About Annuities

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About Annuities

A variable annuity is an investment vehicle designed for retirement savings. You may think of it as a wrapper around an underlying investment, typically in a very restricted set of mutual funds. The selling points of a variable annuity are that the underlying investments grow tax-deferred, as in an IRA, and that when you retire, the annuity will pay you an income, based on how well the underlying investment performed, for as long as you live. Annuities are sold by insurance companies, and use an insurance policy to provide the tax deferral. (Remember, tax deferral is not tax-free. It means that taxes are delayed. That can be both good and bad.)

Unlike an IRA, the money you put into an annuity are not deductible from your taxes. And also unlike an IRA, you may put as much money into an annuity as you wish. But beware, because this may sound at first like a good investment, annuities look pretty bad when you examine them in close detail.

The following discussion compares an annuity to an index fund (see also the article on index funds in the FAQ for misc.invest.mutual-funds).

Variable annuities are just about the worst investment vehicle you can put your money into. They are extremely profitable for the companies that sell them (which accounts for their popularity among sales people), but are a terrible choice for you. You are much better off in an equity index fund. Index funds are extremely tax efficient and provide, overall, a much more favorable tax situation than an annuity.

The growth of an annuity is fully taxable as income, both to you and your heirs. The growth of an index fund is taxable as capital gains to you (which is good because capital gains taxes are always lower than ordinary income) and subject to zero income tax to your heirs. This last point is because upon inheritance the asset gets a "stepped up basis." In plain English, the IRS treats the index fund as though your heirs just bought it at the value it had when you died. This is a major tax advantage if you care about leaving your wealth behind. (By contrast the IRS treats the annuity as though your heirs just earned it; they must now pay income tax on it!)

If you remove some money from the index fund, the cost basis may be the cost of your most recent purchase (or if the law is changed as the administration currently recommends, the average cost of your index investments). By contrast, any money you remove from an annuity is taxed at 100% of its value until you bring the annuity's value down to the size of what you put in. (The law is more favorable for annuities purchased before 1982, but that's another can of worms.)

Tax considerations aside, the index fund is a better investment. Try to find some annuities that outperformed the S&P 500 index over the past ten or twenty years. Now, do you think you can pick which one(s) will outperform the index over the next twenty years? I don't.

Annuities usually have a sales load, usually have very high expenses, and always have a charge for mortality insurance. The insurance is virtually worthless because it only pays if your investment goes down AND you die before you "annuitize". (More about that further on.) Simple term insurance is cheaper and better if you need life insurance. Annuities invest in funds that are difficult to analyze, and for which independent reports, such as Morningstar, are not always available.

Annuity contracts are very difficult for the average investor to read and understand. Personally, I don't believe anyone should sign a contract they don't understand.

Annuities promise a guaranteed income for life. If you choose to annuitize your contract (meaning take the guaranteed income for life), two things happen. One is that you sacrifice your principal. When you die you leave zero to your heirs. If you want to take cash out for any reason, you can't. It isn't yours anymore. You have made the insurance company rich.

In exchange for giving all your money to the insurance company, they promise to pay you a certain amount (either fixed or tied to investment performance) for as long as you live. The problem is that the amount they pay you is small. The very small payoff from annuitizing is the reason that almost no one actually does it. If you're considering an annuity, ask the insurance company what percentage of customers ever annuitize. Ask what the payoff is if you annuitize and you'll see why. Compare their payoff to keeping your principal and putting it into a ladder of U.S. Treasuries, or even tax-free munis. Better yet, compare the payoff to a mortgage for the duration of your expected lifespan. If you expect to live to 85, compare the payoff at age 70
to a 15-year mortgage (with you as the lender).

For a fixed payout you would be better off putting your money into US Treasuries and collecting the interest (and keeping the principal).

