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Q&A with Kerry Pechter, Author of Annuities for Dummies

Q. Why did you write Annuities for Dummies?

Annuities for Dummies No Baby Boomer, other than the very wealthy or those with generous defined benefit pensions, can afford to approach retirement without understanding the pros and cons of annuities, particularly income annuities.

No other financial tool lets people convert their lifelong savings into lifelong income as efficiently or as safely. But, ironically, the public’s knowledge of income annuities was virtually zero. Hence the need for a book that would make the complexities of annuities simple for the average person.

That need is an urgent one. Baby Boomers are just beginning to retire in significant numbers. Second, the annuity industry itself is undergoing dramatic change. Until recently, annuities were sold as a tool for postponing the taxes due on investment earnings. Today, they’re marketed as tools for creating personal pensions. I saw that this message wasn’t getting out to people. It was as if automakers were quietly switching from gas-powered to electric cars but no one was writing about it.

Q. Given the recent financial market turmoil what should one look for in an insurance company before buying an annuity?

Financial strength, primarily. An annuity contract can last for decades, and you need a financial partner who’ll be around for the next 30 or 40 years. In the past, you could take it for granted that most big carriers have the necessary staying power.

But now, you can’t take anything for granted. Fortunately, there are legal firewalls and state guaranty funds that protect annuity owners from insurance company failures.

There are other considerations, depending on what kind of annuity you buy and whom you buy it from. If you’re buying a deferred variable annuity, you should consider the number and the quality of the underlying funds that the contract offers, as well as the costs. If you’re buying a fixed income annuity, it’s a good idea to compare bids from several different carriers. Certain companies, at certain times, will offer higher monthly payouts than others.

If you buy an annuity direct from an insurance carrier, you’ll want a company that has a helpful consumer website and knowledgeable phone representatives. If you’re buying through a financial advisor, you need an advisor who understands annuities and knows the reputations and capabilities and strengths of the carriers. You might also consider whether the carrier is publicly held or mutually owned by its policyholders. The two business models often have different cultures, different products, and different sorts of relationships with their clients.

Q. In your opinion, why don’t more people buy annuities when they retire?

When people win a $1 million dollar lottery jackpot, they’re usually given a choice between an annuity of $50,000 a year for 20 years or a check for the “present value” of a $1 million annuity, which is roughly $500,000. Most people choose the check, because $500,000 today looks ten times more attractive than $50,000 once a year.

For the same reason, most people are reluctant to take a big chunk of their savings — say $250,000 to $500,000 — and exchange it for the $20,000 to $40,000 per year that a fixed income annuity will pay them for the rest of their life. They’d feel like Jack after he traded the family milk cow for four magic beans. But that’s an outmoded view of what annuities offer. Today’s annuities have options that that let people keep two magic beans and part-time use of the cow, so to speak. As more people learn about these options, I think more people will consider buying annuities.

A number of other factors have made annuities unpopular. First, every one of us already owns an annuity. It’s called Social Security. So why buy another one? Second, millions of people, particularly public sector employees, still have traditional pensions. Pensions are annuities. Why should they buy a third one? But millions of Baby Boomers don’t have pensions and won’t receive enough from Social Security to cover their monthly expenses in retirement. Those millions are my book’s target audience.

It’s important to point out that fixed-income annuities tend to be more attractive when interest rates are high.

Q. How can annuities be used as a part of a retirement plan?

I’m not sure if you’re referring to a retirement savings plan or a retirement income plan, or both. Let me assume that we’re talking about a retirement income plan. There are innumerable ways you can use annuities in a retirement income plan.

In fact, that’s part of the problem. The good news is that there’s virtually no limit to the potential creativity that annuities can bring a retirement income plan.

Here’s one example. Consider a 65-year-old retired couple with $5,000 in fixed monthly expenses. We’ll ignore taxes and use rough estimates to make things simpler. If the couple has $2,800 in Social Security income, they’ll need at least $2,200 a month in guaranteed income in order to sleep easily at night.

They can obtain that $2,200 a month by investing about $528,000 into a variable annuity with a guaranteed lifetime withdrawal benefit (GLWB) of 5% a year, or by paying about $330,000 for a single-premium immediate annuity (SPIA) with an income stream that lasts as long as either spouse is living but not for less than a guaranteed “period certain” of 10 years.

Why is the immediate or income annuity cheaper? Two reasons. First, immediate annuities give you something called a “mortality credit” — or “survivorship credit,” as some prefer. The mortality credit is the dividend you earn by pooling your mortality risk with others. Over time, as owners of income annuities die and the contracts’ guaranteed periods expire, their assets pass to the remaining annuity owners, supplementing their income. That’s the mortality credit. Second, the income annuity pays out principal as well as interest.

