How to Make an Informed Decision about Annuities

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In my last blog post, I talked about how annuities can provide value as a form of insurance against outliving your money, and addressed some of the common criticisms of this type of financial product. In this post, I want to go over what I consider to be the key questions to ask when in the market for an annuity. (Even if you’re not currently interested in an annuity, you may know someone, especially an older relative or friend, who might be, and this information could help save them from getting into a bad deal.)

Without further ado, here are the questions to ask:

(1) “At what age do I want to ‘turn on the faucet’ of lifetime income checks, and what other sources of money outside the annuity will I have access to before then?” This question is critical for determining whether an annuity even makes sense for you in the first place. You don’t want to put yourself in a situation in which you have no choice but to cancel the contract or make a withdrawal from it prior to when you were planning to start collecting the monthly checks for life. Obviously, pulling money out beforehand is going to negatively impact the size of your monthly checks. But beyond that, if you make a one-time withdrawal from an annuity before age 59½, you face an early withdrawal penalty from the IRS. If the annuity is held inside a pretax or Roth account, then the corresponding penalty for early withdrawals applies. But even if you funded the annuity with money from an unsheltered account, an early withdrawal penalty still applies. This penalty is a tax equal to 10% of the amount withdrawn (just like if the annuity were in an IRA or other type of pretax account). This is because when unsheltered money is put into an annuity, the annuity itself provides a form of tax shelter: the money you put in isn’t tax-deductible, but the earnings on that money aren’t taxed until they come out of the annuity. This makes annuities highly tax-efficient, but the early withdrawal penalty means that annuities are not a place to stash emergency funds. Furthermore, even if you’ve already passed the 59½ milestone, if you cancel the contract or make a one-time withdrawal before initiating the stream of monthly checks, you still might have to pay an early withdrawal penalty — not to the IRS, but to the insurance company! Annuity contracts typically include a surrender period, which is a period of years after the purchase of the annuity during which, if you cancel the contract or make a one-time withdrawal, the insurance company gets to keep some of your money. (Check the contract to be sure, but if your plan is to initiate the stream of monthly checks before the surrender period is up, the insurance company likely won’t penalize you. The point of the penalty is to discourage you from cancelling the contract or treating it like an ATM.) Hence, proper planning is needed so that you can comfortably leave the annuity alone until you’re ready to start collecting those monthly checks.

(2) “Once I start collecting the monthly income checks for life, what other sources of money outside the annuity will I have access to?” In order for your annuity to do its best for you as a source of guaranteed lifetime income, you need to treat it like a hen that lays golden eggs, but only lays them at a rate of one per month. As long as you patiently wait for each new golden egg to be laid, you can count on the hen laying those eggs for you as long as you live. But if you try to force her to lay more than one egg at a time, or to lay bigger eggs, then either the insurance company will refuse, or they’ll comply, in which case you’ll end up hurting the hen, and the eggs will get smaller and/or she’ll stop laying them altogether. So, for the sake of financial flexibility, you want to have other sources of money to draw upon. Furthermore, if your monthly income checks stay the same over time, then inflation will erode the purchasing power of those golden eggs. There are annuities that will increase the size of your checks each year as an anti-inflation measure, but the size of your checks will start off much lower, and you'll have to live a long time to see the check size rise above the size of a level monthly check. Instead, you can complement level monthly checks from an annuity with a separate source of money that can stay ahead of inflation and be accessed as needed. Believe it or not, a stock market-based investment would fit the bill here. (There are ways to invest in the stock market in retirement without taking on too much risk. More on this in the future.)