Now let's consider a variable payout, determined by the performance of your chosen investments. The problem here is the Assumed Interest Rate (AIR), typically three or four percent. In plain English, the
insurance company skims off the first three to four percent of the growth of your investments. They call that the AIR. Your monthly distribution only grows to the extent that your investment grows MORE than the AIR. So if your investment doesn't grow, your monthly payment shrinks (by the AIR). If your investment grows by the AIR, your monthly payment stays the same. When the market has a down year, your monthly payment shrinks by the market loss plus the AIR.

If you do decide to go with an annuity, buy one from a mutual fund company like T. Rowe Price or Vanguard. They have far superior products to the annuities offered by insurance companies.

For more information about annuities, you might find these articles helpful:

1."Annuities: Just Say No" in the July/August 1996 issue of Worth magazine.
2."Five Sad Variable Annuity Facts Your Salesman Won't Tell You" in the April 5, 1995 Wall Street Journal quarterly review of mutual funds.

Just to be complete, note that there is such a thing as a fixed annuity. A fixed annuity is a completely different animal from a variable annuity, and is not very popular. The idea of a fixed annuity is that you give money to an insurance company, and they promise to pay you a fixed monthly amount for as long as you live. When considering a fixed annuity, compare the annuity with a ladder of high-grade bonds that allow you to keep your principal.

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The easiest way to remember the difference between a retirement annuity fund and an annuity is that the latter usually occurs after retirement while the former is what you invest in during your working years.

WHAT IS AN ANNUITY?

Annuities are income-generating investments; you invest a lump sum (the capital) to receive a stream of regular income payments in the future. The payments you receive are made up of both a return on your lump sum and the income earned on the money invested.

For many people the lump sum they will invest in an annuity is the capital payout received from their retirement fund when they retire. In fact, the law requires you to buy an annuity with at least two-thirds of the total benefit received from a pension or retirement annuity (RA) fund.

Where an annuity is required to be bought by law, it is called a COMPULSORY ANNUITY.

But buying an annuity needn't always come from the proceeds of your retirement fund. You could inherit R100 000 and decide to invest it in an annuity to give you a regular future income. In this instance, your annuity is termed a VOLUNTARY ANNUITY.

An important difference is in their tax treatment.

The income from a voluntary annuity is split between income and capital, with the capital portion escaping tax. Income from a compulsory annuity is fully taxed.

This article deals with compulsory annuities only.

When you retire, or when you decide to withdraw from your matured RA fund, you will be asked to select your annuity.

The confusing aspect is that there is such a wide range. The options can be divided into two main categories, traditional and flexible annuities.

TRADITIONAL ANNUITIES PAYMENTS

Your annuity is paid out as regular payments at intervals you choose.

How much income will I receive?

Your annuity income depends on four factors:

The lump sum you invest;
The annuity option you choose;
Your life expectancy (which is determined by age, gender and whether you smoke); and
The interest rates ruling on the day you buy your annuity.

Interest rates

When you buy an annuity the life assurance company invests the lump sum payment, with the major share usually invested in the gilts market (gilts are low-risk, interest-paying debt instruments issued by the government) or in other fixed income money deposits.

The interest the life assurer can earn from these investments changes daily because the yield largely depends on the level of interest rates in the country.

The issue for the retiree buying an annuity is this: if you buy when interest rates are low, you'll be quoted a lower rate on your money and hence receive lower future income payments.

Once you have bought your annuity, you are locked into that rate forever.

Your life expectancy

Because the future income payments include the pay back of your lump sum, the life assurer has to calculate the number of years the annuity is likely to be paid.

If you're older, your monthly payment will be higher as there's a shorter time to pay back your lump sum. The younger you are, the lower the monthly annuity because of the longer payout period.

Women have a longer life expectancy than men and receive a lower monthly annuity for the same lump sum investment.

Smokers may receive a higher annuity than non-smokers because of their shorter expected lifespan.

Single life annuity

If you wish to receive an annuity income for as long as you live, which is calculated on your life expectancy, your annuity is termed a single life annuity. As the accompanying table shows, this annuity pays out the highest income out of all the traditional options.

