Dear Liz: I think you missed one of the possibilities when a reader wrote to you about a pitch he received from an insurance salesman. The salesman wanted the reader to stop funding his 401(k) and instead invest in a contract that would guarantee his principal but cap his returns in any given year. You thought the salesman was pitching an equity indexed annuity, but it’s possible he was promoting an indexed universal life policy, which would offer the same guarantees of principal and offer tax-free loans.
Answer: You may be correct — in which case the product being pitched is just as unlikely to be a good fit for the 61-year-old reader as an equity indexed annuity.
Cash-value life insurance policies typically have high expenses and make sense only when there’s a permanent need for life insurance. If the reader doesn’t have people who are financially dependent on him, he may not need life insurance at all.
Furthermore, the “lapse rate” for cash-value life insurance policies tends to be high, which means many people stop paying the costly premiums long before they accumulate any cash value that can be tapped.
Before you invest in any annuity or life insurance product, get an independent second opinion. One way is to run the product past a fee-only financial planner, who should be able to analyze the product and advise you of options that may be a better fit for your situation. If you just want a detailed analysis of the policy itself, you can pay $100 to EvaluateLifeInsurance.org, which is run by former state insurance commissioner James Hunt.
Dear Liz: My former employer is offering the one-time opportunity to receive the value of my pension benefit as a lump-sum payment. The other option is to leave the money where it is and get a guaranteed monthly check from a single life annuity when I reach retirement age. I am 40 and single, and I have been investing regularly in a 401(k) since graduating from college. I have minimal debt aside from a car payment. When does it make financial sense to take a lump sum now instead of an annuity check later?
Answer: Theoretically, you often could do better taking a lump sum and investing it rather than waiting for a payoff in retirement. That assumes that you invest wisely, that the markets cooperate, that you don’t pay too much in investing expenses and that you don’t do anything foolish, like raid the funds early.
That’s assuming a lot. Another factor to consider is that the annuity is designed to continue until you die. It’s a kind of “longevity insurance” that can help you pay your bills if you live a long life.
Some financial advisors will encourage you to take the lump sum, since they may be paid more if you invest it with them. Consider consulting instead a fee-only financial planner who charges by the hour — in other words, someone who doesn’t have a dog in this particular fight. The planner can walk you through the math of comparing a lump sum to a later annuity and help you understand the consequences of both paths. This is a big enough decision that it’s worth paying a few hundred bucks to get some expert advice.
Dear Liz: I invested in an annuity, and now I’m sorry. How do I cancel an annuity? And what are the ramifications of doing so?
Answer: Annuities are a lot easier to enter than they are to exit. Many annuities have substantial surrender charges if you try to cash out in the first few years. You also may owe taxes and penalties on any earnings.
You may be able to get the insurer to “unwind” the annuity (essentially, refund your money without surrender charges) if the salesperson used deceptive tactics. If that’s the case, consider enlisting the aid of your state insurance commissioner.
Otherwise, you may want to consider waiting until the surrender charges no longer apply, and then cashing out or exchanging it for a lower-cost annuity. A visit with a fee-only financial planner could help you decide on the right move.
Dear Liz: My husband and I are 62 and 58. We both are still working and have IRAs. Our financial advisor of 20 years is encouraging us to use some of our IRA money to buy a variable annuity. We lost quite a bit in the recession and have not recovered it all yet. I have read nothing really good about variable annuities and keep telling our advisor that, but she insists we really need one. We cannot afford to have another big loss either, so we do not know what to do. All our IRA money is in mutual funds. Can you give us any guidance?
Answer: If your advisor gets paid a commission for selling annuities, as she probably does, she’s not an objective source for you on this topic. Consider investing a few hundred dollars to consult a fee-only financial planner, who can review your financial situation and your investments and offer advice.
Variable annuities aren’t always a terrible option, but they’re a poor fit for IRAs, which already offer the tax deferral that’s a big part of an annuity’s appeal. The so-called living benefits that guarantee a certain payoff typically come at a high price, which is why you should always run these investments past an objective source before you buy.
Dear Liz: We were recently advised by a financial advisor to put $500,000 into a variable annuity. It is for my mother’s trust, and frankly, my mother is not expected to live past another year. The cost of the annuity is supposed to be 1% above our current fees, and there is a floor on our investment so that no matter what happens in the market, if my mother dies we would still get the $500,000 back. If the market rises, we get the higher fund balance upon her death. Articles that I read online say that variable annuities cost more, generate large fees for the seller and the survivor has to pay taxes on the distribution as ordinary income, not as capital gains. They say variable annuities are not really good, and brokers can get $30,000 to $50,000 in fees on a $500,000 annuity. What is your opinion of a variable annuity?
Answer: Run this investment past a fee-only financial planner — one who is paid only by fees from you, not commissions on insurance products. You’ll get an earful about why this investment is probably a bad idea.
