Unknown Annuity Questions

To begin, let me apologize for my long absence from this blog. I have been very busy making money, and today took the day off of handling my own affairs to assist my mother with some retirement planning. Which brings me to the purpose of this post.

The truth is, when I woke up this morning I had no intention of posting to the blog, but much to my dismay, I found some interesting issues when working with my mother this morning.

My mother is currently retired, and like many other members of the work force has amassed a great number of miscellaneous retirement accounts from various jobs and time periods throughout her life. For the past several months, we have been inventorying these plans, and then making decisions about what to do with them. Usually it goes this way: We find a plan of hers or of my fathers, decide whether to cash it in or keep it, then, depending on what we did in the previous step, either grab the windfall and buy something nice, or decide what we will buy when we eventually do get our grubby hands on that cash! Just kidding, but I couldn’t resist the humor, sorry, back to business!

I should mention that this has all been complicated by my father's sudden death at what would have been the end of his working years, and yes that's right, mom wasn't totally up to date with what was around to feed everyone for the next several decades.

Anyway, two of these plans are annuities with very small values, about $10,000 and $20,000 each, but they still must be dealt with appropriately. As all my readers know, I am not a big or little fan of annuities, especially as a tool for long-term investment, but we must play the cards as they are dealt. So with the interest of saving fees and reducing expenses in mind, I directed my mother to call the annuity companies and find out what fees and cost are involved should we decide to roll these funds over. Upon calling, she discovered that it was going to cost her almost $2,000 to roll these deferred variable annuities over into a regular IRA with a different investment company. Upon hearing this predictable message, I decided to call myself. First, I made a list of questions, one of which was "do these fees apply if my mother makes her withdraw/rollover after reaching age 59 1/2?" The larger fund answered "no," but only after asking me a variety of questions (one of which was "what is your mother's birth date") and then telling me only that it would cost about $1,500 to roll that account over into an IRA "as of yesterday's prices." I only found out about the waiver of fees at age 59 1/2 because I asked specifically if there was one!

Taken alone this could be seen a mere oversite by the customer service representative I spoke with on the phone, but I had the exact same experience when I called about the smaller plan that is with a different company. (Side note: She hasn't been in this plan for very long, so she must still wait 2 more years to avoid any fees, but again, they did not volunteer this information). I only learned she would not incurr any withdraw fees after reaching age 59 1/2 (and having 5 years in the plan) after asking that exact question. Both companies seemed content to let me make the rollover/withdraw and incurr the fees, even though my mother reaches age 59 1/2 in 6 weeks! So all I need to know now are the questions that I don't know to ask!

The Party Animal Saver

I recently got a call from an old friend of mine. We grew up in the same small farming town, attended the same secondary schools, and had the same friends growing up in that small town. Most, if not all of, the kids we had fun and games with still live in that same town. They never got out, and probably never wanted to.

My friend Steve and I both did. He joined the army and I went right to college. Steve saw the world and I learned about finance. We stayed in touch the entire time, and when his tour was finished he went to college on the GI Bill. It covered most of his expenses, and what it didn't cover he earned, working the midnight shift driving the campus bus. Steve initially studied English Literature, but in the eleventh hour switched his major to Engineering.

Steve's grandfather had been a coal miner in Pennsylvania. Talking to Steve, you can get a glimpse of that hardworking, solitary, risk-taking whim so often seen in men and women who put their lives at risk for the hope of a better future. I think it was that same impulse that drove him into the military, and ultimately, by the time he finished his tour of duty, to being the longest serving soldier on the DMZ between North and South Korea. He is an extremely intelligent, loyal, and hard working individual.

He also loves to party all night. He is completely disorganized: forgets to pay his bills, loses his wallet and keys constantly, spends every dime he brings home well before its time, and spills his coffee all over whatever electronic gadget he happens to have on his desk.

The occasion of his recent call was to tell me he had just been given the opportunity to move to Columbia to open the new South American branch of his engineering firm. He's been working at the firm since he graduated from college about 8 years ago, starting out as a grunt and steadily promoted to managing the Philadelphia office of his firm.

