Who Should Buy an Annuity?

On several occasions, I have gotten into a discussion with someone who is what I would consider a sophisticated investor. After all, someone who knows how to balance their risk, spread it out among a variety of investments, use calls and puts, stop loss and so on knows what they are doing, at least that has been my assumption. A portfolio should include a mix of stocks, bonds and international stocks. A book I am reading has 43 different portfolio mixes that include equities, real estate and good old fashioned cash. The goal is to keep up with the market and take advantage of the gains while avoiding the losses. One of the portfolios has 54% US stocks, 12% international stocks, 22% bonds with the remaining 12% in real estate, natural resources and cash. Of the US stocks, it is suggested you have 27% large-cap value, 12% large-cap growth, and so on. As the market shifts, you will want to rebalance your funds to manage your losses. Rebalancing. That means you have to know which of all that you need to sell, pay someone to sell it, then pay someone to buy something else. Where does the profit come in?

This assumes, in my opinion, that the markets move slowly enough to let me catch my breath, buy low, sell high and move on. That isn't how the market works. It is a very, very fast moving machine that doesn't care who gets in the way.

The big investors with billions and trillions of dollars in the market go a few steps further. Companies use huge banks of computers to constantly buy and sell stocks, owning something for only a fraction of a second. Stocks are sold in lots far larger than any ordinary investor such as myself, would ever be able to manage. Buys and sells are based on complicated algorithms that watch every stock for any sort of movement with no regard to poor management, poor returns or much of anything human-based. The computer just watches when a stock shifts one way or another and makes a move toward it. You may recall a few years ago when there was a very large drop in the market that returned a few minutes later all due to someone making a mistake with a computer.

Large numbers have an advantage over small. If I have $1,000 of stock and it earns 1%, I now have $1,010. If I have a billion dollars of that same stock, I now have $10 million. That is power. My little thousand, or hundred thousand, or even a million dollars has no effect on the market. Thus, as an investor I am completely dependent on the actions of fast moving humming computers which don't care an ounce about me. The days of people yelling and screaming on the stock market floor are gone. The analogy I see is myself standing on the freeway in the center divide with my car, trying to get across to safety. I might do it, but my chances are very small.

What is the purpose of an investment? To make my money grow. Savings protects my money but investing makes it bigger. Why do I want my money to grow? Because the cost of everything around me is constantly growing and I need to keep up. Investments with guaranteed returns such as annuities and life insurance are the foundation of my security. Putting my future entirely in the market is just a gamble and one that I will surely lose. Once I have protected my future than I am ready to buy that high tech stock or start my string of rental homes. Before that is done, take care of business. Get a plan and stick to it.

If I want my money to grow, I also want to have a tax advantage. I showed earlier that if I have $1 and let it double every year for 20 years without taxes, I would have over $1mil. But if I had to pay taxes of, say, 35%, each year as it grew, I would only have around $26,000. I mention this here because when I buy and sell stocks, I have to keep paying taxes on my gains.

Another thing I get tired of hearing is that this fund or that has an "average return" of some X%. The trouble with that is the average is not the actual return. Thus growing one year by 50% and losing 50% the next has an average return of 0. If I have $100 and it grows to $150 the first year, the next year I lose half, $75, leaving me with an actual return of -25%.
The insurance products guarantee that I will never lose money. Guarantees cost money, but never as much as the result of the guarantee.

Thus in my humble opinion, no matter how much money I have, I would not be wise to depend on market fluctuations for my future. I want some guarantees and then I will spin the roulette wheel for luck.

Am I an unsophisticated investor if I want to be sure that my financial foundation is strong? I don't think so.  Who should buy an annuity?  Anyone who is going to depend on their savings for their retirement.  I am one of those people.

Make Your Own Pension with an Annuity

If you have been reading up until now, you know that I started this blog talking about how a friend of mine got me to buy an annuity to protect my retirement savings. I had heard of annuities before, but didn't really understand them. Thus, I have done much reading lately and this is what I learned.

An annuity is a savings fund that you can build just like an IRA or a 401k. You buy them through a life insurance company which gives protection of your investment. Some have fees involved while others do not. The traditional annuity would let you save money, have it grow, and then, when you retire, you can have it pay you money each month for the rest of your life. At least, that is what I thought they were and then I did some more research.

Three things need to be decided before you sign up.

How do you want to put money in it?

How do you want to grow?

How do you want to take money out?

Putting money in can be either one big amount like rolling over an old IRA you have been watching shrink or maybe some CDs you have been praying the Fed will allow growth over 1%. Otherwise, you can set up a payment plan similar to your IRA. If you want it pre-tax, it can be a traditional IRA or if you want after tax money, make it a Roth. Both are subject to limitations, which I won't go into here. And finally you can start with a large sum and then continue to put money into it.

