Immediate Annuities: They're Insurance Against Living Too Long
The marketing push is on.
For months, insurance companies and financial services firms have extolled the virtues of immediate annuities.
Advertisements, once rare, now appear regularly in financial magazines.
Financial services firms, with their sights set on aging baby boomers, are rolling out products and services that include these annuities, which in exchange for a lump-sum premium can guarantee an income for life.
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And the insurance lobby, as part of a coalition of business and consumer groups stands behind legislation introduced in the House of Representatives in July to make immediate annuities more attractive by lowering taxes on the income received.
Overall, this is good. But consumers need to understand how these annuities work so they can make informed and intelligent decisions.
So there is no confusion, I like immediate annuities.
To guard against the risk of living "too long," most Americans should consider an immediate annuity to cover at least part of their essential expenses in retirement, such as food and housing.
Several studies have shown that immediate annuities tend to produce higher lifetime spendable income than bonds or other income-producing securities. Including an immediate annuity in a diversified portfolio can substantially lessen the risk of running out of money.
Still, a relatively paltry $11.5 billion worth of immediate annuities were sold in the United States last year, compared with $202.5 billion in more common "deferred annuities," in which the money grows tax-deferred.
Why the reluctance about immediate annuities? In the most extreme case, once you hand over your money to the insurance company, you lose access to it, and your heirs get nothing after you, or you and your spouse, die.
Some annuities today allow limited access to principal. You can always choose a reduced payout that continues for a specified time or amount after you die.
But the basic tradeoff remains: You give up money in hand for a guarantee of lifetime income from the insurance company.
The problem is, you don't get straight answers when you ask what return you get. You are quoted a payment -- for example, for a $100,000 premium, a man and wife, both 65, would receive $563.19 a month from a top-rated insurance company until both die.
At first blush, that's a return of more than 6.75 percent a year -- $6,758.28 annual income divided by $100,000 -- and the annuity may advertise a "6.75 percent payout for life."
But the real investment return is likely to be considerably less.
Since the insurance company won't tell you what it is, or even the assumptions on which payments are based, I will. The explanation will also help you understand the proposed House bill.
Payments from an immediate annuity are based on how long you are expected to live and an assumed interest rate. If you die when expected, your total payments will consist of both interest and a return of your entire principal.
Each payment, until the whole principal is returned, is part principal and part interest, and you are taxed only on the interest -- unless you buy the annuity with previously untaxed money, such as from a deductible IRA, in which case the entire payment is taxed.
Therefore, a typical immediate-annuity quote includes an "exclusion ratio" telling how much of each payment is excluded from taxes.
We had heard about annuities and were investigating them for our IRAs. We also heard bad things about pushy brokers over the years. So when we went to the ImmediateAnnuities.com site we were skeptical about calling them. But whenever we called their staff was really friendly. They answered all our questions and one of their reps even told us that at our ages there was no advantage to buying the annuity with our IRAs. These guys are really honest!
In the previous example, the exclusion ratio was 59.2 percent, meaning that $333.41 of each $563.19 monthly payment is a return of principal and not taxed.
Do the math, and you'll see that after 300 payments you will have received the $100,000 principal back. Any subsequent payments would be considered all interest and fully taxed. Under the proposed House bill, one-half the taxable income from lifetime annuities bought with after-tax money would be exempt from taxes, up to $20,000 a year.
From this example, you can see that the insurance company is counting on you and your spouse being dead after 25 years, or 300 payments. And 300 payments of $563.19 per month represent a return of 4.6 percent a year on your $100,000 premium, a figure you can arrive at by using a financial calculator available at office supply and electronics retailers.
It is only after 30 years, when payments are all interest, that you start getting a 6.75 percent return -- if you live that long.
Are the returns on immediate annuities worth it?
Only you can decide, once you know what they really are. I do urge you to look at immediate annuities as insurance first -- protection against outliving your money -- and only secondarily as investments.
Source: sun-sentinel.com - 08-18-2004