Annuity Abbey Part 2: The Enlightenment

John and Mary Swanson arrived at the annuity seminar. Mary noticed that most of the people at the gathering seemed to be about their age. As they took their seats, Mary could hear snatches of conversations around her, most of which seemed to be about how little interest the banks were currently paying. As the clock hit the top of the hour, a woman at the front of the room stepped forward and began speaking.

“Good morning, thank you for coming, my name is Julie Johnson,” she continued, “I have written on this board the words ‘CDs, fixed annuities, and savings bonds.’ One element that all three have in common is that both principal and credited interests are protected from stock market risk of loss. I’m sure you’re aware that savings bonds are issued by the U.S. Treasury and certificates of deposits are issued by banks. Fixed annuities are issued only by insurance companies and they have an excellent record of safety. To illustrate this, why don’t we take a little poll? Let’s have a show of hands if you know anyone that has lost money in a fixed annuity.” Not a hand went up.

She continued, “Another element they share is they’re all designed for serious longer-term money that you can’t afford to lose. Each of the three has penalties if you cash them in early and you need to be sure that your liquidity needs are taken into consideration.”

“A final element is that they each pay interest, as opposed to dividends or capital gains. The interest earned may change each year or stay the same for a specified number of years.”

“What I will be talking about today is fixed annuities. Fixed annuities provide a guarantee of principal – it’s a guarantee on the money placed in the annuity. These sometimes get confused with another type of annuity called a variable annuity and variable annuities are usually the ones you see talked about in financial magazines. They are called variable annuities because the value of the annuity will vary with its investment performance. In a fixed annuity, the account value is guaranteed by the insurance company and doesn’t vary with the market.”

“Fixed annuities pay interest in two different ways. The first way is they announce or declare a stated rate that will be paid for a stated period of time. The other way is the interest paid is linked to the performance of an external index. If the external index does well, you could earn more than if you’d accepted the fixed rate.”

“How much more?” asked the blue-shirted man in the audience.

“Perhaps two to three times more.” responded Julie, “And we’ll talk about that after the break.”

After the Break
“As I said before the break,” annuity expert Julie said, “Fixed rate annuities do what their name says. They pay a fixed rate of interest. In a fixed index annuity, the amount of interest earned is based of the performance of an external index – usually a stock index. As an example, if you purchased a fixed rate annuity, you might lock in a 1% interest rate for next year.”

Mary Swanson’s ears pricked up, “1% would be almost three times more interest than we’re getting from the bank,” she thought.

Julie went on, “Or you could earn up to 3% interest in a fixed index annuity if the index cooperated. Please realize that with an index annuity, if the index went down next year that you wouldn’t earn any index-linked interest, but you wouldn’t lose any principal. This is why some people put part of the money into the fixed rate choice and part into the index-linked choice.”

Mary Swanson’s mental blackboard was up again as she cogitated, “We might earn 2% overall and that’s enough to go out to brunch again. At worse, even if all we got was the fixed rate interest, we’d still earn more than the bank is paying.”

“Can I lose principal if I cash the annuity in early?” spoke up John.

“Of course,” said Julie, “As I mentioned before, the one thing that annuities share with CDs and savings bonds is there are penalties for early withdrawal. With this annuity, you incur a penalty if you cash it in earlier than ten years from now. This is why you need to make sure your liquidity needs are taken into consideration and you don’t put all of your money into one place – or one annuity. Of course, there’s no penalty on taking out the interest – in fact, you can usually take out up to 10% a year without a penalty.

John turned to Mary, “The whole point of those CDs is to not spend the principal. Maybe putting part of that CD money into a fixed annuity might help us avoid this, and we’d still have two CDs around if we need the cash for an emergency. I think we should talk to Julie, what do you think?”

Before she could answer, annuity expert Julie Johnson began to describe a new benefit, “Some fixed annuities offer a benefit that may provide at least a 4% income if a couple begins receiving an income at age 65 or an even higher percentage at older ages.

“Yeah, I know what this is,” said the blue-shirted man, “you give your money to the insurance company in exchange for this lifetime income, and if you die early, the insurance company keeps the rest of the money.”

“Not at all,” said Julie, “This is something new. What you’re describing is something called an immediate annuity and some of them work exactly as you said. With an immediate annuity, you give your money to the insurance company and in return you get a guaranteed income, but you lose access and control of your principal. By contrast, with these lifetime withdrawal benefits you maintain control of your money. The annuity guarantees you can withdraw at least a specified amount each year for as long as you live. Even if interest rates never improve, you can still withdraw at least the guaranteed amount you started withdrawing.”

Mary turned to John, “I don’t remember our mutual funds offering any guarantees, do you?”

Julie Johnson saw a hand raised in the annuity seminar audience and nodded for the man to go ahead.
The blue-shirted man looked puzzled, “Earlier you said that I could take out at least 4% a year for life, but if I take out 4% and earn 2% or 3%, couldn’t my annuity principal go to zero?”

“Absolutely,” replied Julie, “If you take out more than you put in, the value of any account goes down. However, with this type of fixed annuity you maintain control every step of the way. If you want to take out less than 4% so you can keep more in the account, then do so. If you want to stop taking money out for a period of time, you can do that too. The real benefit is this. Most retirement income ideas suggest you withdraw a certain amount and hope the income lasts as long as you do. These annuities insure your income lasts as long as you live even if your account runs out of money. If you die, your beneficiaries get whatever is left in your account. If you live, you are guaranteed to have an income for as long as you live. The fixed annuity helps preserve your independence in retirement.”

As the annuity seminar ended, John and Mary looked at each other. “Why didn’t I know about fixed annuities five years ago? We’d be in a much better place today if we’d put some of our money into fixed annuities when we retired,” said John. Mary replied, “It’s not too late, we’ll meet with the annuity expert this week and see how fixed annuities can improve our retirement.”

Annuity Abbey continues next issue.

Jack Marrion is President of Advantage Compendium Ltd, providing research and consulting services to select financial companies. He has twice been asked to address the National Association of Insurance Commissioners on annuity issues. His insights on the annuity and retirement income world have appeared in hundreds of publications, including Business Week, Kiplinger and The Wall Street Journal, and his research is frequently referenced by regulators.