (and some will still work part-time), insurance companies have come up with benefit guarantees to ease the fear of running out of money. Today’s version is called the Guaranteed Minimum Withdrawal Benefit (GMWB), which usually will guarantee a 5% withdrawal rate based on how much you put in, no matter how the market does. For example, if you put $200,000 in, and your account dropped to $180,000, the GMWB would still allow you to take $10,000 that year (5% of $200,000).
But as with anything that sounds this good, looking under the hood reveals a few problems. First, you, the customer, pay for that benefit guarantee to the tune of .6% to .85% usually. This might not seem like much but it can almost double the expense ratio of the product. Second, the guarantee really only kicks in if you run out of money – at the point your account hits $0 the insurance company starts paying you. But until then, you are using your own money with higher expenses to do so. Third, if you pull out more than the guarantee, it reduces the following year’s guarantee. In my example above, suppose you needed an extra $25,000 for a new car one year, the following year’s 5% calculation would be based now on $175,000 instead of $200,000, which reduces your income to $8,750 going forward. Finally, this income stream is not indexed for inflation so in reality, you are losing spending power as you go forward.
There could also be tax differences as well since annuities are taxed on a Last In First Out (LIFO) basis – the initial distributions, if they are gain on your original contributions, will be taxed at income tax rates, not capital gains rates. And beware the salesman that wants you to do this in an Individual Retirement Account (IRA). IRA’s are already tax-deferred so adding a tax-deferral product like an annuity to a tax-deferred account like an IRA adds no value, just expense.
There are other ways to cushion a portfolio instead of using annuities. And as I mention, sometimes an annuity might be a good answer. But in the end, do not let fear of the market be the guide on this journey we call retirement. Change the word retirement to financial independence and focus on decisions that allow you to be freer in the next phase of life – and inherent in the word free is the ability to change your mind whüen you are in products that you understand.