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Dr. David Eifrig Jr's - September 2016


This Is THE Investment for Retirees

We’re talking about annuities. Annuities are a financial contract between you and an insurance company. In the simplest terms, you pay a large amount up front, then the company pays you back over the following years... either for a fixed number of years or until you die. When used properly, annuities can provide stable income and remarkable peace of mind.

The folks who like to play with mathematical models and do advanced analyses of retirement portfolios find annuities to be invaluable assets. As early as 1965, a seminal paper found an annuity to be “invariably” the best option for retirees, given they don’t know exactly how long they will live.

Other approaches have confirmed this result. Think about it this way... When you try to figure out the best portfolio for your retirement, you need to consider dozens of variables. You don’t know how long you’ll live, how much you’ll need each month, what the stock and bond markets will return, or what allocation you should have. When you start stacking up all those unknowns, you can come up with millions of possible results. That’s what makes retirement planning so overwhelming. However, when you put a chunk of retirement money into an annuity with a guaranteed payout for life, you remove a lot of the uncertainty. Now you have a foundation on which you can build your wealthy retirement. That will help you sleep well at night.

The Center for Retirement Research at Boston College suggested in a recent working paper that many middle- and high-income families would experience a “sizeable” increase in monthly income if they used more annuities. The group suggests taking part of your 401(k) savings and investing that in an annuity to ensure payouts from both types of accounts.

So why aren’t more folks using them? Part of the reason is the complexity. And part of it is the high fees some providers charge. Annuities can be structured in so many different ways that it makes them difficult to understand. Plus, many are poorly designed, have high fees, and are sold aggressively by those who’d rather make a commission than find the right product for you. But when used right, annuities are a powerful tool to help ensure a secure, comfortable retirement. So let’s start by nailing down...

The Basics of Annuities

The idea of an annuity is to start off retirement with a piece of your nest egg invested in a guaranteed stream of income. For example, a 60-year-old man can spend $200,000 today and, in return, receive $966 a month for life. That becomes a total of almost $290,000 in payments by the age of 85. The longer you live, the bigger the return on your investment principal.

Now, this can get more complex based on how much of a payout you want and over what length of time. In the above example, the 60-year-old man chose what’s called a “single premium fixed immediate annuity.” But you have many other variations available...

• You could set an annuity to pay for a certain number of years, rather than base it on your anticipated life span.

• You can buy one today, but not start collecting income until decades into the future (called a deferred annuity).

• You can earn a guaranteed return or allow it to fluctuate in the market.

• You can avoid paying taxes on your investments.

By selecting, combining, and adjusting these factors (and more), you can tailor the right annuity to your situation. So let’s start by looking at the different kinds of annuities.

The First Two Decisions

First, start with two questions... Question No. 1: Do you want to start collecting income from your investment now or start saving for the future? If you want to start your income stream now, you want an immediate annuity. If you can wait, you want a deferred annuity.

Question No. 2: Are you willing to accept investment risk, or do you want a guaranteed rate of return? Variable annuities involve investment risk but offer potential higher returns. Otherwise, you can simply accept a fixed rate. A fixed deferred annuity means you have a fixed rate of return on your investment that’s set to start payouts in the future.

A variable deferred annuity changes its rate of return based on the investments. The payouts start in the future. The rate changes because the company is investing in more-volatile investments like stocks and mutual funds. Immediate annuities begin paying out right away. The income payment you receive each month can be fixed or variable.

You can start to put these pieces together to build different outcomes. A new retiree who wants a certain income stream can use a fixed immediate annuity. Someone saving for a future retirement may use a variable deferred annuity to participate in stock market gains while accumulating wealth. But you might ask yourself – why would you invest in a variable account if the insurance company just uses it for stocks and funds you can buy yourself in a traditional account?

That brings us to one of the big benefits of annuities... tax deferral. We’ve talked about how taxes can cause a drag on investment returns. When you pay annual taxes on dividends, interest, and capital gains, it costs you a bundle now, and even more over time as you lose the effects of compounding that wealth. That’s why it makes sense for most people to get as much longterm savings as possible into tax-efficient accounts like IRAs and 401(k)s. There’s a government-imposed limit to those accounts though. It depends on your income levels and other details, but let’s call the max $23,500 a year. Annuities aren’t technically an investment. They are a contract you enter into with an insurance company (known as the “issuer”).

This means the gains that accrue within annuities get to grow without paying taxes along the way. When you take withdrawals down the line, you have to pay taxes on those as income. There’s no limit to how much wealth you can tuck into annuities to legally avoid taxes on investment gains. Annuities offer other benefits too, in the form of riders. Riders are documents you can add on to your annuity contract to provide different features. You can get an annuity with living benefits. In this situation, you can get guaranteed income for life. It’s not income for a certain number of years. It’s not income until the balance runs out. It’s more like an insurance policy that agrees to pay you until you (and your spouse, if that’s how you arrange it) both pass away. Living benefits come at a cost, but they can eliminate the possibility of running out of money.

Variable deferred annuities can also reduce market risk. If you invest in the market on your own, you can end up losing money. If retirement comes at a down time in the market, you can end up with less than you planned. Many variable annuities – even though they are variable – offer the safety of your invested capital or even a guaranteed minimum return if the market craps out. You can also tack on inflation adjustments or a minimum payout.

Are Annuities the Perfect Investment?

Based on what we’ve covered so far, it may seem like annuities are perfect... with incredible guarantees and tax benefits. Of course, you’ll pay a price for something so good. Annuities often have high fees to offset all of those benefits.

