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Assuming you are talking about an immediate fixed income annuity, the biggest disadvantage are the low record interest rates and hence they aren't paying out much of anything. The way to go is a longevity annuity aka deferred income annuity. However what I leaned there is you can't buy any of these in a retirement account past a certain age generally around 68 to 68 and 1/2. There is a new product, a Qualified Longevity Annuity Contract, that you can purchase in an IRA in older age. This product has some advantages such as being exempt from your annual RMD. Personally, I would only buy an annuity from New York Life because of the company's history of financial stability.
Regarding liquidity risk, this is a reason why I (and others) suggest that an annuity be purchased only to cover essential cash flow needs, i.e. those expenses which you cannot reduce.
Reiterating one of the risks in the article cited by Lewis - inflation risk. I don't think it's as much of a risk for longevity insurance (assuming you buy enough to deal with inflation up to the point at which it starts paying), because that income stream won't go on for decades. But an immediate annuity could run for several decades, if you've got good health and luck.
Regarding insurance company risk - as a general rule of thumb, an insurance company cannot be rated higher than its sovereign's debt - thus S&P doesn't rate any insurer AAA. (S&P says that it's because they invest in - gasp - Treasuries.)
That article lists the 5 AAA insuers in 2011. That list hasn't changed much since then: NYLife, TIAA-CREF, Knights of Columbus, Northwestern Mutual, and USAA.
(I got both that list and the quirk about sovereign debt from a TIAA-CREF rep I spoke with a few years ago; he said he had to explain to people why TIAA-CREF wasn't AAA rated anymore.)
Here's a 2014 list - it looks like Fitch downgraded USAA to Aa1 from Aaa (no other ratings agency made a change), otheriwse, all the usual suspects are still top rated. It also has Berkshire Hathaway and Gen Re in this top group.
Any of these insurers IMHO would be fine. I especially like TIAA-CREF because unlike the other insurers, it does not have a separate subsidiary in NY to comply with the more stringent NYS reserve requirements. I believe you get that same higher standard across all 50 states with this insurer.
Lewis' link succenctly lays out three prime areas of concern with these. Agree with all. Junkster's done a great job over recent weeks researching these and sharing his impressions. He, msf, Bob C and some others on the board understand them far better than I do.
However, I can never get past the simple math that seems to show that they give you back over a roughly 15-year time-span (+ -) essentially all your money along with a very low rate of return (in the order of 1 or 2% compounded). Of course, it depends on how long you live. Exceeding that period produces a somewhat better rate of return.
I'm big on inflation protection. Maybe that's because my formative years budgeting & investing were during the highly inflationary 70s and 80s. That left a lasting impression. Of course, there's no assurance we'll witness anything like that again anytime soon. Still - I'd list the article's point #1 (inflation protection) as my biggest concern with these products.
Junkster's point-on about the current low interest rates pretty much torpedoing any chance for an annuity purchased today to provide an attractive return on investment. That's because the annuity company has to invest that money during your drawdown period, and there aren't a lot of attractive options right now.
I think Vanguard or some other fund provider once marketed a mutual fund which was meant to generate a modest rate of return and also provide a relatively safe monthly pay-out to retirees over time. Not an annuity in name - but having similar appeal. (Unlike an annuity, the years of payout would be finite.) Anyone know what fund that might be and whether it still exists? If it does exist, it's probably struggling against the same low-rate headwinds as any similar investment today.
@hank - I'll try to address your questions as best I can. But I would first like to point out that there are subtle (and not so subtle) differences among the various products out there.
At the 50,000 foot level, annuities and other insurance products are just that - insurance. They aim to insure (guarantee) something that you want insured (e.g. that your checks won't run out, no matter how long you live). In contrast, noninsured products provide a different but related service - managing your cash flows so that it's likely (but not guaranteed) to last as long as you do, and likely (but not guaranteed) to remain relatively constant (with or without annual increases/inflation adjustments, depending on the product).
Mutual fund companies have come up with two different types of "managed payout" products to manage your cash flow. One is designed like an annuity - to spend down after a number of years (like a "term certain only" policy). Another is designed to last in perpetuity - drawing income only and preserving principal.
As the linked-to article points out, Vanguard and Schwab provide funds of the latter type. Vanguard had problems with its three funds (designed for different levels of growth/risk and different payout levels), and combined them into a single fund VTINX. Schwab still has its three funds:SWJRX, SWKRX, SWLRX.
