Retirees who want to supplement their Social Security and pension income can look to their savings. They can invest those savings to generate an income or they can annuitize all or part of them. The annuity – as an insurance product – can offer a lifetime income. But are annuities safe? Well, that all depends on what you need to be safe from? 

Because annuities are insurance products, insurance companies can guarantee a lifetime income. Their vast number of annuity contracts allows mortality statistics to govern predictable payout obligations as a whole. So, these insurance companies need only keep their funding, investments, and finances in good order for the duration of their payout obligation to you for your safety.

AM Best and others monitor each company’s ‘financial health’. But companies can potentially fail their obligations – although this possibility is generally low. If you start with annuities that have a safety rating of A+ form AM best and AA from S&P, your annuity safety will be high.

Retirees either want to begin annuitization (getting monthly payouts) right away or delaying it until there much older. The latter option is a form of insurance against running out of income due to living too long. These days, retirees have a 50% chance of living longer than 20 years once they turn 65. So, the projected duration of any annuity contract is a significant amount of time – if you’re healthy. Note also that lifetime annuities generally leave nothing for beneficiaries.

Annuities come in two essential flavors: fixed annuities and variable annuities. For fixed annuities, the insurance company pays you a constant income for life. The contracts rely on long term interest obligations from high grade bond investments to assure your constant income.

The benefit of a fixed annuity is your assured of this lifetime constant income. But living 20 years will allow even minor inflation rates to significantly erode the value of that income.

Payouts from variable annuities – and these include indexed annuities – are vulnerable to market variations. These also can give you a lifetime income – but one that continually varies. That’s because their funded by stocks and mutual funds and other similar investments whose values fluctuate. Such investments may compensate for inflation.

Although a rising economy can increase your payout, a downturn can significantly erode the amount of payout you get. So, variable annuities leave you vulnerable to market variations – which will occur.

It appears that choosing a fixed annuity offers more safety for the retiree who needs to rely on savings’ income. He may have to risk the threat of inflation.

Those that can afford more investment risk, might consider a variable annuity. But for the possibility of a retirement cut short, a better approach may be to split his savings - put part into a fixed annuity and judiciously invest the rest for growth.

Note that annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

If you are considering an investment in any type of variable annuity please carefully consider investment objectives, risks, charges, and expenses of the Variable Annuity and its underlying sub-accounts before investing. For this and other information about any Variable Annuity investment, always obtain a prospectus and read it carefully before you invest.

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Medicaid picks up the long term care cost of elderly who are impoverished.  Long term care is very expensive and can eat up savings fast. The elder may not be able to leave a legacy to their children.

Medicaid is a federal program but handled at the local level by your State. State restrictions and regulations on Medicaid vary so you always need to be aware of your own states’ Medicaid policies.

Nevertheless, simply giving your assets away and then immediately applying for Medicaid is unacceptable under federal rules . To be safe you need to irrevocably transfer assets 60 months prior to applying. Anything shorter will prompt your state Medicaid office to attribute those assets to you and require you to pay your Medicaid monthly rate (state dependent) until all those assets have been exhausted. Only then will Medicaid foot the bill.

If you still have substantial assets, you can protect some assets for your spouse but you must strictly abide by rules for Medicaid eligibility. Here, a Medicaid annuity may be used.

A typical scenario would be if one spouse needs long term care costs to be covered by Medicaid. The couple must then divide all their assets in half and the spouse needing care must spend his or her half of the assets down to less than $2,000 in order to qualify for Medicaid benefits. But this loss of assets may reduce the standard of living for the healthy spouse at home.

So, Medicaid will allow the spouse needing care to convert his or her share of the assets into an income annuity that belongs to the healthy spouse. This legal strategy provides the healthy spouse with more income and avoids the impoverishment imposed by the Medicaid spend down requirement. These annuities must meet strict rules  imposed by Medicaid and you should seek a legal expert in this area to help you.

You can also prepare for Medicaid qualification by investing in a deferred annuity anticipating its eventual conversion into guaranteed income before applying for Medicaid. These deferred annuities should be designed so that the policy can be turned into a guaranteed income stream for either spouse of a couple. That income stream should go to the healthy spouse — the one not requiring Medicaid assistance.  In some cases, the annuity strategy can even benefit a single person.