Joint and survivorship annuity

This annuity is based on the lives of both you and your spouse. On your death, the annuity will continue to be paid to your spouse until his or her death. The annuity to your spouse can be paid at the same amount or at a lower amount.

For both the above annuity types, you have two more decisions to make - whether to take a guaranteed payment term and/or an annuity escalation rate.

Guaranteed payment term

As a traditional annuity ends on your death (or your spouse's death in the case of a joint annuity), you might consider a guaranteed payment term.

This means that if you die within the guaranteed term, the annuity will be paid to your heirs until the end of the term. If you outlive the guarantee term, the annuity will continue for as long as you live, but terminate on your death.

You can specify the length of your guarantee period - five to 10 years is the usual period. Opting for a guaranteed term can be expensive.

Escalation rate

The objective of this option is to beat inflation. The accompanying graph shows the decrease in purchasing power of a fixed annuity income.

You can opt for an annuity income which rises each year, either at a percentage you choose (usually not more than 10 percent) or at a variable rate in line with the bonus declared by the life assurer.

The price of this benefit is a significantly reduced annuity income in the first years.

And, if the retiree dies in the early years, it means a substantial loss of money.

DISADVANTAGES

A traditional annuity dies with you - your heirs do not receive the outstanding capital left in the annuity.

The life assurance industry does have an option to overcome this, but again, this is expensive.

Under a back-to-back or capital guarantee plan you can insure your life for the outstanding capital amount on the annuity, and on your death this amount is paid to your heirs. The policy premium is deducted from your annuity income. Your annuity income is taxed - and you are effectively taxed on the capital portion of your annuity.

To get the full benefit of your lump sum investment you have to live a long time.

If you combine all the available options, your annuity income can drop by half.

ADVANTAGES

Your investment carries no risk as your income is guaranteed for life. You are assured of a regular income of a fixed amount.

Shop around when buying an annuity - the rates quoted by the different life assurers can vary considerably. You are not obliged to buy your annuity from the life assurer who invested your matured RA, but you might not have this option with your pension fund money.

FLEXIBLE ANNUITIES

Called the new generation of annuity, the flexible or living annuity was first introduced in 1989 in a bid to overcome the shortfalls of a traditional annuity.

Nearly all life assurance companies offer both traditional and flexible annuities. However, some of the major players in this market are non-assurers like Investec, TMA and UAL.

A different animal

Your lump sum is invested in the investment portfolio of your choice. This portfolio may be an in-house portfolio run by the life assurer, interest-bearing investments, or unit trust funds. At least 25 percent of your investment must be in gilts or similar assets.

Bear in mind that some financial institutions offer a wider choice of investment portfolios than others.

You are not locked into your chosen investment portfolio, you can switch between the different investments offered by your financial institution. Another area of flexibility is in the amount of annuity income you receive.

The income you can withdraw ranges from half a percent of your investment balance (although this minimum varies among institutions) to the maximum of 20 percent of your investment balance. You can change your income selection at any time in line with your income needs.

Market talk has it that the minimum income level will be regulated at five percent in the near future (but this is unlikely to be applied retrospectively to existing annuities).

Capital appreciation

Provided your income withdrawal is less than the growth rate achieved on your investment, your fund will benefit from capital growth.

DISADVANTAGES

You bear the risk of your retirement nest-egg -- if you invest unwisely and the value of your investment falls, your income will be restricted.

A flexible annuity is not a passive investment, it has to be actively managed to render the best possible return in a changing market.

Your annuity income is not regular, nor is it assured. You cannot plan with the same certainty as with a traditional annuity. Financial planners advise against a flexible annuity if it is the retiree's sole source of income.

ADVANTAGES

Flexibility and transparency in both the costs and investment portfolio.You leave an asset to your heirs. Your annuity income is taxed, but the tax planning aspect is that you can vary your income. The interest earned on your investment is not taxed in the fund.

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