Fidelity's Income Replacement Funds can be found here. Regarding PIMCO, it had two funds, PIMCO Real Income 2019 and 2029. Apparently they never got much traction and were liquidated Nov 14, 2014, shortly before their manager was dismissed for improper trading.
PIMCO still seems to offer a "Real Income Strategy" if you can figure out how to participate. (The page links only to generic mutual fund and separate account pages.)
If you'd like to compare these funds with how insurance companies invest, here's a two page paper on that from the Chicago Fed, April 2013.
Yeah - I realize you're buying insurance with an annuity. For some reason, this "insurance" appears to carry an expensive price tag. Sometimes insurance doesn't make sense. I rarely carry any, except for legally mandated PLPD, on vehicles over 4-5 years old. (Probably not a good analogy.)
VTINX, which you linked, is an interesting fund. It's about 30/70 equity/bond, compared to TRRIX at around 40/60. I've owned the latter a number of years and am quite fond of it as a substantial long term retirement holding.
Haven't studied all your leads yet - but intend to do so. Lots of food for thought here.
A final thought: While The two funds I mention look like they would provide a steady stream of decent retirement income and offer a high degree of principal protection over many decades, there's of course no assurance of that.
There are some forms of insurance that are fairly clearly not cost effective. This is for at least a couple of reasons: - The expected payout is not that much more than the cost of the loss, and - The cost of the loss is low enough that you can "self insure"
These apply to collision/comprehensive insurance on older cars - the amount of the payout will be small because the depreciated value of the car is small. Since it is small as an absolute amount, it can't be large relative to the premiums you paid (bullet 1). Also since the payout's small, you'll be able to afford self insurance (bullet 2). I feel dental insurance has similar attributes, because the payout is capped at such a low amount.
On the other hand, people buy term life insurance, even though they expect to lose 100% of the premiums. The payout is large (albeit unlikely), and the cost of self insuring is prohibitive.
IMHO annuities are similar. The typical person likely loses a little - that's the expected cost of the insurance. But the potential payoff is huge, in the unlikely event that you live as long as Ms. Susannah Mushatt Jones (116 and counting)
Consider the cost of self insuring. Sure you can take a pile of money and invest it, but you can't have say, a 99.9% confidence level that you'll be able to pay out that long at a fixed amount, unless you invest a heck of a lot more than makes any reasonable sense. You might be able to afford that, but to what end? You'll wind up way underspending, and not enjoying the use of that money. That's a huge cost.
"Expensive price tag" might mean that you (and many others) feel that life insurance companies are making money hand over fist with these policies. After a little digging, I did find a statement confirming my understanding - that if not for the money that the insurance companies make investing your premiums, they'd actually be losing money. (As you pointed out, they're not making a whole lot of money on those investments.)
In effect, insurance companies are banks. They borrow from savers (policy holders), and invest the money at a higher rate of return than they pay out. But they do pay out, and they add value in providing insurance - spreading risk. Try doing that yourself - see if you can find enough people to set up a tontine efficiently.
Here's a page quoting Warren Buffett (who probably knows a little about insurance):
The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an "underwriting loss", which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money."
Correction - it was pointed out to me that I misstated the current Vanguard managed payout fund. It is VPGDX, not VTINX.
As a side note - like most everyone, I'm prone to mistakes. Sometimes they're embarrassing, other times like here they simply reflect sloppiness (I really did know which fund I wanted to point to). Either way, please post the correct facts. Better that everyone have the correct information quickly. Thanks.
This is pretty simple, really. Assuming you are referring to immediate, fixed annuities, the process is sort of like Social Security or a corporate/public pension. In return for giving an insurer a sum of money, you receive an income for life. The income could be for your life only, for you and a spouse, a period certain (for at least 10, 15, etc. years even if you (and your spouse) should pass before that period is up. Depending on the interest rate used and your life expectancy, the income received will vary. Now is not a good time to give money to an insurance company for an immediate fixed annuity, since rates are really bad. We are advising clients to wait until immediate annuity rates are in the 3-4% range. That is still not great, but a lot better than they are now.
This is for immediate fixed annuities only. The income starts now. We would certainly not use deferred fixed annuities in the current interest rate environment. This guaranteed contract depends on the ability of the insurance company to remain solvent, so do your homework on the company. And I would never recommend something like VPGDX as an annuity substitute. It is a mutual fund, where you really have no guarantee of any kind. With almost 60% in stocks, you need to be able to handle a 14-15% loss in that 60% (assuming a correction will occur). So the fixed annuity is an ok option, if you are willing to give that lump sum of money to an insurance company in exchange for a guaranteed payout for your lifetime. Again, sorta like SS or a pension.
