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For Dummies is a registered trademark of Wiley Publishing, Inc. in the United States and other countries. Used here by license.Many people confidently walk the financial high wire of life without a safety net. Others, especially those who are approaching retirement, feel more secure when a net is there to catch them — just in case the tightrope snaps.
If you prefer a financial safety net and you’re willing to pay for one, then consider an annuity. Put simply, annuities are investments with money-back guarantees. Imagine a typical investment in stocks or bonds; then imagine that same investment with a guarantee that you’ll get your money back with interest after (or over) a certain time period. That’s an annuity.
Of course, annuities aren’t quite that simple. Most annuity brochures and prospectuses contain enough disclaimers, footnotes, and contingencies to keep a dozen lawyers busy. But it’s useful, at least at first, to ignore the complexities of annuities and take a high-level snapshot of what they are and how they work.
To resume the circus metaphor, an annuity is both a tightrope and safety net; it’s an investment and insurance against the loss of that investment. Annuities aren’t always as exciting as the investment alone (like a tightrope walker without a net), but they’re not as risky. If you’re in or near retirement, you might find such a trade-off appealing.
In this article, I give you the basics by explaining what annuities are, what they do, how they work, who should buy them, and so on. In the interest of full disclosure, I also share my own opinions about annuities, because my opinions inevitably shape this article.
Annuities: Older Than You (Probably) Think They AreBecause people don’t know how long they’ll live, they don’t know how much money they’ll need to support themselves for the rest of their lives. The history of annuities is the search for a solution to that problem.
Annuities have existed for at least 1,800 years. In ancient Rome, contracts called annua promised a stream of payments for a fixed number of years or for life in return for an up-front payment. Speculators who sold insurance for Mediterranean shipping ventures sometimes offered these insurance contracts to the public.
Wealthy Romans often willed their heirs or friends an income for life. Because tax collectors needed to know how much that income would cost the benefactor’s estate, they also needed to know how long those heirs or friends were likely to live. In AD 225, a Roman judge named Ulpanius produced the first known mortality tables. By his reckoning, a 30-year-old Roman man would live until age 60, on average. Any man over age 30, he concluded, had an average life expectancy of 60 years minus his current age.
William Shakespeare is said to have invested a large part of his wealth near the end of his career in an “annuity-like arrangement.” In pre-Renaissance Europe, both the Church and assorted annuity dealers sold life annuities to raise funds. As early as 1540, the Dutch government sold annuities to finance wars and public works, just as modern governments sell bonds.
In the 1600s, special annuity pools called tontines operated in France. In return for an up-front payment, purchasers of tontines received a lifetime income. As purchasers died over time, their income was divided among the survivors. The last purchaser to die collected the remaining money. Tontines were eventually banned — partly because they gave the last two or three survivors a motive to kill each other!
Edmund Halley, the famous astronomer, used the birth and death records of an isolated German town to create the first modern set of mortality tables. He surmised that if the town had 600 30-year-olds but only 300 57-year-olds, a 30- year-old’s average life expectancy must be 27 years. He published his tables in 1693, but they weren’t widely used for another century.
The first record of annuities in the United States is from 1759, when the Corporation for the Relief of Poor and Distressed Presbyterian Ministers and Distressed Widows and Children of Ministers was chartered in Pennsylvania. In 1812, the Pennsylvania Company for Insurance on Lives and Granting Annuities was founded.
After the stock market crash of 1929, many people turned to guaranteed annuities as a safer place to put their retirement savings. The modern era of annuities began in 1952, when TIAA-CREF (the educators’ retirement fund) offered the first group variable deferred annuity — a precursor of other employer-sponsored retirement savings plans.
Individual annuities (which are purchased by individuals from insurance companies) flourished after the tax reforms of 1986, when deferred annuities became the only remaining financial product that allowed people to save and invest unlimited amounts on a tax-deferred basis. As of 2007, Americans have saved more than $1 trillion in annuities, along with the trillions they hold in employer-sponsored retirement plans and other accounts.
Today, many economists and finance professors (not to mention life insurance companies) hope that the baby boomer generation, whose oldest members are just beginning to retire, will rediscover the original purpose of annuities and use them to turn their 401(k) accounts and IRAs into guaranteed lifetime income.