Growth depends on how much risk you want. The choices are fixed, variable and indexed. Fixed has a set rate that it pays and never changes. Variable lets you put your money into mutual funds and other investments. Indexed pays interest based on the return of one or more market funds like the S&P 500. Variable annuities carry the risk of market changes so you could end up with a loss, unless you have a rider that maintains your balance at the highest market level and then pays interest when the market is down. That is what I have. It is a bit expensive, but it is giving me such a good return, the fees are minimal by comparison.

Indexed annuities come in all sorts of variations, but have more flexibility at taking money out without having to annuitize. If you do that, most will stop growing and pay you something every month until you die, if you so choose.

Have I lost you yet? If so, be sure to leave a comment in my blog and I can respond. Basically, there are many variations to an annuity. I prefer to buy the ones that guarantee growth and protect me from market variations.

My annuity is a variable deferred annuity with a minimum return. If I choose to annuitize it some day, I can get a life payment. Should I die before my wife does, she will continue to get payments until she goes. I rolled over my money from an IRA that was previously a rollover from my 401k's I had built over the years in various jobs. Since the money is from a pre-tax savings plan, I will have to pay taxes on the money some day when I take payments from it. With that, I have introduced a number of terms that I will explain.

For receiving payment some day, there are two basic types of annuities; immediate and deferred. Immediate annuities are usually started with a single large payment. Deferred annuities multiple payments over a number of years, similar to a 401k or they can be funded with one single payment. The idea is to build up a fund that will some day pay you money to live on for a certain period of time. Later I will discuss the many ways you can receive payments.

One final benefit to annuities is there is a death benefit. Should I die, the insurance company guarantees my beneficiaries a certain amount.

I wrote earlier about the four cornerstones of a good investment should include Growth, Safety from market changes, Tax Advantages and Protection for my family. For my annuity I get fantastic growth. In just a year and a half I have grown 20% so I am happy. Since I have the rider to pay me interest when the market drops, I have safety. The tax advantage is based on how I saved in the beginning. Since I rolled my IRA money over to it, I have a tax-deferred plan. As such, I will have to pay taxes as I take money out. And then finally I have the protection for my family should I die.

All in all, I think it is much safer to put my money into an annuity. But there is another solution. If I were younger, I could have done something else. I could have funded a permanent life insurance policy and taken all my growth out tax-free. In my next blog I will talk about how to do that.

When the long run becomes the present

I was reading another investment book.  This one is says that you shouldn't panic when the market drops and keep your stocks.  But sooner or later that long term investment comes due and you have to start drawing down.  I compare it to milking a running cow.  Sure it has milk, but you can't get much if it won't sit still.  Depending on the market, whether it is stocks or mutual funds, is going to leave you constantly worrying about your next check.  Pensions were supposed to eliminate that worry until they disappeared. 

The market dropped almost 1,000 points this last week.  If you moved fast enough, you might have moved your money to cash equivalents like CDs, but that means you are paying fees to a broker to sell your stocks adding to your cost.  Cost is not adding to your value.  It takes away.  The market will ultimately return to its original value which means you have a net gain of ZERO.  And when the market returns you can buy stock again. 

Wait a minute!  I thought we were supposed to buy low and sell high?  The trouble is that people panic and get out when things are going bad and get back in when it is too late.  The dream is to beat the market but statistically that just doesn't happen often enough.  You have a better chance of hitting it big in Las Vegas.  The real winners in stock market swings are the stock brokers.  They get commissions when they buy or sell.  A good business for them. 

My annuity lets me invest in the market and I get to take advantage of the growth when it happens.  It also has a rider, an extra benefit, that I paid for.  That guarantees that when the market rises, I win.  When the market drops, they hold my value at the top and start paying interest.  So I win again. 

When the time comes for me to retire, I can do one of two things.  I can either tell the insurance company to annuitize my investment and they will pay me a percentage of it for the rest of my life.  A good deal.  Also, I have it set so if I die before my wife, she also continues to collect this pension until she dies.  I think that is a great deal.  When I do this, my account value will freeze and I will get the same pension amount forever.

Another way to do this, though, is to take out a part of the annuity each year without annuitizing.  When I do this, the fund continues to grow, often right back to the value it was before I made my withdrawal.  There are a number of rules and limits regarding this, but that varies from annuity to annuity. 

Try that with your collection of mutual funds and stocks and see if you can get the same results.  When the market is going up, you can.  When the market goes down, though, you will need to cut back what you withdraw and hope the market recovers by the next year.  If you like gambling with your life savings at the age of 85, go ahead.  I prefer some protection, myself, and I don't want to have to worry about it.

