Tuesday, September 28, 2010

Building a Boomer Annuity without the Insurance Company

I have been writing about money for almost thirteen years now and if anything thing has remained consistent over all of that time, it is my opinion of annuities. Not the idea.  I have always liked the concept that you had the knowledge in hand that a fixed amount of money was coming in each month, and even if it was diminished over the years by inflation and taxes, so be it.

On The Surface
I'm sure your probably wondering what's not to like about annuities? They have the ability to grow in value, guarantee a steady stream of income, never run out and are tax-deferred. Some have loan provisions and some even have nursing home language that allows you take more of your annuity out without penalties.

And that's where the annuity really takes a downside.  You might think all of those things about annuity I just mentioned are all worth the costs of what annuities charge.  But there is little reason to purchase an annuity if those costs can be had for some much less with almost no more effort.
All annuities have surrender charges.  These are penalties that often go away after seven years, sometime longer in the case of CD Type annuities; some, as in the case of fixed annuities, fifteen years. These charges can be steep and demand you consider how much of your money you want to be unable to touch without incurring huge costs if you change your mind.

And we all change our minds. In fact the older we get (studies point to this ability to get financially confused occurs after age 70), the greater the chances are we will make bad financial decisions. In fact, insurers know this about you and because this is part insurance/part investment, who you are also determines how much you can receive in the form of monthly payment over the course of your lifetime.

Inflation in layperson's terms simply tells us that each year that passes, your dollar will purchase a little less. Economists see this as a good thing if it is kept under control.  But the simple fact is that if you found ten bucks in your jeans, a pair you hadn't worn in a while, the money wouldn't go as far as it would have had you spent it the last time you had them on.

Taxes are the hidden surprise in annuities.  You buy an annuity with a fixed amount of cash. In a great many instances, this huge amount of cash comes to you upon retirement.  You are left with a couple of choices.  You could reinvest it back into an IRA - because, in most instances, the money in this lump sum payment is stuffed with cash that hasn't been taxed.  So you need to keep it that way. Or you could buy a tax-deferred annuity.

The oddest thing about this decision is that most folks turn down the opportunity based on what the stock market has done in the last six months. If it has done well, these newly minted retirees will take their chances and invest on their own.  If it hasn't done so hot, they look at the safety a regular monthly payment offers and how it makes them feel.

So back to the tax part.  Unlike every other form of investment which can be passed on to your heirs without any taxes being paid - until they decide to sell whatever you have left them, annuities are taxed.  And you and probably your heirs were not aware of this. And the tax is done on a stepped-up basis which means the taxes reflect the increased value of the annuity. And yes that is the other up-sell for the product, annuities gain over the years based on a guarantee of sorts from the insurance company.

Making it Better for Women
Because women live longer, they generally receive less as a monthly payment than their male counterparts. That's why annuities inside of a defined contribution plan like a 401(k) can be beneficial for women. In the current state of the economy, knowing how much income you could receive as you accumulate retirement savings can be a huge help in retirement planning.  If your plan doesn't have such an option, you can ask.  But the change may be coming.

One study suggests that "about one in four companies (22%) that offer DC plans provide an annuity as a distribution option, while 10% of those who don’t supply one are considering adding it."
The most interesting thing of all: You can do it yourself. And in many instances with just CDs. Here's how it works.

The DIY Annuity
First find a ten-year CD (or a five-year if you are skittish about the concept) with a low early withdrawal penalty (this can often be for a short-period of time, like two years and might not be so prohibitive an amount to pay if interest rates begin to inch their way up - and they probably will - and you want to turn the CD in). They are FDIC insured so you will never lose your invested money.  The government does tax your heirs if you should die before the CD matures.  The interest is still taxed more favorably than income or annuities. And the fees run about 0.02%.

Sure, you will have to buy another CD when it matures, or if interest rates go up making worthwhile to sell the CD you have in favor of a better one.  But this doesn't require a boatload of financial savvy to master.
Keep in mind, you should not bail on your retirement plans in favor of a total investment in CDs.  But having something else safely earning while your 401(k) works its own form of market-based compounding, is as good a way as any to build a safety net for the future.

Paul Petillo is the managing editor of Target2025.com/BlueCollarDollar.com and a fellow Boomer.