Dr. Paul Price argues convincingly against annuities, explaining why they are not the best investment choices. ~ Ilene
Courtesy of Dr. Paul Price
Barron’s May 28, 2012 issue ran this as their front page over the holiday weekend…
Annuities are popular right now due to near-zero fixed interest rates accompanied by stock market action that has scared away many investors that typically would have preferred equity or balanced portfolios. If you read and understand the story’s details you’d likely be much less enthusiastic about buying any of the featured annuities.
Why are annuities in style? They offer income for either a specified minimum number of years or for ‘the rest of your life’ depending on the plan you select. They can start paying monthly income immediately or at a preplanned age in the future. On the surface they appear to offer superior income to currently available fixed-income rates.
So where’s the catch? Unlike bonds, T-bills or CDs, annuities generally provide nothing to your heirs upon your demise. They never mature and return your principal. You are typically buying an income stream with no residual value.
Annuity sales professionals like to tout the high percentage of the monthly distributions which are considered ‘tax free’ to the recipients. One seminar I attended correctly claimed 82% would not be subject to federal income tax. How can that be? Simply put…. that percentage is the part of the payment which is considered a return of your own money. It’s equivalent to simply withdrawing money from your own bank account. You don’t owe taxes when you do that either.
A key number to keep in mind is the projected life expectancy for an American male. For men 55 or 60 presently it is 83.27. A 65 year old male is projected to live until 84.89 – slightly higher due to already having made it that far. [Data source: SSA.gov actuarial life tables] http://www.ssa.gov/oact/STATS/table4c6.html
Here are the top-rated examples (issuers rated A+ or higher) listed in the Barron’s article for the most common types of immediate annuities. The second example includes payments with 3% annual inflation adjustments at each year’s conclusion.
Immediate Lifetime Annuities: Turn a lump sum into guaranteed payments for life.
A) $200,000 initial purchase for a 60 year old male; payments to begin immediately
Pacific Life Yearly Income: $12,445.32 No COLA [cost of living adjustments]
Years/Age until initial deposit is fully returned: 16.1 yr. / 76.1 years old
B) $200,000 initial purchase for a 60 year old male; payout begins immediately. 3% annual inflation adjustment
Nationwide Financial 1st yr. Income: $8,622.72 25th yr. income: $18,612
Years/Age until initial deposit is fully returned: 16.8 yr. / 76.8 years old
In either case buyers of these annuity products would not see anything more than the return of their original principal for longer than the first 16 years. Assuming anything more than a 2% annualized investment result on the $200,000 lump sum deposit (if invested in a non-annuity) could easily make the ‘break-even’ period well above the buyer’s actual life expectancy. Ironically, choosing the inflation adjusted product produced a slightly longer time to get to break-even due to the lower annual income in its early years.
Distinct risks of owning annuities include:
Solvency of the issuer. The promise to pay is backed solely by the issuer’s ability to pay. Today’s AAA ratings cannot ensure future fiscal health.
Annuity distributions are taxed as ordinary tax rates (as opposed to more favorable capital gains rates) to the extent the IRS considers them ‘income’.
Unless you buy a minimum payout period, or a return of principal annuity there will be no residual asset to leave for your heirs.
Inflation risk. The first example provides no increases in monthly income over your entire lifetime. The second policy offers just a 3% annual adjustment along with significantly less current income than non-adjusted annuities for some years to come. In a world with QE programs maximum 3% inflation protection may end up seeming like a cruel joke.
Unless you feel both extremely pessimistic about all investments and you have the genes to expect to live a very, very long life immediate annuities look like a poor choice. Simply putting the same money into insured deposits or a diversified portfolio while gradually withdrawing money to live on is likely to outperform most annuity products with less risk, greater inflation protection and more flexibility.
Dr. Paul Price
Disclosure: The author was previously licensed to sell life and health insurance products