(3) “At the age I plan to turn on the faucet of lifetime income, what will be the size of those monthly checks?” I strongly suggest you request an illustration, so that you can see concrete dollar amounts. (Illustrations are free and don’t signify a commitment to buy anything.) Some annuities are very straightforward in that they tell you exactly how much your monthly checks will be (depending on the amount you put in and the age at which you start collecting the checks). It doesn’t matter what the stock market does between now and then; that’s the amount the insurance company will be contractually obligated to pay you. With other annuities, the illustration can’t tell you with certainty what you’ll get because it depends on your account balance at the time you start the monthly checks. But if the annuity contract guarantees that by the time you start collecting your monthly checks, they'll be bigger than they would've been had you started collecting them right away, then the illustration will show you the minimum size you can expect your monthly checks to be (again, depending on the amount you put in and the age at which you start collecting the checks). It’s important to see an illustration so that you can decide if the amount you’re going to get (or the minimum amount you’re going to get) gives you enough bang your for your buck. Ultimately, this is what the expenses of the annuity should be judged against.

(4) “Can the company be trusted to endure and keep its promise of guaranteed income for as long as I live, however long that might be?” The marketing literature for the annuity should include credit ratings for the company from the three major rating agencies: A.M. Best, Moody’s, and Standard & Poor’s. I’d rather get a contract from a financially healthy and stable company that will send me smaller monthly checks than a contract from an iffy company that promises the moon.

(5) “Do I want to make further contributions to the annuity down the road?” Some annuities don’t accept additional payments after the first year; some don’t accept any payments after the initial one. So, if your plan is to open the annuity with a relatively small sum and then make subsequent payments to boost your eventual income stream, you don’t want to get an annuity that won’t accept those subsequent payments.

(6) “How do I want to implement the stream of monthly checks?” Broadly speaking, there are two ways to turn on the faucet of lifetime income, and the distinction between them is far from trivial. One way (the more traditional way) is to annuitize the contract. Once you annuitize a contract, there’s no going back; the faucet can’t be turned off again, and you can’t get out of the contract. This is because, legally speaking, annuitization means that the money you put into the contract no longer belongs to you; it belongs to the insurance company. But in return, the insurance company is contractually obligated to send you monthly income checks for as long as you live, even if it means they end up paying you more than what you put in. If the annuity is held in a pretax account, then annuitizing it will exempt it from RMDs; the IRS will still collect taxes on your income from the annuity, but your monthly checks can stay at the same level year after year. However, there’s a serious drawback to annuitizing: because the money you put in is no longer yours, the insurance company gets to keep any portion of it that hasn’t made its way back to you before you die. Which means you could end up forfeiting the bulk of all the hard-earned money you put in! If you want to ensure that that won't happen and the remainder of the money you paid in will go to a recipient of your choosing, make sure the contract allows you to select such an annuitization option, which typically goes by the name “Life with Refund”. Or get a contract that includes a feature called a living benefit. This is the other way to turn on the lifetime income faucet. It’s typically a rider (an add-on feature that costs extra), but it offers a number of advantages over annuitizing. For one, it allows you to collect monthly income checks for life without sacrificing ownership of the money in the contract. Since the money is yours, any amount of it left over when you die automatically goes to a beneficiary of your choosing. (The size of your monthly checks might not be as large as if you annuitized, but there’s no risk of the insurance company getting to keep any of your money.) And even after you’ve turned on the lifetime income faucet, you retain the ability to cancel the contract and get the balance of your account refunded to you, if you so choose. (Of course, the point of getting an annuity is to not give it up…) Now, because you still retain ownership of the money, if the annuity is in a pretax account, you’ll still have to withdraw RMDs. But every living benefit I’ve ever seen will enlarge the size of your monthly checks as needed each year to satisfy your RMDs for that account. Another advantage of a living benefit is that it guarantees that, by the time you turn on the income faucet, the size of your monthly checks will have grown by no less than a certain amount. For example, say that your initial payment into the annuity is $100,000. The living benefit might guarantee that if you started the income stream the very next year, your monthly checks would be at least $500, but if you waited a full 12 years before starting the income stream, your monthly checks would be at least $1000 - even if your account balance at that time is less than your initial $100,000 due to poor investment performance! When considering an annuity with a living benefit, make sure you get to see an illustration that shows the minimum amount your monthly checks would be under the terms of the living benefit. (Be aware that, as a rule, an annuitization option doesn’t have to be selected until you’re ready to annuitize, but a living benefit has to be selected at the time you purchase the annuity.)

