Debating the validity of traditional fixed annuities, Pt. 2
By Lew Nason
Insurance Pro Shop
Here’s a continuation of the interesting conversation I had recently with a financial planner on LinkedIn about the validity of using annuities.
Dave xxxxx, RFC:
Just to be clear, I don’t think I mentioned the word stocks at all in any of my points, as my points really have nothing to do with stocks, per se. They have more to do with the high expenses of annuity contracts, and the fact that your money is tied up in a fixed income investment for a very long time with little flexibility and diversity.
Sure, you can ladder the annuities, but that doesn’t really change the character of the investment. The underlying return on the insurance company’s money that they must invest to pay the annuities is fixed by the market (mostly the bond market.) Subtract 2 percent to 3 percent from that market return that the insurance company makes and that result is what is left to pay the client (on the average.)
I guess we will just have to agree to disagree, and certainly keep right on doing what you are doing, as it seems to be making money for the both of us!
Hi Dave, You state, "my points really have nothing to do with stocks, per se. They have more to do with the high expenses of annuity contracts."
Let's be clear, there are generally no expense charges in tradition fixed (deferred) annuities. The company makes their money on the spread and pays the commission, expenses etc. from that money.
And let's be fair. There is no investment out there where the person and the company that is selling the product doesn't make money. There is always a cost to the investor: spreads, annual company management fees, expense charges, adviser management fees, commissions, financial planning fees, etc. These fees generally range from 2 percent to 4 percent or more.
You also state, "and the fact that your money is tied up in a fixed income investment for a very long time with little flexibility and diversity."
There are trade-offs in whatever you do. The money in a fixed deferred annuity is not tied up for a long period of time. You can withdraw 10 percent penalty free, and the remainder with penalties. However, the penalties are reduced over time.
So generally, after two years you are only losing some of your gains. And there are fixed deferred annuity contracts where you don't lose any of your principle, no matter when you withdraw the money. The advantage of the fixed deferred annuity is that you are getting a higher rate of return than most other fixed investments.
Maybe you can strengthen your argument by reinforcing what you said above about how people can get their money out of an annuity and its rate of return.
Let's contrast a 65 -year old who buys a 20-year corporate bond paying 6 percent against the same 65-year-old who buys a fixed immediate annuity that also pays 6 percent.
The individual invests $100,000 in each of these products, so the payout is $6,000 a year from each.
At age 85, this individual has some health issues and wants to cash out each investment. What is the value that this person would get from both of these investments and what is their true rate of return annualized over the 20 years?
1. An immediate annuity paying 6 percent is going to pay out principle and interest. So if they deposited $100,000, aren't they going to get a lot more than $6,000 per year?
2. If it's non-qualified money, how much money are they going to save on income taxes over the 20 years based on the exclusion allowance?
3. How much are they going to save on income taxes from keeping their Social Security income from being taxed at the 50 percent or 85 percent rate?
4. What will they pay for the $100,000 corporate bond to get the 6 percent? (premium or discount)
5. Is the corporate bond callable and how is it rated?
6. Can you guarantee the bond will pay $6,000 every year?
7. What will the bond be worth at age 85?
8. Are they concerned about going into a nursing home and having to spend down all of their money and leaving their spouse without an income?
Should I go on?
"It's not how much money you make, but how much money you'll get to spend."
1. A $100,000 invested in a joint and survivor life annuity, with both participants age 65, will pay out $5,600 per year, guaranteed for the life of both participants. And that is even at today’s extremely low rates of returns.
Note: The older they are when they invest in a joint and survivor life annuity, the higher the income.
2. With an exclusion allowance of just 70 percent, they’ll be taxed on $1,680. At 15 percent, their taxes would be $252, so their net spendable income is $5,348. 3. If you invest $100,000 in stocks and/or bonds, you would need to withdraw $6,292 per year (that’s over 6 percent per year) to have the same net spendable income of $5,348 ($6,292 – 15 percent taxes = $5,348).
4. Numerous independent studies have shown that a 3 percent to 5 percent withdrawal rate is all you can take if you want a 90 percent or better chance of not running out of money during retirement.
How would it feel to have to tell one person they have run out of money? How would it feel to have to tell 10 of your clients (out of 100) that they have run out of money?
5. How many people will run out of money if they withdraw over 6percent per year? 20 percent, 30 percent, or more? How would it feel to have to tell 20 or more of your clients (out of 100) that they have run out of money?
6. If the safe withdrawal rate for stocks and/or bonds is 3 percent to 5 percent, then using an average of 4 percent, they would have only $3,400 in spendable income after taxes ($4,000 – 15 percent taxes = $3,400). This gives them only a 90 percent chance of not running out of money.
7. If they put $64,286 into a joint and survivor life annuity, with both participants age 65, it will pay out $3,600 per year, and their net spendable income is $3,438 ($3,600 – 15 percent taxes = $3,438). This gives them a 100 percent chance of not running out of money. The income is guaranteed for life.
8. Now they have $35,714 that is growing each year for emergencies or to supplement their income. (In 24 years @ 8 percent, they would have $307,195.10) Plus, they have the guaranteed income they cannot outlive.
9. If they have their money in stocks and bonds and have to use it all or part of it for an emergency, what happens afterwards when they have a reduced income or don’t have any income?
10. This isn’t even accounting for the potential tax savings on their Social Security income from a joint and survivor life annuity. And, this doesn’t take into account that if they need long-term care, they may have to spend down their money in the stocks and bonds, then their spouse would lose that income.
11. If you are concerned about the low interest rates today for a joint and survivor life annuity, then you might want to consider using the split funding annuity concept, with stocks and/or bonds for long-term gains. It has the potential to provide substantially more income, with even more liquidity.