By Rosilyn H. Overton, CFP, CRPS
Many people, especially retirees, are strapped for cash. Interest rates on CDs, money market funds and Treasuries are the lowest they have been in years, and while inflation is low, it hasn’t stopped. The stock market has been in free fall for more than two years, and it seems there is nowhere to turn to make a decent income without undue risk. Bonds are unpredictable, since their values will go down if interest rates go up.
Enter the fixed annuity. Especially for those 59 and older, a fixed annuity can provide stable principal and a guaranteed income. Guarantees of 5 percent or more for four to six years are available from New York domiciled insurance companies. The annuities even offer some liquidity. Most modern deferred annuities allow withdrawals up to 10 percent per year without any surrender penalty from the insurance company.
So, what’s the catch? First, if you take money out of an annuity before age 59, the government is going to tax you an additional 10 percent on the earnings, and your income is deemed to have been withdrawn first, not your principal.
Second, if you take out more than your allowed 10 percent in a given year, the insurance company, just like the banks with early withdrawals from CDs, will charge you a penalty on the earnings. In the first few years, the penalty can equal an entire year’s earnings.
Third, if interest rates rise, the surrender charge will trap you in your investment until maturity.
The description so far has been on what professionals call “plain vanilla” annuities. In my book, vanilla is just fine. Let’s examine some of the bells and whistles that have been added to some annuities, and why they don’t always pan out.
One provision that you want to look out for in a fixed annuity is the so-called “market value adjustment” or MVA. Various companies have different names for it, but it always comes out to the same thing: If interest rates have risen since you first invested your money, and you take out money before the allowed date, the company will adjust your payout for the effects that the changes in the market would have on your principal.
This means you can lose money if you are forced to withdraw your money prematurely. The plain vanilla annuity guarantees that you cannot get back less than you invested (minus any prior withdrawals, of course) even if you withdraw the next day. To me, the MVA defeats the purpose of investing in a fixed annuity, which is to keep your principal safe while giving you good income, so look for an annuity without a market value adjustment.
You also have to look out for a guarantee period that is shorter than the surrender charge period. Although all annuity policies have a base rate that is the minimum that they will pay, you should look for a fixed annuity whose guaranteed rate and surrender period are the same. That way, everything is known. You know exactly what you will be paid, exactly the consequences of taking money out early and there are no variables.
If the interest rates are the same, the fixed annuity with the principal guarantee is superior to bonds for the fixed income portion of a diversified portfolio. The price for which you can sell a bond goes up and down as interest rates change. When interest rates go down, the market value of your bond rises.
Unfortunately, when interest rates go up, the market value of your bond goes down since there are other alternatives people can invest in that are paying more. The fixed annuity guards against this interest rate risk. I think that this is particularly important to retired clients who need to make sure that they don’t lose money.
Annuities reinvest your earnings at your guaranteed rate. With a bond or Treasury, you must reinvest at whatever the market is paying and you may have small amounts that are difficult to invest. You do not pay any tax on the earnings in the annuity until you withdraw them, so you can manage your withdrawals to be in years when you make less.
Annuities pass to your beneficiary outside of the probate process. Only you and your beneficiary need to know that you have left them that money, since there will be no publicity of the beneficiary provisions. A spouse who is a beneficiary often will get the distribution of the value of the annuity in only a few days after submitting a certified death certificate. This can be a tremendous help to the spouse if the estate process drags. He or she will have ready cash for expenses.
There is one more advantage to a fixed annuity. Many fear they will outlive their funds. If you get to a point where you need to invade principal to live, the fixed annuity offers a settlement option that will guarantee you an income for life.
The cash flow on this income is more than you could achieve with investment, since some of the money coming to you is a return of the money that you invested; however, you do not pay tax on the portion of the monthly payment that represents a refund of your original investment. If you live longer than it takes to use up your principal, the insurance company just keeps on paying. While you probably wouldn’t want to do this with all of your money, it can be a comfort to invest some of it this way.
This feature can be very useful to those whose income is close to the limits for taxability of Social Security benefits. Since they can enjoy a guaranteed income that is partially tax-free, they still can have more spending money while their total taxable income stays below the limit that would cause 50 percent or 85 percent of their Social Security payments to be taxed.
Despite all these advantages, this is not the perfect investment. Equities (stocks) still are the only investment that tends to pay more than inflation over time, but for the portion of your portfolio that you want to keep safe and produce income, you always should consider an annuity.
Rosilyn H. Overton, CFP, CRPS is a Certified Financial Planner whose practice is on Northern Boulevard in Little Neck. She is a principal in Mid-Atlantic Securities, Inc., member NASD & SIPC and a registered investment advisor. She is a past chairman of the Financial Planning Association of New York and past president of the International Association for Financial Planning of New York. She can be reached at 631-4000.