Correction - it was pointed out to me that I misstated the current Vanguard managed payout fund. It is VPGDX, not VTINX.
As a side note - like most everyone, I'm prone to mistakes. Sometimes they're embarrassing, other times like here they simply reflect sloppiness (I really did know which fund I wanted to point to). Either way, please post the correct facts. Better that everyone have the correct information quickly. Thanks.
Thanks msf. Correction noted. However your .999% batting average is still the best here IMHO. In fact, knowing you're there to fact-check many of us (at great sacrifice of time and effort I'm sure) has led me to try to be more careful. Suspect that's true of others. Thanks for all you do.
--- Side note. At some point we need to toss-away the most unlikely scenarios and simply not insure against them. Living to 116 might be one. Putin dropping a nuke on my house might be another, as believe my homeowners' policy excludes acts of war.
I agree that this is not a good time to purchase a fixed immediate annuity. The calculation may be a bit different for someone (over 59.5) in the accumulation phase.
In most market environments, fixed annuities generally provide better returns than comparable CDs (albeit wth higher risk - the insurer might go bust, and much more severe "early withdrawal penalties"). Here's a Marketwatch column that says the same thing with a lot more words.
Even in this low interest rate environment, Fidelity shows a NYLife 3 year fixed annuity (with a whopping 7%+ surrender rate) yielding 1.75%. That's a few basis points higher than I can find at a credit union. Not enough of a difference to make it worthwhile - just enough to show that sound, shorter term fixed annuities can still beat CDs. (Going out five years, the current CDs seem to do better than fixed annuities from top rated insurers, and with lower surrender costs.)
That's the only reason why I could see purchasing a deferred fixed annuity now - as a CD alternative. (The reason for age 59.5 is so that there is no IRS penalty for cashing out.)
When buying an annuity with post tax dollars (oppose to using tax deferred IRA dollars) are the pay outs partially tax free since some of the payout is a "return of principal" that has already been taxed?
Also, if an annuity to purchased with resources from a Roth account are you for tax purposes purchasing a "Roth annuity" and, therefore, both the "investment" and the "return on investment" are tax free?
Is there such a thing as a tax free annuity? Yes it's called life insurance. when you die, someone collects the $$$$$ tax free. Derf
So, if I approach my kids, and tell them that I would gladly pay them (a life Insurance policy) on Tuesday for (monthly income) hamburg today I should be all set.
thanks.
What are was hoping for was a tax free income annuity.
When buying an annuity with post tax dollars (oppose to using tax deferred IRA dollars) are the pay outs partially tax free since some of the payout is a "return of principal" that has already been taxed?
Yes, but.
If you annuitize (give up cash value in exchange for a guaranteed income stream), then a portion of each payment is treated as return of principal (based on your expected lifetime - the insurance company will calculate this for you).
If you get payments by simply making periodic withdrawals rather than by annuitizing, those payments are treated as earnings first, then principal (the opposite of the way Roth distributions are treated). So ultimately some payments will be tax free, but those will be at the end, and they'll be fully tax free (while the earlier ones will be fully taxable).
Also, if an annuity to purchased with resources from a Roth account are you for tax purposes purchasing a "Roth annuity" and, therefore, both the "investment" and the "return on investment" are tax free?
Is there such a thing as a tax free annuity?
You got it right - a Roth IRA. Remember, IRA in the tax code stands for both Individual Retirement Account (28 USC 408(a)) and Individual Retirement Annuity (28 USC 408(b)>
Comments
The only thing I would add is there can also be a liquidity risk as you are locking your money up in the annuity and won't necessarily have access to it in case of emergency.
Reiterating one of the risks in the article cited by Lewis - inflation risk. I don't think it's as much of a risk for longevity insurance (assuming you buy enough to deal with inflation up to the point at which it starts paying), because that income stream won't go on for decades. But an immediate annuity could run for several decades, if you've got good health and luck.
Regarding insurance company risk - as a general rule of thumb, an insurance company cannot be rated higher than its sovereign's debt - thus S&P doesn't rate any insurer AAA. (S&P says that it's because they invest in - gasp - Treasuries.)
That article lists the 5 AAA insuers in 2011. That list hasn't changed much since then:
NYLife, TIAA-CREF, Knights of Columbus, Northwestern Mutual, and USAA.
