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Financial Basics For Baby Boomers
Wed March 20, 2013
Annuities Explained: The Choices And Red Flags
Originally published on Wed March 27, 2013 9:32 am
Companies are licking their chops at the prospect of a wave of baby boomers leaving their jobs with trillions of dollars in 401(k)s and other savings accounts, so older Americans may find themselves bombarded with ads for annuities. And younger boomers, too, may be targeted, since many are helping their parents with investment decisions.
Annuities are a $200-billion-a-year business for life insurance companies and financial institutions that sell them. They are a sort of private pension that people can buy for themselves to create regular income for after they retire. They are tax-deferred mutual-fund-like investments, there are no annual contribution limits, contributions can be made in a lump sum or over time, and the payouts can be immediate or deferred.
"The older you are when you invest the money, the more your annual payouts are," Kiplinger's Kimberly Lankford tells Morning Edition's Renee Montagne. Payout amounts also depend on how long they go on for. For example, to get the highest amount, payments stop when you die. It's possible to extend payouts out, say, 10 years after death to go to your beneficiary, but that will lower the annual amount. "There are all these choices to make," Lankford says. (For more details on the different types of annuities available, click to hear the interview above.)
As with any financial product, annuities — or, rather, the salespeople who market them — promise benefits like guaranteed payouts. But salespeople can make big commissions on annuities contracts, and the insurance companies that issue the contracts earn hefty fees. There have been abuses, and in the past, state regulators have fined insurers for putting investors into unsuitable annuities.
Given the mind-boggling math involved with annuities, even a highly literate person will have trouble making a decision. Lankford has been writing about annuities for years, noting several red flags to watch out for:
Surrender fees. These are fees you pay to cancel an annuity contract or withdraw funds early. They are designed to encourage investors to stay in their contract. A typical surrender charge starts at 7 percent of the funds contributed to the contract or on withdrawals in the first year. The fee percentage could fall in subsequent years and can also remain for 10 years or more. If older seniors buy an annuity, these fees may still be in effect exactly when the investor needs to withdraw the money.
Churning. This is when an annuities salesperson convinces an investor to switch contracts. Moving money from one annuity to another earns the salesperson additional commission. Sometimes it's OK to switch to another annuity with lower fees or different guarantees, but you need to be careful that the salesperson is not trying to get you to switch just for the commission.
Buybacks. Currently, some insurance and financial companies are finding that the annuity contracts they sold many years ago have terms that are generous for investors but not good for the company's bottom line. So they are offering investors large sums to buy back contracts. Lankford warns investors in a recent article that "in most cases, the extra payments will be a bad deal for seniors who own older annuities."
"Free lunch" seminars. Investment seminars offering a free meal may be touted as educational, but they've been listed as a top threat to investors by the Securities and Exchange Commission and other regulatory groups. These seminars often target older adults and can include high-pressure tactics to buy products they may not need.
RENEE MONTAGNE, HOST:
In today's conversation about baby boomers and their finances, we're talking about annuities. This is a $200 billion a year business for the life insurance companies and financial institutions that sell annuities. What they are is a kind of private pension people can buy for themselves, to create regular income for after they retire.
To talk more about the benefits and the risks of annuities, we're joined by Kim Lankford. She's a contributing editor at Kiplinger's personal finance magazine. Good morning.
KIM LANKFORD: Good morning. Thank you for having me.
MONTAGNE: Now, let's begin with a real basic thing. How old are people when they start buying annuities?
LANKFORD: Well, annuities are generally for retirement, and there are several different kinds of annuities. Variable annuities, which is one that has very large sales right now, are targeted towards people in their mid-50s to mid-60s, who are about to retire in about 10 years; and they worry about what might happen if there's a market drop right before they start to need the money.
Now, there's another kind of annuities, called immediate annuities. And those are for people who have already retired. They're in their 60s or their 70s. And you put a lump sum of money into that, and it starts to pay out immediately. But all of them are focused on some sort of retirement savings.
MONTAGNE: How, exactly, do they work?
LANKFORD: Well, the immediate annuities are the easiest ones to explain. And they're the ones where you put in the lump sum, and it starts to pay out. And because interest rates are so low right now, the payoffs are not particularly good, compared to how they had been several years ago. Right now, a 65-year-old man - if he invests $100,000, he'd get about $6,800 per year. And the older you are when you invest the money, the more your annual payouts are. So if you invest it at 75 instead, you'd get about $9,200 per year right now. And that's all based on interest rates.
If interest rates were to go up, people who invest that money then would get more for their annual payout. But the key thing is, you're locking in whatever the payouts are when you purchase the annuity. In order to get those highest payouts, the payouts will stop when you die. You can also get ones that pay out as long as you or a spouse live, or maybe as long as you live plus 10 years; and that will all lower your annual payouts. You have all these choices to make but in order to get the highest amount, those ones stop when you die.
MONTAGNE: That might be a very good idea for someone right at retirement - given interest rates in a savings account, which are usually like, .01 nowadays.
LANKFORD: Well, pros and cons. Unlike a savings account, you can't ever get that lump of money back. So that money that you're getting back, part of it is interest; part of it is return of your own principle. So, you know, at the end, there's going to be nothing left. But the key thing is, if you don't worry as much about what's going to happen after you die, but you're really worried about being able to pay those bills while you're alive, then this is one way to get that regular income - and especially if you don't have a pension coming in.
MONTAGNE: And, of course, that eliminates a lot of people who are concerned for a spouse or children, that they inherit something.
LANKFORD: That's true and that's you really need to set your priorities. And that's why there's several different kinds of annuities. For people who are interested in having some money in the end, or being able to access that money in a lump sum and in an emergency but still have guaranteed payouts, those are the people who are interested in what's called a deferred annuity. You invest a lump sum and they guarantee that you can access a certain amount of money every year, but you do have the flexibility in order to take that money in a lump sum if you need to. The deferred annuities are for the people, when they're 55 to 65 or so, who haven't retired yet, are trying to lock in some income.
MONTAGNE: And that group - those pre-retirement, near retirement group - that would be the baby boomers that we're talking about.
LANKFORD: That is correct. So the insurance companies are seeing that this is a huge potential market.
MONTAGNE: Just to be real specific about one thing, if someone has, say 30 or 50,000 dollars in a savings account for retirement - a retirement savings account - why not just put the money in a bond or a mutual fund - or just invest it in say, stocks?
LANKFORD: It's a good idea to invest some of that money in stocks, some in fixed income and have an overall portfolio. And that's the key thing. If you talk with a financial planner, they say, usually, a key thing to look at is what are your expenses in retirement, what guaranteed income do you have coming in - from a pension, from Social Security, and what is that gap, what do you need that regular income coming in that you have no guaranteed source of income? That's what they say should maybe go into an annuity, but then invest the rest of your money in stocks funds and bond funds, things that can grow for the future without the extra fees of annuities, because a lot of these annuities have some very high fees, so you really need to be careful about how you put this into the context of your overall portfolio.
MONTAGNE: Kim Lankford is a contributing editor with Kiplinger's Personal Finance magazine and a columnist for Kiplinger.com.
Thanks very much for joining us.
LANKFORD: Oh, it's my pleasure.
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MONTAGNE: You can read more about annuities at npr.org.
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MONTAGNE: You're listening to MORNING EDITION from NPR News. Transcript provided by NPR, Copyright NPR.