Should You Get an Annuity?So, should you get an annuity? This is a not a simple question. The only sensible answer is that certain annuities are right for certain people. If you recognize yourself in any of the following categories, then you should definitely explore annuities further:
People in high tax brackets often like deferred annuities because they can contribute virtually any amount of money to the plan and still defer taxes on the gains for as long as they like.
Middle-class couples in their 50s who are earning $100,000 or less and have a savings of $250,000 or more but no pension should like income annuities. They have a 50-percent chance that one of them will live to age 90.
Financial advisers sometimes put their wealthy clients’ money in variable annuity subaccounts (mutual funds) instead of conventional (taxable) mutual fund accounts so that they can defer taxes on any gains they realize when buying and selling fund shares.
Pessimists — otherwise known as Cassandras, doomsayers, and bears— who believe that the gigantic, highly leveraged house of cards (the United States’ financial system) may collapse at any time, should like the guarantees that annuities provide.
Women are much more likely to need annuities than men. It’s true. Women live significantly longer and are therefore at greater risk of running out of savings.
Single or widowed women are more likely to be poor in old age than single or widowed men. Many people expect that, in the future, as birth rates in developed countries (the United States, Japan, and much of Europe) fall, and the number of elderly citizens rises, a retirement financing crisis will occur. Women will probably bear the brunt of that crisis.
Raising Your Awareness
As I mention earlier, I hope this article raises your awareness of annuities and makes you a reasonably savvy consumer of these complicated but useful financial tools. And although I try not to prejudice you for or against them, I do share my point of view, make judgments, and draw conclusions.
So, as you read, don’t be surprised when you hear elements of my credo more than once:
Costs matter. John C. Bogle, the founder of The Vanguard Group and the best friend an individual investor can have, has said it loudest, “Costs matter.” Don’t expect annuities to be cheap; guarantees are expensive. But be vigilant about the annual costs, fees, and expense ratios you’ll pay, particularly if you buy a deferred variable annuity.
Don’t invest in a contract you can’t understand. Many annuities are highly (and sometimes necessarily) complex. They may have moving parts that can change your costs from year to year, and they often function in counterintuitive ways. Many annuity prospectuses defy comprehension entirely. If one contract makes no sense to you, investigate another.
The survivorship credit is the core strength of annuities. Income or immediate annuities distribute the assets of deceased contract owners to the remaining owners, thus enhancing the income of all surviving contract owners. This often-neglected feature makes an annuity an annuity, and some experts think it should get more attention.
Creative combinations of annuities should be explored. The question is not, “Should I buy an annuity?” The question is, “Is there an annuity or a combination of two or three annuities that can give me the financial security I need in retirement?” A creative mixture of deferred and immediate annuities can often do the trick.
The best annuities are yet to come. Many of today’s annuities are prototypes of better annuities to come. As more baby boomers retire and recognize that they need guaranteed lifetime income, they’ll demand cheaper, more attractive annuities.
Mortality pooling (see the sidebar “Survivorship credits — the unique aspect of annuities” later in this article) allows all annuity owners not only to receive lifelong income but also to maximize the amount of income they receive from a fixed amount of money while living. For instance:
If a 65-year-old man retires with $300,000 and wants it to last at least as long as he lives, research shows that he can safely withdraw about 5 percent a year ($15,000) from age 65 until around age 90.
If the same man buys a single life annuity with $300,000 at age 65, he can receive more than $25,000 a year for life, no matter how long he lives. To protect his beneficiaries, he can buy an option that guarantees payments for a certain number of years or until he dies, whichever is longer.
Annuities guarantee a pension-like income for life better than any other financial product. There is no more efficient tool for converting a specific sum of money into a monthly income that lasts as long you live — even if you’re still kicking at 105.
So why don’t more people buy annuities when they retire? There are lots of reasons. But it’s likely that more people will buy annuities in the future. People are living longer and saving less. Fewer employers provide pensions. Social Security benefits may be trimmed back. Millions of people will replace their lost pensions and benefits with annuities.
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For Dummies is a registered trademark of Wiley Publishing, Inc. in the United States and other countries. Used here by license.