When he did start at the firm all those years ago, he had a conversation with an old army buddy who had attended the University of Virginia after completing his tour, and now worked on Wall Street. Steve's friend told him "Look Steve, you're basically an animal, and anything you bring home you are going to immediately devour. Do yourself a favor: max out whatever retirement plan options you have through your employer, and send $200 a paycheck to an account at ING Direct (who at the time was paying the highest yield). You won't miss it if you do it right from the start, and you won't know what you spent your take home pay on anyway." Steve's army buddy went through the process of helping him set up these two accounts, and since that day it has been on autopilot.

Steve hasn't withdrawn anything from his ING Direct account since he opened it, and I don't think he even looks at his 401k statements. To him, it's all money in the bank that he won't need for a long time, but when that time comes he should have plenty of it. I think when he started working the 401k max was $12,000, assuming he never raised it and a 9% rate of return, he probably has about $145,000 in his retirement account. Assuming an average rate of 4% on his savings account, at $200 a pay and 24 pays a year, he likely has about $40,000 in the account. Not bad for a guy who spends every dime he brings in the door! Even more impressive, at this rate, in another 8 years, he'll have about $430,000 in his retirement account and $108,000 in his savings account. Talk about a reason to party!

Steve is a good example of someone who is using the modern tools for wealth building that are available to everyone. These are tools that barely existed for the baby boomer generation, and did not exist for their parents. Unfortunately, too many people in our generation, the generation who will soon be the powerhouse of our economy, are uninformed and underutilizing these tools. As a result, they will be working long after the 'Steves' and 'me's' of the world have left working for new fun and games. Only this time it won’t be a small country-farming town, it’ll be on a South American beach!

The Roth IRA

The Roth Individual Retirement Account was created by an act of Congress. The Roth allows for post tax contributions that can be invested in a number of ways, the most common being mutual funds and stocks. Almost any financial institution provides Roth IRA accounts. Banks, brokerage houses, and insurance companies offer certificates of deposits, money markets accounts, mutual funds, and stocks. Considering the long term outlook of most Roth Investors (the funds cannot be accessed tax free until age 59.5), it probably doesn't make much sense for Roth account holders to invest their dollars into anything other than stocks and mutual funds that have a reasonable amount of risk and reward potential.

Contributions to a Roth are made post-tax, therefore, unlike a Regular IRA, contributions to a Roth are not deductible on your tax return. The advantage is that withdraws from a Roth, so long as they qualified, are completely tax-free. Qualified withdraws include those made after age 59.5, up to $10,000 for the purchase your first house, or if you become disabled. A Roth IRA effectively allows you to prepay a future tax liability at a tremendous discount. This is true for two reasons:

First, taxes in the future will very likely be higher than they are now. As the population ages, and there is a smaller percentage of people in the workforce, but a greater demand made on the government for services to support the aging, taxes will need to be increased to pay for this increased demand and lowered supply. Think of the welfare states of Western Europe. Their taxes are a much higher percentage of income. They offer more services, like free health care for all, have greater unemployment, and have a larger percentage of elderly and retired citizens.

Second, the money you invest now in a Roth IRA will grow and you will experience compound returns, so if you're 30 years old and make a $5,000 contribution in 2008 that you have already paid taxes on, when you withdraw that money at age 60, that same $5,000 is now worth $66,338 (30 years at average 9% return per year). Further, even at a 25% tax rate (and believe me the tax rates in 30 years will be higher, not the same and definitely not lower than they are now) that $66,338 is effective worth the same amount as earned taxable income of $88,459. But you paid taxes on $5,000! And at a lower rate!