Note that annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments.  Use of annuities as a Medicaid planning tool is regulated by each State with their own rules and a qualified advisor should be consulted. Annuities are insurance products and are subject to insurance related fees and expenses.

  http://www.medicare.org/content/view/20/67/ ‘Medicaid pays for health services for the very poor of any age. Qualifications for Medicaid vary by state, but generally the law says you must first spend down to the poverty level, using up all but about $2,000 of your assets.’
  (Section 1917(c) of the Social Security Act; U.S. Code Reference 42 U.S.C. 1396p(c)), http://www.cms.hhs.gov/MedicaidEligibility/10_TransferofAssets.asp#TopOfPage
  Medicaid guidelines for the use of annuities, which clarify OBRA ‘93, have been published by the Health Care Financing Agency. See your state rules for current restrictions.  http://www.hcfa.gov/medicare/medicare.htm

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Asset protection is an important consideration when deciding on retirement investments. One investment of particular interest to retirees is the fixed annuity. Annuities are geared to protect you from running out of income while you’re living.

But because a fixed annuity is an insurance product, it has special protections afforded insurance over the years. So, beyond protecting a lifetime income for you let’s, summarize some other protections that a fixed annuity offers you.

 While you’re living, a fixed annuity offers you 3 protections. They are protection from

·         Market fluctuations: Because fixed annuities offer guarantee of principal and an interest. You’re protected from the loss in principal and earnings that stock and bond market investments are vulnerable to.

·         Current taxation of annuity earnings: Since fixed annuity earnings are tax-deferred, they’re not reported on your tax forms. This keeps your fixed annuity investment off your tax records until you withdraw money from them. This affords you a privacy feature.

·         Lawsuits:  Annuities are generally[1] not liable to attachment or garnishment in favor of any creditor of the person insured under the contract,. i.e. annuities offer creditor protection

Because your annuity is a contract with an assigned beneficiary, it gives two more protections when you die. They are protection from

·         The probate process: Your fixed annuity investment transfers immediately to your beneficiary. This minimizes costs associated with probating this money, avoids its characteristic delays, and keeps the transfer of this money private – another privacy feature.

·         Contestability: No one may contest your decision as to who will receive your fixed annuity benefits at the time of your death. Assets subject to your will can rightly be contested.

 Curious about how much fixed annuities pay? See current rates on the fixed annuity calculator.

Note: Fixed annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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[1] These are state-related issues. Check with your state laws; as an example: Florida Statute 222.13 states: “whenever any person residing in the state shall die leaving insurance on his or her life, the said insurance shall inure exclusively to the benefit of the person for whose use and benefit such insurance is designated in the policy.”

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A $100,000 5yr-CD paying  5% gives you an annual taxable income of $5,000. At a 25% income tax rate, you’re left with $3,500. Of course you’re also left with your $100,000 too.

But if you need more income, and you don’t want to get locked into any current income rate, you may consider investing your $100,000 into a set of annuities. Laddering these (i.e. stagger when begins its income stream) allows you to follow income rates if they go up (or down).

Laddered Annuities Option
We’ll assume you’re 70; and with your $100,000, you buy 5 annuities each for a single premium of $20,000. The first will be a Single Premium Immediate Annuity (SPIA) for a 5 year payout term. The four others will be Single Premium Deferred Annuities (SPDA) geared to produce a payout after 5, 10, 15, and 20 years respectively. Let’s consider what sort of income you’d generate in this case. Refer to the table. These are hypothetical examples and all fees have been ignored (immediate annuities usually don’t have fees as they are already included in the income stream).

You can see under the SPIA 5 year certain payout  that you’d receive $4248 income giving you an after tax (25% income tax rate) of $4,186. This beats out your CD net income, although all the money in this SPIA is gone after 5 years. But, you’re still accumulating savings in all the other SPDAs.

I’ve assigned a hypothetical accumulation interest rate of just 4.5% - safely under the CD’s rate. And I’ve kept the rate constant over time as a neutral scenario. Increasing (decreasing) rates would affect both the annuities and the CDs together.
 
You can see what the (neutral) projected values of the 5, 10, 15, and 20 year SPDAs would be when they become due as you turn 75, 80, 85, and 90 respectively. Along with these values are the projected income they’d produce  (based on current payouts) for both a 5 year term payout and for your remaining lifetime – if you chose the latter.

As you approach age 85, you may decide to choose a lifetime income from the next SPDA, and leave the remaining SPDA as a legacy for your beneficiary.

By annuitizing your assets, you have more income to live on.  You can use the fixed annuity calculators to see the figures for yourself. 

