31 Aug Need a paycheck? Dissecting annuities

Q. I have $800,000 in IRAs and my only income is $20,000 a year in Social Security. I’m 64. My neighbor said I should buy an annuity so I can have more regular income and not have to worry about the stock market. Is that a good idea?
— Annuity-wary

A. There are many approaches to creating income in retirement.

Luckily, you have accumulated a sizeable IRA that can be used to supplement your Social Security income.

An annuity can definitely be used to generate regular income, so your neighbor may be onto something.

But you’re also right to have concerns about annuities, said Andrew Novick, a certified financial planner and estate planning attorney with The Investment Connection and Brookner Law Offices in Bridgewater.

He said most of the time, he doesn’t recommend annuities and he wouldn’t put your entire IRA into an annuity.

First, he said, let’s review some annuity basics to determine if an annuity is right for you. And keep in mind it can get complicated because there are many annuity variations.

Broadly speaking, he said, there are two types of annuities: deferred and immediate.

Novick said a deferred annuity is a savings vehicle.

“Funds inside a deferred annuity grow on a tax-deferred basis, which is its most attractive feature,” he said. “You can invest regular or IRA assets in a deferred annuity, but since an IRA already grows on a tax-deferred basis, you won’t benefit from the annuity’s best feature.”

Novick said there are three types of deferred annuities:

1. A variable annuity lets you invest in one or more subaccounts that are similar to equity and bond mutual funds, so the account value will fluctuate based on investment returns.

2. A fixed annuity increases by a set interest rate, similar to a CD.

3. An equity-indexed annuity (EIA) pays interest based on formula tied to an equity index, such as the Dow Jones Industrial Average. While equity returns are variable, an EIA offers some principal protection in exchange for limited upside returns. Thus, EIAs are called hybrids because they have characteristics of both variable and fixed annuities.

Novick said surrender charges apply to most annuities, such as 7 percent declining 1 percent per year over a seven-year period, but the schedule varies by product.

“Although you will probably by allowed a limited annual `free’ withdrawal, any surrender charge impedes access to your own funds,” Novick said.

High annuity fees will negatively impact performance, he said, noting the internal costs of investing in a variable annuity are about twice the cost of investing in a comparable mutual fund.

For an extra cost, you can often add optional riders that guarantee a minimum rate of return, percentage lifetime payout without annuitizing, or payout at death, he said.

“On first glance, the riders have a lot of appeal, but restrictions diminish their real life application and research shows that they are typically not worth it,” he said.

It’s also important to keep in mind that annuities receive unfavorable tax treatment when it comes time to making withdrawals and at death.

“Gains in an annuity are taxed at ordinary income rates upon withdrawal or at death,” he said. “This compares to capital gain tax treatment on investment gains made outside of an annuity and a step-up in cost basis at death, which results in no tax.”

And, he said, distributions from an IRA are generally taxed at ordinary income rates whether invested in an annuity or not. A 10 percent early withdrawal penalty will also apply to distributions out of an annuity prior to age 59 1/2.

“Between the surrender penalties, fees, and tax treatment, I am not a proponent of deferred annuities for any investor, especially not one with IRA assets and looking for current income,” he said. “Instead, I recommend simply investing your account in a manner that is consistent with your investor profile and making withdrawals as needed.”

Novick said a balanced investment approach should be able to sustain a 3 to 4 percent withdrawal rate indefinitely and still grow, which will provide inflation protection. However, he said, the account will be subject to market risk so the account value and corresponding withdrawal amount can vary.

On the other hand, a single premium immediate annuity (SPIA) has some appeal.

“In exchange for a lump sum of money, an insurance company will pay you a set amount every month for the rest of your life,” he said. “A deferred annuity can also be `annuitized,’ which is the same thing. In this regard, a SPIA is similar to a pension or Social Security benefits. It ensures that you’ll never run out of money during your lifetime and can be a useful part of retirement income planning.”

How much you will receive depends on the amount of the lump sum as well as interest rates and your age at the time the SPIA is purchased, Novick said, and payouts will be larger if interest rates are high and for older individuals.

“Considering interest rates today and your age, I suspect that you will be underwhelmed by the payout,” he said. “I estimate that a $100,000 lump sum will result in a single life payout of $500 per month for a 64-year-old in New Jersey, but this can vary based on the insurance company.”

Once a payment is determined, it never changes, he said, noting this can be a big problem because you can’t ask for a bigger distribution if you have an emergency and need access to additional funds. For this reason, it is never prudent to put all of your money in a SPIA, he said.

The “value” of a SPIA comes if you live for many years because payments continue for your life, he said.

Another problem arises if you die early. The payments stop and the insurance company keeps a significant portion of your wealth, he said.

“To partially protect against this risk, you can select a joint-life payout – typically your life and your spouse’s life – so the payments will continue for as long as either annuitant is alive,” he said. “Joint life payments are somewhat lower than single life payments, but the payments should continue for a longer period of time because two people are likely to live longer than one person.”

Still, he said, it’s possible for both annuitants to die before enough payments are made to even get back the initial premium, so Novick prefers what is known as the “cash refund” option.

With this option, your heirs receive the initial premium less any lifetime payments to you. In exchange for this protection, the insurance company reduces the SPIA payments, but between the lifetime payments to you and the death payments to your heirs, if any, there is essentially no risk of loss other than the time value of money. Novick calls this a reasonable tradeoff.

Also keep in mind that if the sponsoring insurance company runs into financial difficulties, your annuity payments are at risk. For that reason, Novick said, he only recommends SPIAs from top-rated insurance companies.

“I look at the Comdex rating, which is a composite score averaging the ratings of the major insurance rating organizations, and only consider companies with a score of 90 or better on a scale up to 100,” he said.

Also know that every state has an insurance guaranty fund to help protect policy holders from insurance company failure. While the level of protection isn’t boundless, the guaranty fund in New Jersey is robust and protects up to $500,000 in a SPIA, Novick said.

“So my long-winded answer to your question is that buying an annuity may be right for you, especially if you want some lifetime income with no market risk, but I would only consider a SPIA for a portion of your IRA and only if you select the cash-refund option,” he said.

Good luck making your decision!

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This post was originally published in September 2017.