(I got both that list and the quirk about sovereign debt from a TIAA-CREF rep I spoke with a few years ago; he said he had to explain to people why TIAA-CREF wasn't AAA rated anymore.)
Here's a 2014 list - it looks like Fitch downgraded USAA to Aa1 from Aaa (no other ratings agency made a change), otheriwse, all the usual suspects are still top rated. It also has Berkshire Hathaway and Gen Re in this top group.
Any of these insurers IMHO would be fine. I especially like TIAA-CREF because unlike the other insurers, it does not have a separate subsidiary in NY to comply with the more stringent NYS reserve requirements. I believe you get that same higher standard across all 50 states with this insurer.
Junkster's done a great job over recent weeks researching these and sharing his impressions.
He, msf, Bob C and some others on the board understand them far better than I do.
However, I can never get past the simple math that seems to show that they give you back over a roughly 15-year time-span (+ -) essentially all your money along with a very low rate of return (in the order of 1 or 2% compounded). Of course, it depends on how long you live. Exceeding that period produces a somewhat better rate of return.
I'm big on inflation protection. Maybe that's because my formative years budgeting & investing were during the highly inflationary 70s and 80s. That left a lasting impression. Of course, there's no assurance we'll witness anything like that again anytime soon. Still - I'd list the article's point #1 (inflation protection) as my biggest concern with these products.
Junkster's point-on about the current low interest rates pretty much torpedoing any chance for an annuity purchased today to provide an attractive return on investment. That's because the annuity company has to invest that money during your drawdown period, and there aren't a lot of attractive options right now.
I think Vanguard or some other fund provider once marketed a mutual fund which was meant to generate a modest rate of return and also provide a relatively safe monthly pay-out to retirees over time. Not an annuity in name - but having similar appeal. (Unlike an annuity, the years of payout would be finite.) Anyone know what fund that might be and whether it still exists? If it does exist, it's probably struggling against the same low-rate headwinds as any similar investment today.
At the 50,000 foot level, annuities and other insurance products are just that - insurance. They aim to insure (guarantee) something that you want insured (e.g. that your checks won't run out, no matter how long you live). In contrast, noninsured products provide a different but related service - managing your cash flows so that it's likely (but not guaranteed) to last as long as you do, and likely (but not guaranteed) to remain relatively constant (with or without annual increases/inflation adjustments, depending on the product).
Mutual fund companies have come up with two different types of "managed payout" products to manage your cash flow. One is designed like an annuity - to spend down after a number of years (like a "term certain only" policy). Another is designed to last in perpetuity - drawing income only and preserving principal.
As the linked-to article points out, Vanguard and Schwab provide funds of the latter type. Vanguard had problems with its three funds (designed for different levels of growth/risk and different payout levels), and combined them into a single fund VTINX. Schwab still has its three funds:SWJRX, SWKRX, SWLRX.
Fidelity's Income Replacement Funds can be found here. Regarding PIMCO, it had two funds, PIMCO Real Income 2019 and 2029. Apparently they never got much traction and were liquidated Nov 14, 2014, shortly before their manager was dismissed for improper trading.
PIMCO still seems to offer a "Real Income Strategy" if you can figure out how to participate. (The page links only to generic mutual fund and separate account pages.)
If you'd like to compare these funds with how insurance companies invest, here's a two page paper on that from the Chicago Fed, April 2013.
Yeah - I realize you're buying insurance with an annuity. For some reason, this "insurance" appears to carry an expensive price tag. Sometimes insurance doesn't make sense. I rarely carry any, except for legally mandated PLPD, on vehicles over 4-5 years old. (Probably not a good analogy.)
VTINX, which you linked, is an interesting fund. It's about 30/70 equity/bond, compared to TRRIX at around 40/60. I've owned the latter a number of years and am quite fond of it as a substantial long term retirement holding.
Haven't studied all your leads yet - but intend to do so. Lots of food for thought here.
A final thought: While The two funds I mention look like they would provide a steady stream of decent retirement income and offer a high degree of principal protection over many decades, there's of course no assurance of that.
- The expected payout is not that much more than the cost of the loss, and
- The cost of the loss is low enough that you can "self insure"
These apply to collision/comprehensive insurance on older cars - the amount of the payout will be small because the depreciated value of the car is small. Since it is small as an absolute amount, it can't be large relative to the premiums you paid (bullet 1). Also since the payout's small, you'll be able to afford self insurance (bullet 2). I feel dental insurance has similar attributes, because the payout is capped at such a low amount.