Note: With tax deferred investments, income taxes may be due upon withdrawal of funds, withdrawals prior to age 59½ are subject to a 10% penalty, the rate of return above is hypothetical and does not reflect the return of a particular investment and the values shown should not be used to project future income. This table refers to hypothetical investments only and is not indicative of a guarantee of any particular investment results. There are no fees or expenses in the annuity illustrated, but if they were present, they would reduce performance.  Earnings withdrawn from an annuity are taxed as ordinary income.  Note that many differences exist between CDs and fixed annuities such as the FDIC insurance which applies to CDs but not to annuities or bonds, the fact that annuities may have surrender charges or expenses associated with them, while CDs may have early withdrawal penalties and the fact that the term of annuities often exceeds the terms of CDs. While CDs are FDIC-insured, annuities are guaranteed by the claims paying ability of the insurance company. Additionally, the purchase of annuities may incur commission and annuities may not be as liquid as CDs. Annuities, once annuitized, cannot be surrendered for value.

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A single premium immediate fixed annuity (SPIFA) gives you a fixed monthly payment for the term of the annuity. That term may be a certain number of years or for the remainder of your life.

The amount the insurance company will pay you depends on the amount of premium you pay and prevailing interest rates in addition to expenses and your life expectancy if it’s a lifetime payout.

Companies will quote you their monthly payout to you but not the interest rate (interest rates on immediate annuities are typically 2%-4%). Nevertheless, since all earnings of the company are dependent on interest-based investments, higher prevailing rates will allow them to make higher monthly payments – and vice versa.

Earnings and taxation of your investment
What you earn is the excess of payouts over the premium you pay. Every payout is considered part earnings and part return of premium. The fraction of each payout that’s taxable is the ratio of the total excess payout to the premium.

To illustrate let’s take a hypothetical example of the payout over a 10 year term certain to illustrate both taxation and the effective interest that produces earnings. We’ll use the average monthly payout quote  based on 16 insurance companies for a $50,000 premium for a 10 year payout term for a 70 year old man. This average quote is $515 per month. Prevailing  interest rates at time of this quote are 3.30, 3.48, and 4.06 % for 1 yr, 5 yr and 10 yr US treasuries respectively.

The total payout over ten years is $61,800. So, the earnings on the premium investment is $11,800 which is the excess received over the premium paid. That’s an earnings of 23.6% (= $11,800/$50,000) –but over ten years!  Of each payment, only 19% is taxable because of the way IRS taxes immediate annuities.

The example shown above is strictly hypothetical based on the assumptions described and is not representative of an investor’s actual earnings or tax consequences.
 
Your effective interest rate
Because the annuity company’s constant payout schedule returns both earnings and premium payments back to you, it can only earn interest with the premium payments it retains. In the beginning it has most all the premium to earn interest with. But this decreases linearly to no premiums left at the term’s end.  Equivalently from an averaging point of view, we can consider the annuity company having only half your premium for the whole term to earn interest while the other half goes back without earnings to bolster the payouts – as is the annuity’s purpose.

So, we can deduce the “effective interest” the man earned by assuming only $25,000 (half his premium) did all the earning of the $11,800 excess payout over the 10 years. A compounded annual interest rate of 3.72% applied to $25,000 will increase it by $11,800. To see the numbers for your situation, use the immediate annuity calculator.
Note that annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments.

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Not knowing when we’ll die means making sure we arrange our finances to produce income for as long as we live. Aside from being able to live off just the earnings of our investments, only social security, pensions and annuities can pay you a lifetime income.  We would all like to have jut enough money to last until our last day and die broke.  While that seems like a wild idea, it’s doable.

Social Security gives you a lifetime income because the government can compel taxpayers to pay for it. And, if things get tight, they can print the money necessary to pay you.  And it stops the day you die.  If you do get a pension, it’s likely being paid by an insurance company in the form of an annuity.  As long as the insurance company remains solvent (large companies such as Prudential and New York LIfe lent money to the federal government during the Depression), you receive income for life that stops the day you die. If you like that idea, making optimal use of your money while your alive and then dying broke, you can also create your own private pension. 

Insurance companies – generally being more fiscally responsible than the government – use the voluntary premiums of thousands of annuity holders, the premium earnings, and the statistics of mortality to assure everyone a lifetime income. Using an annuity has some other advantages for you, too. Let’s look at a few.