Beginning in 2008, Congress has allowed contributions of up to $5,000 for taxpayer’s age 49 and younger, and $6,000 for taxpayers age 50 and older. After 2008, contribution limits will be indexed with inflation and raised at $500 intervals. There was a lot of talk for years in the financial services industry that the Roth was too good to be true, and that Congress would eventually be forced to close this opportunity to taxpayers. That has not happened yet, but most Americans do not take advantage of this powerful tool. As both the Roth IRA and the Roth 401k gain in popularity and the pool of taxable income continues to shrink, it's anybodies guess what the future holds.

Annuity Puzzle

I don't like to invest in anything I don't understand. I think the greatest investor of our time, Warren Buffett, has expressed similar sentiments from time to time as well. So if a brilliant investor like Warren Buffett won't put his money where his brain can't get to, why should you or I?

What I'm talking about are annuities; variable, fixed, deferred, immediate, purple, and pink. There are so many different types of annuities all packaged differently from different insurance companies and sold under different names, it is very difficult to understand which would be most appropriate, if any, for your portfolio. This confusion leads investors (the purchases of these products) to ultimate confusion and into the arms of a perhaps untrustworthy "Investment Advisor" aka insurance salesman.

Many "Investment Advisors" will direct their clients (prey) into these products with promises of tax deferral heaven, compound returns, and the big S - safety. I'll do my best to rebut all of these benefits here, but please keep in mind that this is merely the tip of the annuity iceberg, and that each annuity contract (yes ladies and gentlemen, an annuity is a contract, and if you break its terms, guess what, you bought it, and it will cost you substantial fees) is very different and needs to analyzed on its own merits.

Tax deferral heaven. Annuities allow purchases to defer taxes on earnings and interest until the money is taken out of the annuity. These tax savings are therefore allowed to continue to compound over time, and increase overall earnings. But here's the rub, those deferred taxes, when paid, are paid out as income taxes, rather than the much lower capital gains rate your earnings would be subject to if, for example, you had simply invested at retail (sent the fund company a check directly) in an index based mutual fund. In addition, most experts agree that taxes will be higher in the future than they are today, so you will be paying at an even higher rate. As an aside, this belief that taxes will be higher in the future is what makes the Roth IRA such a powerful tool.

Compound returns. Yes its true that your annuity money will earn on its earnings over time, and you will experience compound returns, however, those compound earnings will in no way compare to the compound earnings you could have earned historically in the United State stock markets, and again if historical results are any guide (who else can guide us?), you will end up with considerably less money than if you had simply invested in that previously mentioned S&P 500 Index fund.

The big S - safety. For example, most deferred annuities will guarantee at least a very low rate of return, like 3%. They will also very often guarantee that your annuity contract will be worth at least the amount originally invested when you begin to take disbursements many years later. They will also charge you a tremendous amount for these insurances. There is often a 1-2% (of the total value of your annuity) charge for guaranteeing survivor benefits, a .1-.3% charge to guarantee a stated growth rate for death benefits, fees for waiver of withdrawal charges (a fee to waive a fee! What a terrific idea!), and a fee for something known as 'total protection.' If you feel confused, you're not alone. The important truth here is all of these fees work to reduce your earnings, and therefore the amount that is available to compound. Are you really safer with less money? Too little risk is very dangerous!

Annuities are insurance products. Your money is usually invested in the same types of instruments that you could invest in yourself, again like that S&P 500 Index fund, only there are at least two more sets of hands in the money pot: the insurance salesman aka "Investment Advisor" (who is often an independent broker who works on commission), and the insurance company. They both need to get paid for their services, and they both get paid from your money. With so many hands in the pot, someone will be left short, and it won't be the mutual fund managers who get a fixed percentage of the monies they manage, it won't be the salesman who gets a fixed commission for selling you the annuity, and it won't be the insurance company who gets paid by insuring your money against all future catastrophe, it will be you!

Annuities are appropriate for some portfolios at some times, but they are a highly commissioned financial product, and are largely oversold for this reason. Please remember that a financial advisor has a great deal of interest and incentive in persuading you to purchase one of these products. If you are considering an annuity of any kind, make sure you understand all of the fine print, even if your financial advisor does not.