Do you remember the famous saying in the Popeye cartoons from the character Wimpy? His favorite food was hamburgers and he was known for saying, “I’ll gladly repay you Tuesday for a hamburger today.” Sounds like a good deal for Wimpy.
The moral of the phrase: People will unlikely pay you for the hamburger (or whatever) on Tuesday or any day, for that matter, once they get what they want. Unfortunately for investors, the world of annuity salespeople is also often filled with such promises. They ask that you move your money now in exchange for a better income later, and then they take the commission and run. This is a must-read for anyone who has ever considered moving their money into an annuity.
Today’s retirees are the first wave of American workers who are retiring without a traditional pension. Instead of defined benefit contribution plans, they have access to defined benefit contribution plans such as the 401(k), the 457(b), and the 403(b) or tax-sheltered TSA plans. These plans give employees a place save money where it can grow without being subject to federal or state income tax until it’s withdrawn.
Generally speaking, these plans have the following similarities:
- They allow you to grow your money tax-deferred.
- They have contribution limits set by the federal government.
- Investment options are limited to those chosen by the employer.
- They may have high administrative costs.
- They offer optional loans and hardship distributions for employees.
Problems arise when salespeople, brokers, or agents come in to talk to employees about moving their money into this fund or that in order to earn more money or guarantee an income. In a 2016 article published in the New York Times, one 66-year-old teacher was sold three different annuity products over the course of eight years, all of which paid out high commissions to the broker, and none of which she understood.
If you have dedicated your life to a chosen profession, then it’s unlikely you’ll have any training in financial matters. This makes it difficult to figure out which financial products or strategies are suitable income producers during retirement. Here is a look at the pros and cons of the annuity versus the typical stock and bond portfolio so you can decide for yourself: which is the right choice and why?
OPTION #1: THE STOCK AND BOND PORTFOLIO
Proponents of the stock and bond portfolio cite the low cost and potential for significant returns over time. Of the $5.02 trillion invested in 401(k) plans in 2017, $3.2 trillion are invested in mutual funds. Generally speaking, stocks are known for their high degree of risk in exchange for the potential for high returns. Bonds, on the other hand, are known for being safer as compared to stocks. The typical allocation of 60/40 divides a portfolio into 60 percent stocks, 40 percent in bonds, ideally rebalanced once a year.
- The Pros: For investors who are 10 or MORE years away from retirement, the stock and bond portfolio can be a useful accumulation tool. It bets on an improving market over time. As long as you are not withdrawing money from the account, then the portfolio has time to recover from the market loss.
- The Cons: As investors get closer to retirement, the risk of losing your money becomes more severe. Investors intuitively understand this without knowing why. Here’s why: the size of your ongoing contributions becomes dwarfed by the size of the returns your portfolio is earning. To take a hit as you approach retirement means to significantly reduce the returns you are able to earn.
Making It Work for You
Generally speaking, the impulse to seek greater safety is a good one. The problem is there are a lot of salespeople out there who can sell you safety. Guarantees come with a price. What happens if you don’t want to spend money on a guarantee?
The traditional way to get an income from a stock and bond portfolio is to make automatic withdrawals. Your broker or plan administrator can set this up for you. An amount is automatically withdrawn from your portfolio annually, usually 4 percent, and this amount is increased every year for inflation. For example, on a $100,000 portfolio, the investor would receive $4,000 the first year, which would then be adjusted to $4,120 the following year for inflation. There is no guarantee, however, that your portfolio won’t run out of money.
Critics of this method point to the low bond yields and suggest that a safe withdrawal rate might be closer to 2.8 percent. Ouch – that’s quite a pay cut.
Your other option is to work with an investment advisor who, for a 1 percent fee, can design a custom strategy for your portfolio to give you greater confidence. However, even with this option, there’s still no guarantee that the money won’t run out.
OPTION #2: THE ANNUITY
Proponents of the annuity cite its insurance against the risk of living too long and its higher income guarantees. An annuity is the only financial instrument that can guarantee you a paycheck for the rest of your life, no matter how long you live. It can also give you higher payments than what you could get investing on your own or with the help of a professional unless you’re willing to take on more risk.
Of the $1 trillion invested in 403(b) plans in 2015, 47 percent were invested in mutual funds, 26 percent in fixed annuities, and 27 percent in variable annuities. Studies have found that workers who retire with a guaranteed income are happier than those who retire without an income. Problem is there are so many different kinds of annuities on the market today that all of them have gotten a bad name.
- The Pros: For investors who are 10 or FEWER years away from retirement, an annuity can be a great way to grow your money without the risk of stock market loss. For example, deferred annuities (sometimes known as longevity annuities), can secure a smaller sum of money today for an even bigger income payment tomorrow. Using a typical deferred annuity, you could invest $100,000 at the age of 55, and then at age 75, you would receive an income of just under $4,000 a month for the rest of your life, guaranteed, no matter how long you live. If you get the right kind of deferred annuity and keep it simple, your fees will also be low cost – less than what you pay to manage the typical stock and bond portfolio.
- The Cons: Investors are often sold annuities without understanding what they are really getting. For this reason, they sometimes end up in the wrong annuity, paying expensive fees for features they don’t really need. For example, you don’t have to buy an income rider in order to get a guaranteed income from an annuity. You also don’t have to give up access to your money. One such annuity trap is the variable annuity. While it’s never correct to say that an investment is always bad, you would be hard-pressed to find somebody who would knowingly get into a variable annuity if they understood all the fees and regulations. Yet 27 percent of all people in 403(b) plans own them. Annuities are long-term contracts with surrender fees and penalties that can be pretty steep and last anywhere from five to 15 years.
Making It Work for You
There is a misconception out there that you can get a higher income payment by investing in a portfolio of stocks and bonds than you can with an annuity. The truth is, given today’s low bond yields, high market volatility, and increased life expectancies, it’s pretty much impossible to beat the payments you can get from a good annuity. A 2015 research paper by retirement income expert and former U.S. Treasury Department official Mark Warshawsky shows that annuities generally provide you with MORE lifetime income than what you could get by systematically withdrawing 4 percent. These investment vehicles were designed specifically to pay out income, so if income is what you need, then an annuity is the place to go to get it. Here’s why:
All annuities are backed by insurance companies. When an insurance company creates an annuity, they pool together the money from thousands of annuity owners. Your income payments are then derived from three different sources of revenue:
- The returns earned by the investment gains.
- A portion of your original investment amount.
- The mortality credits.
Mortality credits are basically the money that would have gone to an annuity owner who did not use them. A lot of people are turned off by annuities because when they pass away, they would rather that the money went to their family. If this is important to you, then you can shop around and find an annuity that offers this feature. They do exist but finding the one that gives you the benefits you need for the lowest cost possible is where most people need help.
Getting into an annuity is a long-term relationship, so you want to make sure you’re getting what you need before you buy. For your own protection, you want to work with an independent party who is not selling annuities for one particular company. Professionals who work independently are not restricted to the kinds of annuities sold by their firm, but rather they can help you shop around and compare the costs of different benefits and features to get the best annuity for you.
We hope this article has been helpful. If you still have questions about the best allocation for your retirement plan, reach out to a retirement expert for a complimentary consultation and one of our advisors will get back to you, no strings attached.