Where is the bottom of the market?

The market fell another 500+ points today and will probably continue to fall for a few more weeks.  No one can predict where it will bottom out but anyone trying to live on their 401k money will be forced to make some tough decisions. 

For instance, imagine you had a fund worth $300,000 before the market started to fall.  You were able to take 5% a year to add to your living expenses, or $15,000.  Then suddenly the value of your account drops to $225,000.  What do you do?  You got used to getting $15,000.  Now, though, if you take that much you will be taking out almost 7% bringing your account value down to $210,000.  From there, you will need to have much faster growth to get back to where you were before.

Why 5%?  Assuming you retire at 65, it is reasonable to assume you will live another 20 years to 85 and 1/20th of the total balance is 5%.  Since we don't know when we will die, we are gambling that we will be gone by then, not to mention the fact that inflation could also eat up the value of your withdrawals.  When you start taking 7% or more you are cutting into your future and could end up broke when you are too old to get another job.

Thus, depending on the stock market for your retirement is a bit like diving into a pool blindfolded and hoping someone put water in it.  My annuity continues to grow. 

I mentioned a few posts ago that the market has become extremely inflated by all the 401k money held by unprofessional investors.  When we see the market take a dive, we panic, we worry and then we take some action that is probably not wise.  Thus, moving your money to something stable with guaranteed growth and cool-headed investment managers looking out for my better interest might help you sleep much better at night. 

I am not endorsing any particular company here.  You need to do your own research.  What I would recommend, though, is that you give annuities some serious thought as a way to protect both your future and your present.  In future writings I will explain how annuities work. 

Now or later - What type of plan do you need?

Here is a primer on the ways you can save for retirement. Each has it advantages and disadvantages. 

• Pay taxes now - These are traditional savings accounts and stock and bond investments. A bank pays me interest each year and I pay taxes on it immediately. If the stock pays a dividend, I am taxed. And when I sell the stock or bond I have to pay taxes on what I earned. I have prepared taxes for folks for several years, and these always cause the most disappointment. They come in with a big smile on their face with their statements from their investment firm, to show me how much they made on the stock market this year. I then have to tell then that they now I taxes as regular income at their normal withholding rate. What this means is that they not only have to pay taxes on the earnings, the income could push them into a higher tax bracket causing them to pay even more tax. The advantage is that the cash is easily available which is where I would want to keep my emergency fund.  
The trouble with this method is that when I pay taxes as I go along, I never get ahead. For instance, consider starting with one dollar and double it every year for 20 years without paying taxes. How much would you have? The answer is over one million dollars! But take that same dollar and double it each year and pay taxes as you earn it. What would I have then? About $27,000 assuming a 30% income tax rate. Enter the pretax savings plans.

• Pay taxes later with tax free growth - 401k, 403b and IRA all let me deduct money from my paycheck before taxes are deducted. The money is placed into a fund managed by someone like Vanguard or Fidelity, who offer a number of mutual funds for growth. Also, when, or if, the money grows, the income isn't taxed until I take it out. Money taken from my pay is usually based on a percentage of my total pay. Also a few of my employers gave me a match up to a certain limit. For instance, if I were to save 5% of my paycheck, the employer will give me another 2 to 5%. It all depends on the employer and how generous they want to be. I like free money.  This method is better because I can take advantage of growth without paying taxes, as I mentioned earlier. There are no free lunches, though, because I will have to pay taxes on the money as I withdraw it. And no matter how you may feel about taxes, one thing is certain. Taxes will increase. Our national debt has to be paid and we have to pay it someday.

For example, if I need to have $50,000 cash to live on each year, and my only source of income is from my pre-tax account, I will have to withdraw at least $70,000 to cover both what you need and what Uncle Sam wants.

• Never pay taxes with after tax money and tax free growth - The Roth IRA lets me take money from my payroll after I have paid taxes on it and invest it. The growth is tax-free while it grows, and, if I keep it the required number of years, I can take out the earnings tax-free as well. Unfortunately, for most of us, we can only put $5,000 per year or $6,000, if I am over 50. Not quite enough money for a big nest egg, but a good start.

What I want, though, is something I can invest it, not pay taxes as it grows, not pay taxes when I spend it and have something left to take care of my family when I die. And maybe, if I am a good planner, I could even use it for part of my retirement money.

Other than the pay now tax now savings accounts, all the other methods are for a long term plan. I should not put my money in with the expectation of taking it out until retirement.