On the other hand, people buy term life insurance, even though they expect to lose 100% of the premiums. The payout is large (albeit unlikely), and the cost of self insuring is prohibitive.
IMHO annuities are similar. The typical person likely loses a little - that's the expected cost of the insurance. But the potential payoff is huge, in the unlikely event that you live as long as Ms. Susannah Mushatt Jones (116 and counting)
Consider the cost of self insuring. Sure you can take a pile of money and invest it, but you can't have say, a 99.9% confidence level that you'll be able to pay out that long at a fixed amount, unless you invest a heck of a lot more than makes any reasonable sense. You might be able to afford that, but to what end? You'll wind up way underspending, and not enjoying the use of that money. That's a huge cost.
"Expensive price tag" might mean that you (and many others) feel that life insurance companies are making money hand over fist with these policies. After a little digging, I did find a statement confirming my understanding - that if not for the money that the insurance companies make investing your premiums, they'd actually be losing money. (As you pointed out, they're not making a whole lot of money on those investments.)
In effect, insurance companies are banks. They borrow from savers (policy holders), and invest the money at a higher rate of return than they pay out. But they do pay out, and they add value in providing insurance - spreading risk. Try doing that yourself - see if you can find enough people to set up a tontine efficiently.
Here's a page quoting Warren Buffett (who probably knows a little about insurance
As a side note - like most everyone, I'm prone to mistakes. Sometimes they're embarrassing, other times like here they simply reflect sloppiness (I really did know which fund I wanted to point to). Either way, please post the correct facts. Better that everyone have the correct information quickly. Thanks.
This is for immediate fixed annuities only. The income starts now. We would certainly not use deferred fixed annuities in the current interest rate environment. This guaranteed contract depends on the ability of the insurance company to remain solvent, so do your homework on the company. And I would never recommend something like VPGDX as an annuity substitute. It is a mutual fund, where you really have no guarantee of any kind. With almost 60% in stocks, you need to be able to handle a 14-15% loss in that 60% (assuming a correction will occur). So the fixed annuity is an ok option, if you are willing to give that lump sum of money to an insurance company in exchange for a guaranteed payout for your lifetime. Again, sorta like SS or a pension.
In fact, knowing you're there to fact-check many of us (at great sacrifice of time and effort I'm sure) has led me to try to be more careful. Suspect that's true of others. Thanks for all you do.
--- Side note. At some point we need to toss-away the most unlikely scenarios and simply not insure against them. Living to 116 might be one. Putin dropping a nuke on my house might be another, as believe my homeowners' policy excludes acts of war.
Regards
In most market environments, fixed annuities generally provide better returns than comparable CDs (albeit wth higher risk - the insurer might go bust, and much more severe "early withdrawal penalties"). Here's a Marketwatch column that says the same thing with a lot more words.
Even in this low interest rate environment, Fidelity shows a NYLife 3 year fixed annuity (with a whopping 7%+ surrender rate) yielding 1.75%. That's a few basis points higher than I can find at a credit union. Not enough of a difference to make it worthwhile - just enough to show that sound, shorter term fixed annuities can still beat CDs. (Going out five years, the current CDs seem to do better than fixed annuities from top rated insurers, and with lower surrender costs.)
That's the only reason why I could see purchasing a deferred fixed annuity now - as a CD alternative. (The reason for age 59.5 is so that there is no IRS penalty for cashing out.)
Also, if an annuity to purchased with resources from a Roth account are you for tax purposes purchasing a "Roth annuity" and, therefore, both the "investment" and the "return on investment" are tax free?
Is there such a thing as a tax free annuity?
Derf
thanks.
What are was hoping for was a tax free income annuity.
Derf
If you annuitize (give up cash value in exchange for a guaranteed income stream), then a portion of each payment is treated as return of principal (based on your expected lifetime - the insurance company will calculate this for you).
If you get payments by simply making periodic withdrawals rather than by annuitizing, those payments are treated as earnings first, then principal (the opposite of the way Roth distributions are treated). So ultimately some payments will be tax free, but those will be at the end, and they'll be fully tax free (while the earlier ones will be fully taxable). You got it right - a Roth IRA. Remember, IRA in the tax code stands for both Individual Retirement Account (28 USC 408(a)) and Individual Retirement Annuity (28 USC 408(b)>