Your research has turned up most of the disadvantages. One you didn’t mention was surrender charges. If the money needs to be accessed in a hurry, you are likely to pay stiff fees for doing so.
Variable annuities are designed to be long-term retirement savings vehicles, not short-term repositories for cash. If you’re concerned about the safety of your mother’s investments, talk to the fee-only planner about your options, such as moving some or all of the money to an FDIC-insured bank account.
“I know it’s boring, but the money will be there in case they need it for Mom,” said financial planner Delia Fernandez of Los Alamitos. “And it will be liquid and available at her death to help settle final costs.”
Dear Liz: I’m a financial planner who liked your answer to the dad who wanted to fund his children’s IRAs but was shocked to see your recommendation (though with caveats) to purchase annuities.
I can’t imagine annuities would be suitable for children under any circumstances. Only under the best possible scenario of assumptions would an investment in an annuity (even a low-cost annuity) beat a reasonably tax-efficient mutual fund over any time period.
As long as money withdrawn from an annuity remains taxable as ordinary income, and as long as ordinary income tax rates are measurably higher than capital gains rates, this will be the case. I fear that brokers will be handing out your article as a tool to sell annuities for kids. To get an endorsement from someone of your reputation has probably helped some of them make this week’s sales goals. Let’s hope not!
Answer: Let’s hope not, indeed. Annuities tend to have high costs and do just one thing efficiently: turn capital gains that would otherwise qualify for low tax rates into ordinary income, which is taxed at a much higher rate.
Most investors would, as you point out, be much better off investing in index funds or other tax-efficient mutual funds.
However, annuities have one advantage that might appeal to this dad: They’re typically not counted in financial aid formulas, according to FinAid.org founder Mark Kantrowitz, because they’re considered retirement accounts. If the children don’t have enough earned income to fund IRAs, annuities would allow him to start saving for their retirements without having to worry about reducing their future aid packages.
This advantage may not outweigh all the disadvantages of annuities. But it’s something the dad should know about as he’s mulling over his options.
Q: I recently attended an “elder planning” workshop. The presenter said my husband and I should sell our bank stock (worth $95,000) and buy an annuity that’s invested in the Standard & Poor 500 index. Does this sound like a good idea, or is it something to leave alone? We are in our 80s. The presenter is getting antsy and wants us to meet with him to take the annuity.
A: Of course he’s getting antsy. He’s imagining the fat commission he’ll be paid for talking you into what may well be an unsuitable investment.
Variable annuities, which combine mutual-fund-type investments with an insurance wrapper, often aren’t a good fit for elderly investors. You may be in too low a tax bracket to benefit much from the investment’s tax-deferral feature, and heavy surrender charges could take a big bite out of your savings if you needed to access your money in the next several years.
What’s more, selling your stock could set you up for a big fat tax bill, particularly if your shares have grown substantially in value over time.
A final problem with variable annuities: They aren’t given what’s known in tax circles as a “step up in basis.” Your stock would be revalued on your death so that your heirs wouldn’t owe any income or capital gains taxes if they sold the shares immediately. Withdrawals from variable annuities, by contrast, incur income tax.
Unfortunately, these downsides may not have been explained to you. The salespeople who promote variable annuities sometimes neglect to adequately illustrate their disadvantages, which is one of the reasons regulators have gone after insurance companies and agents in recent years for selling unsuitable variable annuities to elderly investors.
Bank of America, for example, just announced a settlement with Massachusetts state regulators that would allow customers who were at least 78 when they bought their annuities in 2003 and 2004 to liquidate them without having to pay surrender charges.
Now, it’s entirely possible that you might be better off in an index fund or even a certificate of deposit than having so much money wrapped up in a single stock. But you’ll want to discuss that issue with someone more objective than an annuity salesperson, such as a fee-only financial planner.
Q: In the past, you’ve mentioned that variable annuities aren’t a good investment for seniors. Why, then, does an official at our bank try to convince us to put our savings into one? We are in our early 80s and have always had certificates of deposit at this bank.
A: The answer is pretty simple: profits. The bank can make a lot more money from you if it can sell you a variable annuity, compared to what it can make selling you a CD.
At your time of life, though, variable annuities don’t make much sense. It typically takes 15 to 20 years for the tax advantages of a variable annuity to offset the increased costs, and chances are pretty good you won’t live long enough to see that day. Annuities also come with surrender charges that can cause you to lose 10% or more of your cash if you need to tap your savings in the first few years; with a CD, you’ll typically lose only a few months’ interest if you need to make an emergency withdrawal.
Regulators have repeatedly warned banks and brokerages about pushing annuities on seniors. If this official persists in hounding you, you might mention that fact and suggest he call the Securities and Exchange Commission or the National Association of Securities Dealers if he needs more details about why these investments are often inappropriate for seniors.