After all, what I want, when I retire, is the ability to continue getting a paycheck. I don't want some huge windfall of cash because I would still need to put it somewhere safe so I can take it out as I need it. Given that, there are two ways I can invest my money into something that will protect my money from the falls in the market, give a death benefit to my wife, grow, and give me a tax advantage with the growth. For me, at my age, I would invest in annuities. For someone younger, say in their 20's, they would want to give serious consideration to a permanent life insurance policy.

Coulda, Shoulda, Woulda

$108,000 from $100k in ten years.  I could have done better keeping it in a savings account.  That would have been a poor choice, as well, though.  What would have happened if I had met my friend ten years earlier?  Would I have more in savings and how much would that be?  Leaving my money in my IRA let me ride the market with all its ups and downs.  The annuity had protection from the market that I couldn't get in my IRA.  First, here is how my money grew in ten years without protection.

Between 2000 and 2003, I lost almost $40,000.  Then the market recovered with that big bubble everyone talked about, but didn't do much to change.  Besides, who knew about credit default swaps and such?  I certainly didn't.  By 2007 I recovered my $40,000 and added another $13,000.  Wow!  Now I am back on track.  Well, almost.  In 2008, I dropped back to $71,000, again losing $40,000.  Finally, after all that pain and excitement, by the end of 2010, I recovered back to $103,000.  In ten years, my money had grown by $3,000. 

What if I had met my friend earlier, perhaps in 2000, before the first drop?  If I had met him, believed him and taken a chance with my money, I would have been ok.  Would I have actually done that?  It is difficult to say.  As a reminder, the annuity I have is called a variable annuity.  It lets me put my money in various types of mutual fund type accounts, including something that would have followed the S&P 500.  These are index funds.  The beauty of the annuity, though, is that when the market falls, the company continues to pay me 6% interest on my balance.  How different would my outcome have been?  Look at the chart below.

If I had put my money into this annuity in 2000, my money would have grown from $100,000 to $340,000!  My money would have more than tripled.  Leaving my money in my IRA I gained $8,000.  Putting it into an annuity would have given me $240,000.  How much would you have been willing to spend to get that return?

A Real World Example

I like to see how the market is doing each week, so I check out a few numbers, one being the Dow Jones Industrial and the other is the S&P 500.  Both are a selection of the largest stocks in the market and the numbers represent how the stocks have grown or shrunk in value.  Each morning when I turn on the news, since I live on the west coast, I get to see the opening of the stock market at 6:30.  After that, I get to see the Dow Jones and S&P numbers as they rise and fall.  The market is up today because of .....  The market is down because....  I am never really sure what to believe other than the numbers. 

For instance, sometimes the market increases because some big companies have laid off workers, with the assumption that less money given to payroll will add to the value of the company.  The next day the market drops because of rising unemployment.  That never makes sense to me, but that is the world in which I live.  As an investor, the best I can do is read, watch the market and pray.  Or I can do what a lot of other people do which is to put my 401k money into some funds that HR suggested, and then ignore them from then on.  Frankly, that is what I did for a long time and now I see the error of my ways. 

When I started this blog, I mentioned that I had spoken to a friend who showed me how I could be safer putting my money in an annuity rather than leaving it in my IRA.  I had complained that my money had not grown at all in the ten years that I had held on to it.  How could I possibly expect to live off money that wasn't even growing? 

What I got was a program that let's me still invest in the market and I can take advantage of the growth.  When the market goes down, the annuity pays me 6% until the market recovers.  The program isn't free, so I decided to do a bit of math to see if I was getting a good deal.

If you go to a web site called http://www.moneychimp.com/ and go find the Advanced CAGR or Compound Annual Growth Rate of the stock market.  There I found the percent change in the S&P 500 over the last 10 years.  Between 2000 and 2010, the S&P 500 rose, on average a little over 2%.  Really?  Here are the numbers.

S&P Annual Percent Change   

2010        14.32 

2009        27.11

2008       -37.22    

2007          5.46

2006        15.74     

2005          4.79

2004        10.82     

2003        28.72     

2002       -22.27    

2001       -11.98    

2000         -9.11     

Avg Return         2.40 

Here is how this looks graphically.

Another way to look at this is to add some money to it and see where it goes.  Let's take me, for example.  Over the years, I had managed to accumulate $100,000 in my 401k that I had rolled over to an IRA.  A popular way to invest was, and is, to put it into an index fund.  For instance, if I put my money into a fund that matched the S&P 500, my money would keep up with the market.  In 2000, that sounded like a pretty good idea since I could never keep up with all the changes.  So, let's see what happened to my money when I put it into the S&P 500 Index Fund and let it ride.

Keeping my money in that fund let it grow from $100,000 to $108,000.  Is that magic, or what?  Where did my money go?