Do you need an annuity rescue?

By Peter “Coach Pete” D’Arruda


If you like the adventure of the stock market, then no worries. But if you don’t like roller coaster thrill rides, then it may be time for an annuity rescue.

“Time is nature’s way of keeping everything from happening at once.” – Woody Allen

As a broadcaster, I have learned that people want things simple. Just give me the facts. Cut out the fluff, and shoot it to me straight. As a financial advisor, I have learned that simple is not always easy when it comes to money matters. If you make it too simple, you gloss over important facts that need to be understood. Over the years, I’m sure that I have irritated some folks who came to me for advice because I insisted that they understood the details of a document they were signing, or by making sure that they fully understood a financial instrument into which they were placing their assets. But I believe fine print is meant to be read. In fact, when the type gets tiny, that’s when I read more carefully than ever before.

When it comes to money, there are no stupid questions. They all deserve answers. That is especially true when large amounts of money, perhaps your life’s savings, are on the line. In the financial world today, too many people have fallen for the enticement of a glossy brochure and put their money into financial vehicles that they didn’t understand, only to have it come back to bite them. Annuities can be useful tools in helping people reach their financial goals, but there is no one-size-fits-all annuity. They are complex financial instruments with several moving parts.

What is an annuity?

An annuity is merely a contract offered by an insurance company that is similar to a CD with a bank. But because they are offered by insurance companies, and because insurance companies have actuaries, annuities can offer the extra feature of a “guaranteed lifetime income,” which is something banks can’t do. But in most other respects, especially with fixed annuities, they behave in a similar manner. They pay interest, and like CD owners, annuity owners pay penalties for early withdrawal.

All annuities grow tax-differed, which means that the earnings inside the annuity are not taxed until money is withdrawn. Annuities are unique financial products that have become increasingly popular among retiring Americans who are drawn to guarantees, coupled with better returns than typical bank CDs. Interestingly, while they may seem to be an invention of the modern banking world, annuities can be traced back to the days of ancient Rome when such contracts were known as annua (Latin for "annual stipends"). Roman citizens would make a one-time payment to the annua, in exchange for annual payments that would last their lifetime. These financial contracts were issued by the Emperor to raise capital.

In the 17th century, the countries of Europe, who seemed to always be fighting each other, came up with a variation on the Roman idea as a way to pay for their expensive wars. It was called the tontine, named after Lorenzo de Tontini, who is credited with inventing it in France in 1653. The way a tontine works is kind of like a lottery with a twist. Participants paid in a lump sum, non-returnable amount, in return for a guaranteed lifetime payout that began right away.

The twist was that as the participants died off, the countries that issued the tontines paid the proceeds out to fewer and fewer people. The last few people alive did very well, and the last person standing did very well indeed. The last survivor of one French tontine lived to be 96. She put in 300 livres, which was the official currency of France until 1795, and was receiving an annual income of 73,000 livres when she died. In 2012 dollars, that’s around $1.5 million.
Annuities come to America

Annuities came to America during the colonial days when, in 1759, a Presbyterian synod formed the Corporation for Relief of Poor and Distressed Widows and Children of Presbyterian Ministers. The ministers made regular contributions to the fund in exchange for what amounted to a pension. Other churches copied the idea. Soon, non-profit groups were making annuities available for the benefit of craftsmen and guild members.

The first commercial offering of annuities came in 1912 when a Pennsylvania firm called Company for Insurance on Lives and Granting Annuities offered the idea to the public. The sale of annuity contracts started to catch on in the 1930s, during the Great Depression, when insurance companies were seen as stable institutions after several bank failures. Because annuities were offered by insurance companies, they were afforded tax-deferred status, which enabled annuity owners to profit from the time value of money.

The first variable annuity came along in 1952. Variable annuities allowed interest to be credited based on the performance of separate accounts. These annuities contained risk because the money was subject to the ebb and flow of the stock market, but they were still insurance products and hence enjoyed the same tax-favored status as did fixed annuities (as with today’s annuities). In those days, annuities had few bells and whistles. Today’s annuities can be purchased with options that will provide nursing home benefits, a guaranteed lifetime income, checkbook access and return of premium, just to name a few. Surrender periods average 10 years or less. While no two annuities are the same, most provide penalty-free withdrawals for up to 10 percent of the account balance per year. Some offer loans of up to 50 percent of the value of the annuity, if a need arises. Today, annuity sales are estimated to be over $200 billion per year.

Variable annuities

Some with whom I have spoken were not aware that some annuities come with risk and others do not. With variable annuities, for example, you get the returns of the stock market — both up and down. Don’t get me wrong. Variable annuities have their place as investment vehicles for some, but they are not for everybody. They especially may not be suitable for an investor with a low risk tolerance. As the name suggests, variable annuities can vary in performance, and they can lose value.

It’s always fun when the market is going up, but it is not so fun when the market is going down. A section of the “fine print” in a variable annuity contract may read, “The account value is separate from the protected withdrawal value, has no guarantee, may fluctuate, and can lose value.” That’s an important little detail to understand, wouldn’t you say? If you like the adventure of the stock market, then no worries. But if you don’t like roller coaster thrill rides, then it may be time for an annuity rescue. If you are in or nearing retirement, you probably want something that is ridiculously reliable, not risky and uncertain.

An annuity rescue here would probably involve a tax-free rollover from the variable annuity into something we call a retirement income annuity (RIA). The RIA eliminates the ups and downs and the high tide/low tide market fluctuation and replaces it with a strategy that takes into consideration your new status as a retiree. (Note: You don’t have to be retired or near retirement to take advantage of an RIA. It is available to anyone over 40.)