When the owner of a deferred variable annuity with a GLWB dies, the remainder of the account, if anything is left, goes to his or her beneficiaries instead of to their fellow annuity owners. There’s no risk pooling, and no mortality credit.

If enhancing current income in retirement is your top priority, the mortality credit can be extremely valuable. Here’s an illustration. If, at age 65, you put $100,000 into a variable annuity with a GLWB today and immediately began taking income, you’d be entitled to at least $5,000 a year for life. If you put $100,000 into a fixed, single-life immediate annuity at today’s interest rates, you’d receive about $8,400 a year for life. The difference reflects the presence of the mortality credit and the fact that each annuity payment includes a portion of the original principal.

Risk pooling appeals to many people, because it increases the effective yield of their investment while they are living. Others find the idea of risk pooling — and the possibility that strangers might share their leftover savings — somewhat repugnant. Keep in mind that the longer you expect to live, the more likely you are to be a winner in the risk pooling game. If you don’t smoke, aren’t overweight, and your parents lived to age 90, you’re a good candidate for an income annuity.

Q. What are the major retirement risks?

Health care risk is the retirement risk that Americans worry about the most. It’s estimated that the average American couple will incur more than $200,000 in medical costs during retirement, over and above what Medicare will cover. A close friend of mine has two elderly parents, both with Alzheimer’s disease, and both living in long-term care facilities. Her entire extended family has felt immense financial, legal and emotional pressures.

In our gut, all of us fear illness, and the potential costs of illness, much more than we fear longevity risk. That’s the risk of living long enough to run entirely out of money. Generally, we underestimate longevity risk, in part because we regard a long life as a blessing rather than a danger. But longevity risk is a real threat, especially for those who don’t have children to support them in old age.

Inflation risk is also widely unappreciated. Inflation can halve the buying power of a fixed income over the course of a two-decade retirement. And two-decade retirements are not unusual. Then there’s sequence-of-returns risk. That’s the chance that a bear market, like the one we’re experiencing now, will occur close to your retirement date and force you to liquidate depreciated investments.

Annuity contracts and riders can help you deal with these risks. The guaranteed accumulation features of certain variable annuities can help insure you against sequence-of-returns risk. Both SPIAs and GLWBs are designed to protect against longevity risk. Many of the latest versions of income annuities offer options that offset the impact of inflation.

Q. Annuities come in many different flavors — can you briefly explain the difference between deferred and immediate and fixed vs. variable?

When you say that annuities come in “different flavors,” you’re underestimating the differences between the various types of annuities. Different types of annuities are so unlike that they should be considered entirely different products. A lot of annuity marketers wish they could get rid of the word “annuity” entirely because it only adds to the confusion about these unusual products, which I think of as the duck-billed platypuses of the financial world.

To tackle your question: A deferred annuity is, effectively, a tax-deferred investment. There are fixed deferred annuities, which invest mainly in bonds, and variable deferred annuities, where the assets are invested in mutual funds. In the case of a deferred fixed equity-indexed annuity, most of the assets are invested in bonds, but a small percentage goes into options that are linked to a stock market barometer like the S&P 500 Index.

For some people, especially those in the highest tax brackets, tax deferral can enhance long-term returns. But the term “deferred” in deferred annuities doesn’t refer to tax deferral. It refers to the deferral of the decision to convert the contract into an income stream. Owners of deferred annuities rarely convert their contracts to annuities — that is, to an income stream. That’s why

I think of deferred annuities as “annuities in name only.”

An immediate annuity or SPIA is an annuity in the traditional or literal sense of the word. It’s a more or less on-the-spot conversion of a lump sum of money into a monthly or quarterly or annual income that’s guaranteed to last for a certain number of years, and for the lifetime of an individual or a couple. You can buy a fixed SPIA, which pays a fixed monthly income, or a variable SPIA, where your monthly payments fluctuate with the equity markets.

Q. What are the major pros and cons of annuities?

Annuities have two primary selling points. First, they provide guarantees — guaranteed rates of returns, guaranteed lifetime income, or guaranteed death benefits — that other types of financial products don’t. That’s why only insurance companies can “issue” annuities. Second, annuities offer certain tax advantages. They can offer the same or similar tax advantages as employer-sponsored retirement plans or IRAs.