Knowing these questions, and why they need to be asked, will drastically increase your odds of ending up with a product that you can — and do — feel good about.

The discussion above should make it clear that there’s no “one-size-fits-all” annuity. That being said, if you or someone you know is in the market for an annuity, it’s worth taking a look at Jackson National Life Insurance. DISCLAIMER: I am not affiliated with Jackson National Life Insurance and will receive no compensation for endorsing them or referring anyone to them. Jackson is a large, highly-rated annuity provider, and one of only two life insurance companies in the U.S. whose credit rating wasn’t downgraded in the financial crisis of 2008-09. And if you’re interested in a variable annuity, then you should explore Jackson’s “Perspective” series of variable annuities.

Before I explain why I like the Perspective annuities, let me first explain that a variable annuity is one in which you direct your money into funds that are invested in assets like stocks and bonds. This means your account value can go up and down, depending on the performance of the funds you’re in. (Although most variable annuities these days offer a living benefit, which will increase the size of your monthly checks up to a certain point even if your investments go down in value.) Whereas in a fixed annuity, either the insurance company deposits interest in your account periodically, or you don’t have an “account” — just a contract that specifies up front how big your monthly checks will be depending on the age at which you start collecting them. Either way, a fixed annuity doesn’t put your money into investments that could cause your account balance to go down in value. In addition, fixed annuities are lower-cost than the variable kind; some don’t charge you anything! But the tradeoff for that low cost and lack of exposure to stocks is that you might end up with smaller monthly checks than if you’d gotten a variable annuity with a living benefit (and used a good system to manage your money in the investment funds — more on that below). Also, in a fixed annuity, your money is placed in the insurance company’s general account, which means that if the company fails, you have to rely on the intervention of the state guaranty association (of the state in which the annuity was issued) to recover any of your money. And like the FDIC for banks, there’s only so much coverage you can get from these guaranty associations. (Moreover, while FDIC coverage is the same anywhere in the U.S., guaranty association coverage varies by state.) Whereas in a variable annuity, your money is placed in a separate account that’s legally insulated from any financial woes that might befall the insurance company.

Now, getting back to Jackson’s Perspective series of variable annuities, what I like about them is the great living benefit they offer. This living benefit not only ensures that the size of your monthly checks won’t decrease due to poor investment performance, but also gives you the chance to permanently increase the size of those checks through good investment performance. The same can be said of other companies’ living benefits as well, but what makes Jackson’s unique is that it gives you the freedom to choose from a wide range of funds, including several that invest entirely in stocks. Other companies’ living benefits don’t grant you the freedom to invest in stock-only funds. In other words, Jackson’s living benefit grants you a greater opportunity than any other to take advantage of the stock market’s upside. And if you don’t have a dependable system for selecting and managing your investments in the account, the 401k Optimizer from Howard Capital Management can fill that gap. DISCLAIMER: I am not affiliated with Howard Capital Management and will receive no compensation for endorsing them or referring anyone to them. Jackson’s living benefit will insure the size of your monthly checks, but it won’t help you maximize your upside on your investments inside the annuity (which is how you grow the size of those checks beyond what the living benefit guarantees you). For that, you need a system for managing your fund selections inside the annuity. Of course, a variable annuity isn’t the same as a 401(k), but they’re similar enough that Howard can (and will) apply its 401(k) risk-management system to variable annuities as well. (Click here for a description of how the 401k Optimizer works.) And Howard’s recommendations are easy even for an investing novice to implement. Which means that even if you cease to be able to manage your own affairs, your power-of-attorney can implement Howard’s recommendations for you.