The application advantage

Unlike life insurance, you generally don’t need a health exam to buy an annuity. Life expectancy for annuity payout purposes is determined by insurance company experience and not as a result of a physical examination.

The later payout advantage

Because of the nature of mortality rates, beginning your annuity payouts later mean your monthly payout increases for the same investment amount. So, the longer you can hold off receiving payments, means you need less investment money to achieve the same monthly payout.  If you have a joint and survivor annuity, two lives are used in the calculation and the amount of the payout is smaller than with a single life contract.

The tax advantage

During the accumulation phase of a deferred annuity, your investment grows faster because its earnings are tax-deferred. You pay income tax only during your annuitization (payout) phase – and then only on what hasn’t been taxed.  

If you purchased an immediate annuity – payouts start in about a month - with after tax money, only the earnings of your premium during the payout phase is taxed. This is a relative small fraction of each payout. If you’re able to outlive the mortality projection, you’ll receive a lot more money over and above your single premium payment.

If you purchase an annuity within your IRA, your payments must meet the Minimum Required Distribution (MRD) rules after you turn 70½. All of each payment is taxable income. The IRS has life expectancy- based table for determining the MRD amount. But with people living longer, this table is becoming dated. So the IRS will accept[1] a ‘lower’ MRD based on the insurance companies longer remaining life expectancy. 

To see if you can die broke and enjoy every last dime while your kicking, consult the immediate annuity calculator.

Note: Annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

[1] www.irs.gov/publications/p590/ch01.html#d0e1252, Special rules apply if you receive distributions from your traditional IRA as an annuity purchased from an insurance company. See Regulations sections 1.401(a)(9)-6 and 54.4974-2. These regulations can be found in many libraries and IRS offices.

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A deferred annuity offers a distinct tax-benefit. It’s earning grow tax-deferred. For the same annual return as a taxable investment, a tax-deferred investment compounds faster because none of the earnings are taxed away each year. However those tax-deferred earnings will eventually be taxed upon withdrawal, whether by you or the annuity beneficiary. Your contributions to the annuity, though, will not be taxed. This is the case in ‘nonqualified’ annuities which are funded with after tax contributions.

Annuitant’s taxation
If a partial withdrawal is made, the IRS presumes that earnings come out first – so that these are completely taxable. But under regular monthly payments – a portion of each payment is not taxed but treated as a return of your nontaxable contributions. An exclusion ratio calculated by the insurance company designates that untaxed portion. When, after some number of payments and you’ve received all your contributions, all future payments will be fully taxed as income.

Beneficiary taxation
After tax contributions made by the deceased owner will remain  untaxed when received by the beneficiary. And of course, all those tax-deferred earnings within the annuity will be taxed as ordinary income to the beneficiary.

Usually, if the annuitant had begun receiving lifetime payments, no benefits would be left for the annuity beneficiary. But if the contract called for a fixed term guaranteed payments, the beneficiary would received those remaining payments taxed at the deceased’s exclusion ratio.

If the annuity owner died before beginning annuitization, provision may be made for either a lump sum distribution or a series of payments. For the lump sum payment, the beneficiary would only pay tax on the earnings portion.

But in the case of a series of guaranteed payments, the beneficiary would not be required to pay taxes on any of the payments until the deceased owner’s contribution were fully received. Any payments beyond that would be fully taxed as ordinary income.

An annuity beneficiary, who earns a substantial income already, can lose a lot of that taxable portion of the annuity as he’s pushed into a high tax bracket. So, if annuity owner decides not to annuitize, he may use his annuity’s value to switch to another option better suited to his beneficiary.

Note: Annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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The secret to growing your investments is its compounding rate. The higher it is, the faster your investment grows. But that’s only half the story. Increasing the compounding rate from 6% to 8% will produce more than that 33% increase in your investment over the years -see first table. That’s the magic! And that’s why tax-deferred investments are such an advantage. Let’s take a look at some results…

Taxable accounts are those that generate interest or dividend earnings that are subject to annual taxation. If your investment return is 10% and your income tax bracket is 28%, then 28% of that 10% (i.e. 2.8%) of that investment return is lost to taxation. This leaves only 7.2% (rather than the full 10%) as the compounding rate of that investment.

But tax-deferred accounts suspend yearly taxation of such earnings. So, no taxation would reduce the 10% investment return and it would remain the compounding rate.

Recognizing taxation’s effect on compound rates, we’re interested now in how much higher an earnings rate must a taxable account have to match the growth of a lower earnings tax-deferred account. And this depends also on the tax bracket of the investor.
 