But, as is true of many things, the virtues of annuities are also their drawbacks. Annuities cost more than other types of investments. Guarantees are never free, and any contract that offers guaranteed income or accumulation or principal will always carry heftier fees than an investment that requires you to bear all of the risks. Second, tax advantages tend to come with strings attached. You can’t always access your money as easily from an annuity contract. And when you withdraw annuity assets, you pay taxes on your gains at ordinary income tax rates, which tend to be higher than capital gains tax rates, which apply to the growth of assets in taxable accounts.

Financial advisors tend to criticize variable annuities for high costs and fixed annuities for low returns or yields. But there’s a reason for those high costs and low yields. You’re paying for safety and for guarantees. Annuities are insured investments. You’d expect to pay more for a plasma TV with a three-year warranty than you would for one without a warranty. In addition, variable

annuities tend to be more expensive than mutual funds because annuity manufacturers pay generous commissions to brokers and agents. Insurance is a tough sell — we have to be persuaded to buy umbrellas on sunny days — so carriers offer higher incentives to those who sell it.

In defending their expenses, insurance carriers usually note that broker-sold annuities aren’t much more expensive than broker-sold, load-bearing mutual funds, especially when you adjust for the cost of the guarantee. And, just as you can buy no-load mutual funds direct from a Fidelity

Investments or Vanguard, you can also buy no-load annuities from those companies.

So-called “surrender fees” are the most controversial of all deferred annuity costs. A surrender fee is a penalty for early cancellation or excess withdrawals from an annuity. It reimburses the insurance carrier for the part of the commission that it paid your agent or broker on the sale of the contract but wasn’t able to earn back from you, via fees, before you canceled your contract.

If surrender fees bother you, you have a couple of options. You can buy a no-load variable annuity. You can also pay the broker’s commission yourself. In any case, the surrender fee steps down over time, so that by the seventh year, typically, there’s no penalty (though there will be tax consequences) on withdrawals. Most people don’t realize, and the press rarely if ever mentions, that all annuity contracts allow you to withdraw up to 10 percent of your assets per year penalty-free during the surrender period.

Q. Annuity products have made some dramatic improvements over the last several years. Can you provide examples of some of the key changes that have occurred?

The development of variable annuity “living benefits” has been the most striking innovation. Annuity manufacturers had been searching for a product that would provide guaranteed income, like a SPIA, while still allowing the annuity owner to withdraw part or all of his money in a personal financial crisis. The result is a hybrid product called a variable annuity with a guaranteed lifetime withdrawal benefit (GLWB).

GLWBs offer an attractive proposition. Typically, if you agree to withdraw only five percent (more or less, depending on your age when you start taking withdrawals) of your contract value (a specific guaranteed minimum balance or your actual account balance, if higher) every year, you will continue to receive that five percent every year until you die, even if an extended bear market wipes out your account before then. This concept has been enhanced by countless bells and whistles, as each product tries to out-promise the other, but the basic five percent annual payout is typical of most contracts.

My favorite bell or whistle is the guaranteed 200 percent roll-up. If you put $100,000 into a variable annuity contract at age 55, many different carriers will now guarantee that, when you reach age 65, you and your spouse can start receiving no less than five percent of $200,000, or $10,000, every year for as long as either of you is living. Although significant fees are involved, and any unscheduled withdrawals you make will reduce your future annual payouts, these options have proven fairly popular.

Less widely known are the recent enhancements to SPIAs, or income annuities. SPIAs are much more flexible than they used to be. You can index SPIA income to inflation, so that your monthly check grows with the Consumer Price Index. You can guarantee that your children or a charity will receive payments for a guaranteed number of years, even if you and your spouse die shortly after buying your annuity.

If you’re not in good health, you can buy your SPIA at a steep discount. If you enter a nursing home or can’t perform at least two essential tasks of daily living, you can arrange for your monthly payments to increase. You can even arrange to receive a refund of your original investment at a discounted rate. Each type of flexibility comes at a cost — in the form of a higher initial cost or lower monthly payments — but an income annuity purchase today is much less stark and scary than it used to be.

As I mentioned earlier, middle-class Baby Boomers need to understand how annuities work and what they can offer. If we could count on bull markets from now to eternity, then we could all live confidently on our investment earnings. But, with lean years looming, most of us would be smart to convert part of our savings into guaranteed income by buying some form of annuity.

Kerry Pechter is editor of Retirement Income Reporter (formerly titled Annuity Market News), a monthly SourceMedia publication. He worked for nine years as a writer at The Vanguard Group, specializing in annuities and retirement accounts. An independent journalist for many years, he has published feature articles in the New York Times, Wall Street Journal, Los Angeles Times, Men’s Health, and many other national and regional publications.

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