How Do Annuities Fit In?
By Alfred L. Kahl, Ph.D.,
Independent Financial Consultant
The Problem - Not Enough Savings: Americans are living longer and they also have difficulty saving money. The government helps us save for retirement by requiring everyone who works to contribute to Social Security and also allows tax-deductible contributions to IRAs (subject to limits). According to the Social Security Administration website (www.ssa.gov) the money paid to retired families in 1999 was less than one-third of the average income before retirement. Thus, it appears that many Americans will have a greatly reduced standard of living during their retirement years unless they do something about it right now! The Solution - A Variable Annuity: For most people, because there are eligibility requirements and limits on contributions to alternative investments such as IRAs and pension plans, and mutual fund investments are subject to taxation every year, one of the best solutions to the problem of saving enough money for a comfortable retirement is a variable annuity. Although contributions to annuities are not tax-deductible, the investment earnings accumulate on a tax-deferred basis until funds are withdrawn, at which time the money is taxed at then current ordinary income tax rates. There is no limit on the amounts that can be invested and everyone can participate. Thus, the investment can grow to a very large sum during the accumulation period. So, anyone now aged 40 has 27 years until the normal retirement age and can expect to live for another 23 or more years. Those who are currently only 30 may live to be 100, so their retirement funds need to last for a very long time. Variable Annuities can be started with as little as $250 by anyone who is 18, and regular deposits can and should be made thereafter. Contributions can be invested in a variety of investments, such as domestic or international equities, bonds, or in the money market (T-bills). Over long periods of time, the historical evidence shows that equities provide the highest returns; for example, during the period 1973-97, the average rate of return on equities was 13%, while on bonds it was 10% and only 7% in the money market. Thus, if someone did start investing at age 40 they could easily have a $1,000,000 by the time they reach retirement age. The annuity can then provide regular payments for life, for life with a certain period of years guaranteed, or even for the joint lives of the spouses. Annuities can be very flexible! When the annuitant dies, there is a death benefit, usually the greater of the original investment or the current value of the account. Thus, a Variable Annuity can be considered as equivalent a mutual fund combined with life insurance into one package. The Cost - There is no Free Lunch! The investor has to pay the insurance company for the cost of selling the annuity, setting up the account, collecting and investing the money during the accumulation period, and paying the regular payments during the retirement period. Thus, expenses may seem to be rather high but some or all of these expenses will be required for any kind of portfolio investment (insurance, pension, IRA, annuity, mutual fund, etc.) and in investments that are tax-advantaged they will still be less than the taxes paid on other investments. Portfolio management and administration fees are usually in the range of 2% to 3% of the value of the portfolio and are deducted each year from portfolio income. When transactions are made in the portfolio, brokerage fees are incurred. Depending on the activity in the portfolio, these expenses can sometimes be as high as 8% of the value of the portfolio for actively managed mutual funds; lower for annuities. Some mutual funds can also charge 12(b)-1 fees of up to 1% of portfolio value for advertising and distribution. Thus, for mutual fund investments, the annual expenses can be as high as 10%. Comparable fees for annuities typically are much lower. Sales costs for mutual funds are sometimes as high as 8% or 9% of the amounts invested, but typically less, in the range of 3% to 5%. These costs are called loads and may be front-end (deducted at the start) or back-end (deducted when the investor sells) or both. The investment most nearly comparable to a Variable Annuity is a Roth IRA (the subject of another article). The contract with the insurance company provides the discipline that many people need to actually make the payments to build up the retirement fund. This makes it more advantageous than a Roth IRA for them. When Should Someone Invest? The answer, of course, is right now! Since no one can tell when is the best time to invest, it is whenever you have the money! One should first invest in any plans for which tax-deductible contributions can be made, such as an IRA, 401k, or Keogh, because these types of savings reduce current taxes. Then, any more surplus funds should be invested in a variable annuity, especially in equities so as to get the maximum growth of the capital. IMPORTANT DISCLAIMER: Information herein is necessarily very brief and is believed to be accurate at the time of writing on July 3, 2000, but the financial services field is evolving rapidly, and important changes to relevant laws may have occurred subsequently. Also, since all annuities are state-specific offerings what is available for purchase to a resident of one state may or may not be available to a resident of another state. Additionally, different issuers have different investment choices within their products. Consequently, potential investors should consult with their financial advisors to determine if a particular product exists that will meet their particular needs and desires.