This is important to retirees who may be interested in putting money aside to purchase an immediate annuity in later years in case they live longer than the expected. Should they put their money in secure investments like treasury bonds or in a deferred annuity to grow for the day they’ll need it. Often, such secure investments grow through earnings that are subject to yearly taxation – as are bonds. They need a basis for comparing the growth rates of different investments.

Your tax bracket determines the tax rate on those extra earnings you receive. So your bond interest earnings would be added to your normal income – from part-time work, your pension, and possibly your social security if taxable and be subject to your (highest) tax bracket. The tax brackets range from 10% to 35%.

The table shows what taxable earnings rate (i.e. subject to yearly taxation) you must receive to achieve a compounding rate equal to the tax-deferred earnings rate based on the tax bracket those taxable earnings are taxed at.

Want a quote on deferred annuities’ earning rates? Just use the deferred annuity calculator.

Note that annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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The fixed term SPIA solution
Use a single premium immediate annuity (SPIA). In this case we’re looking at a fixed term SPIA where you purchase the SPIA for an immediate payout, but only for a fixed term – perhaps 5, 10 or 15 years.

The idea is to buy the fixed term ingle premium immediate annuity with only 50% of your savings. The term you choose depends on how much extra assured income you need and what you plan to do with your other 50% of savings. Let’s see some examples for this approach.

New retiree – getting adjusted
Take this hypothetical example. If you’re a 66 year old man beginning retirement with $400,000 in savings but no company pension, you may want to complement your Social Security income with single premium immediate annuity income while you pursue some endeavour for the first 10 years of your retirement. But you don’t want to lose control over your assets for later alternative choices.

As an option, you could purchase a 10 year term single premium immediate annuity that would pay  you $2,084.01 per month to supplement your social security benefits for about $200,000.  This would leave you with $200,000 in savings that you can invest to grow over the next 10 years. With the assurance of the annuity income, you can invest this remainder of your savings more aggressively.

Investing at a hypothetical 7% or 8% growth rate may allow you to recover your $400,000 over those 10 years if things go as intended.  The growth you can reasonably expect will depend on your choice of investment and if that money is in a tax-deferred account. The latter would allow you tax-deferred high income investments.  Or, you could buy a deferred annuity at a guaranteed rate. But, you’re in control of those assets.

Older retiree – worrying about a legacy and living expenses
Let’s consider another hypothetical example. Let’s take an 80 year old woman with $200,000 in savings and a house with no mortgage. She’s drawing down her savings at about $2,000 per month and is worried about depleting her savings and losing her legacy for her children.

She could purchase a single premium immediate annuity for a fixed term – perhaps 10 years - with a fraction of her savings to pay the monthly drain on her savings. And, invest the remainder in a deferred annuity to grow for later use or as a legacy. Her house’s equity can also be a source of income under a reverse mortgage if necessary.

Note: Note that annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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The IFA gives you a guaranteed but fixed payment – generally monthly for your lifetime. That’s because the underlying annuity investment relies on long term bond investments purchased by the insurance company. But in twenty years the purchasing power of that fixed monthly payment may be significantly less due to inflation.
 
The IVA also offers a lifetime (monthly) payments, but those payments will vary. That’s because the underlying annuity money is invested in the subaccounts that fluctuate with the underlying securities (e.g. stocks and bonds). The attraction of the IVA is based on the hope that over time, the investment markets will rise and help offset inflation by producing larger monthly payments. The danger is that the stock market can go into a slump and reduce those payments.    

With the IVA, you can change how your annuity is invested among subaccounts associated with it. You can also opt for a guaranteed minimum payment despite how far down the market goes and your subaccount investment earnings fall. But that kind of guarantee will add to the cost of the contract.

If you’re especially concerned about future inflation, perhaps you’ve got a better option than locking yourself into an IVA. Instead of investing all that ‘annuity’ money into an IFA, just invest a portion – perhaps half of it. Then invest the remaining half in a conservative mix of bonds and stocks that’ll potentially generate both growth and earnings.

Use only the earnings of this that you need. This gives you more control of your investment money with your own guaranteed minimum from your IFA. Years later you can always opt to invest the balance into an IFA too. Your increased age alone will produce a higher monthly return for yourself because the later in life you start your annuity payments, the larger the payments.  You can see how this works with the immediate annuity calculator.
Note: Annuities once annuitized cannot be surrendered for value.  Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty.  Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

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