On a fixed annuity, the fee will typically be built into the rate of return. If the insurance company promises you 4% a year, that’s less than you’d earn if you could make the same investment that it’s making. But you may not get to see that upfront.

Variable annuities will have administrative fees and investment management fees. There are also expenses for the insurance-like features that you can attach, like income for life or other riders. These costs can add up. Many financial websites and “experts” will advise savers to never, ever buy an annuity because of the fees. We don’t like the fees, but as you’ll see, they can make sense for the right investors... And in many cases, you can minimize the fees you pay. Annuities also lack liquidity. If you put your cash into one, you can’t get it back whenever you want without penalties.

If you buy an annuity that’ll pay for life, you may not get your money back if you don’t survive long enough. Most annuities have a short period during which you can back out without penalty. After that, there are some circumstances under which you can make withdrawals (in excess of the income it pays). You can usually take out up to 10% a year without penalty. Most annuities allow you special withdrawals if you need nursing home care. Even so, an annuity is a big commitment, so you need to make sure you make the right decision at the start.

Harnessing the Power of Annuities

In a sense, annuities are a “goldilocks investment.” They work best for people with a healthy amount of retirement savings, but not a huge amount. Take a wealthy soon-to-be retiree with $2 million in savings. If the nest egg earns a basic 3% a year, the investor could withdraw $100,000 per year for 30 years and still have money left over. This person doesn’t have much of a risk of falling short in retirement.

On the other hand, someone who doesn’t have enough capital to start an annuity may need to keep working and live on Social Security. If he is a low-earner, the tax benefits of an annuity won’t be worth the trouble. There’s a sweet spot in the middle, where an annuity can be just right. The range is something like $200,000 in savings to $1 million. In this case, the annuity can provide enough income in retirement to truly boost your lifestyle. At the same time, your earnings are likely high enough that the benefits of tax deferral make sense to pursue.

Annuities aren’t the be-all and end-all investment solution... but they can add a big chunk of guaranteed weight to your portfolio. Let’s say you’ve got $200,000 to invest and you figure you need $5,000 a year in addition to Social Security. You could invest all $200,000 in a safe portfolio of bonds and try to live off the interest. At current rates, that’d return about $5,000 a year... so it looks like you’ve made it. But what if you could do far, far better... with only half the capital...

Taking the annuity example we gave earlier, putting just $100,000 into an annuity would yield $5,745 a year for life. Now you’ve got your expenses covered – and still have $100,000 leftover. You can use that for extra spending... or you’re free to invest it more aggressively in stocks or other investments with higher returns. After all, you know your bases are covered.

If you’re a long-term Retirement Millionaire subscriber, you’ve likely thought about your asset allocation and tried to figure out what you’ll have in income during retirement. If you’ve got $300,000 saved and you’re trying to figure out how to invest it for 20 years, you can go with a traditional 60/40 split between stocks and bonds.

Or you could put $100,000 of that into a fixed deferred annuity. At current rates (and remember, today’s rates are relatively low), that would turn into just a little less than $200,000. That’s a big, guaranteed pile of cash that you can now plan the rest of your retirement around. That certainty has major value when you’re planning years or decades ahead.

This is a great way to think about annuities... Use one to shore up a portion of your portfolio into a sure thing. Fidelity Investments suggests that an annuity shouldn’t take up more than 30% of your assets. And I agree. The riders also make all the difference. If you want guaranteed income for life, you can make more with an annuity thanks to the insurance-like nature of annuities. Of course, you don’t know when you’ll die, so it’s impossible to plan right down to the end. However, the insurance company sells these annuities to a big pool of people.

If you’re lucky enough to enjoy a long life, your income is partially paid by the savings of other customers who didn’t live long enough to collect many checks. It may sound morbid, but that’s how insurance pooling works. If you tried to invest on your own without the benefit of these “survivorship credits,” as they are called, you simply couldn’t earn as much.

The Final Annuity Secret

We’ve pointed out that fees can be the worst part of an annuity. We’ve also got a solution: skip them. Insurance companies employ commissioned salesmen to sell annuities. Their compensation counts for a big part of those fees. But companies like Vanguard, Fidelity, Schwab, TIAA-CREF, and T. Rowe Price sell low-cost, no-load annuities directly to buyers without the salesman. This type of selling is relatively new and on the rise. There has never been a better time to get an annuity, so check out these low-cost providers. (As a note, we’re a completely independent newsletter and have no ties to these firms or any others.)

It’s impossible for us to cover every possibility for every annuity here. They are too numerous and too customizable. That’s why the most important sentence in today’s issue is this: Make sure you understand every detail of any annuity you purchase. You’re the only one who knows what’s right and what’s best for you.

Yes, the contracts are long and dull and complex. But once you set up an annuity, you won’t have to think about it for decades. Take the time to read your contract multiple times. If there is a section you don’t understand, don’t sign until you’ve asked someone to explain it... Make sure you understand what you’re getting.

Don’t be afraid to shop around. Pick up the phone, do some comparisons, and ask a lot of questions to make sure you’re getting the right deal. Two of my favorite professionals for helping subscribers think through insurance products are Dave and Todd Phillips at Estate Planning Specialists. They specialize in the estate and long-term care planning business. Feel free to give them a shout at 888-892-1102.

But we’d urge you to also do lots of leg work on your own. Check pricing and commissions on sites like Fidelity and Vanguard. Yes, that will take some effort... but it’s worth it to know your retirement is secure. Annuities are an important and valuable tool for those in the right situation. For those folks, it may be the single best way to plan for retirement... and ensure they don’t outlive their savings.

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