In this program you are insulated from market loss, but you are still able to share in the gains of the market up to a cap. When the market skyrockets, you will not get anywhere near the total gains of that upswing. But when the market sinks like a stone, you don’t lose. You advance and protect. A relatively new feature is available on many of these programs. It is a special attachment that provides a guaranteed compound interest growth of between 5 percent and 7 percent for a lifetime retirement income.

Fixed annuities

Some people may find themselves trapped in an underperforming fixed annuity that guarantees a fixed rate of interest for a set number of years. Again, these are fine instruments and useful for meeting certain financial objectives, but if you are saving money, chances are you are saving it for the future. Thus, if you have a specific income need in the future, your goal is probably to try to save enough to meet that need. Unfortunately, many of the fixed annuities that I see in portfolios today are lacking in the horsepower to meet the income needs of those who own them.

An annuity rescue here would mean looking for a more suitable program that would allow us to solve for income while still keeping the element of safety on our side. The RIA with the guaranteed lifetime income attachment may be a fit here as well. But no rescue is advisable if it comes with a penalty. No rollover would be acceptable if it created a taxable event or a penalty.

Planning adequately for the future often involves knowing where we stand at present with our finances. If we have money saved for retirement but it’s not in a safe place or if it is not growing at an appropriate rate for our needs, then consider moving it as we approach that red zone of retirement.
Fixed indexed annuities

The fixed indexed annuity (FIA) is a type of fixed annuity. It provides a minimum rate of interest, just like the traditional fixed annuity that we might call a “floor.” But what makes it different, and what gives it greater earnings potential, is the fact that the performance of a specified stock index, usually the S&P 500, is used to calculate returns over that minimum. That is great! But hold the confetti for just a moment. There are caps ranging between 4 percent and 8 percent. If the S&P jumps up 20 percent in one year, your growth will hit that cap and stop. The caps are a tradeoff for having guarantee of principle. If the index loses 20 percent, the value of your FIA is not negatively affected.

FIAs are growing in popularity because they enable people to share in the upside of the stock market with absolutely no downside risk. Another attractive feature is the ratchet-reset provision. At the contract’s anniversary date, the growth is locked in and now that is the new high-water mark of the annuity that represents the new amount that you cannot lose.

Three common misconceptions

1. Liquidity

Annuities are not entirely liquid. You trade a measure of liquidity for guaranteed safety and guaranteed return on investment. But the idea put forth by some critics of the product that annuities are “illiquid” is silly. Just like CDs at a bank, there are penalties for early withdrawal. Most professionals in the know regard annuity surrender charges and annuity surrender periods as reasonable. Those who point to surrender fees as if they were some kind of “gotcha” rigged by insurance companies to illegitimately take money from poor, unsuspecting customers, are usually investment advisors who do not offer such products. I think the term for such criticism is “sour grapes.”

Surrender fees are necessary. If the annuitant does not keep his money invested with the insurance company for an adequate period of time for the insurance company to make a profit, then the insurance company might be forced to sell an investment earlier than it had planned. So, for the insurance company to guarantee the interest rate it promised and guarantee safety of the principle, it has to set certain limits regarding withdrawals. The usual time limit, as mentioned earlier, is 10 years or less. They are called “10-year walk-aways” in the insurance industry, because after 10 years you have no surrender charges. You can walk away from the contract if you wish. Move your money, spend your money, reinvest your money or put it into another annuity.

During the 10-year surrender period, is your money locked away and untouchable? No way. First of all, you have the 10 percent free (without penalty) withdrawals offered by most contracts. Secondly, the surrender charges are lower every year. They are highest during the first year of the contract, ranging anywhere from 6 percent to 16 percent and decreasing each year until they reach zero.

2. Guarantees

Sometimes detractors of annuities will say that they are not FDIC insured. That is true. They are an insurance product, not a bank product. They fall under an entirely different protection arrangement known as the Guaranty Association. Each state has a different one.These associations guarantee the funds invested with insurance companies in the rare event that an insurance company has financial difficulties. This arrangement is made possible by government regulations that require insurance companies to put money in reserves to cover any risk they undertake. The amount of protection varies by state, but in most cases the amount of protection, dollar for dollar, is more than that offered for bank accounts.

3. Fees and commissions

Contrary to opinions proffered by those who do not offer fixed and fixed indexed annuities, no fees are charged within these products. Not so with the variable annuities customarily offered by brokers and bankers. Variable annuities do charge fees because they are usually invested in mutual funds, which contain fees called “loads.” With variable annuities, you will still pay these fees, as well as the broker or banker’s commissions, even if your variable annuity loses money.

On the other hand, fixed and fixed indexed annuities have no risk, no fees and no commissions that come out of your balance. Any commissions paid to agents are paid by the insurance carriers that produce the product. As to how fixed and fixed indexed annuity agents are paid, think of a travel agent. If you book your trip through a competent travel agent, you will likely be dealing with someone who possesses a vast knowledge of the industry and who can plan for you a worry-free vacation at a lower cost than you could have found had you planned the trip yourself. The airline companies and the hotels pay the travel agent, not you.

Know your options

If I could build this next sentence out of 30-foot tall cinderblock letters and paint it DayGlo orange, I would: Annuities are not for everyone! And I strongly urge you to never put all of your assets into an annuity, regardless of how great it appears to be. You should always approach making a decision to purchase an annuity by first having a thorough, holistic review of your finances. You should then consider all your options. Seek the help of a fiduciary, not a salesperson. Annuities can be fine instruments for income planning and great for retirement planning, but only if they are suitable for your individual circumstances and they match your individual financial goals.