Other highlights from this webcast
- What are the different types of annuities?
- How to decide if an annuity is right for you
- What you should know about annuity costs
- Learn about income annuities
- Learn about Vanguard low-cost annuities
- Annuity withdrawal options
Akweli Parker: Hi, and welcome to our live webcast on annuities. I’m Akweli Parker. Now if you’re near retirement or maybe in retirement, you’ve probably heard of annuities, and perhaps you’ve wondered about how they work, how people use them, and whether you should consider buying one. Well tonight we’re going to answer those questions and more. Here to help us with that are two experts on annuities, Danielle Corey, who leads Vanguard Annuity Insurance Services and Stephen Weber, a Certified Financial Planner professional with Vanguard Investment Strategy Group. Danielle, Stephen, welcome and thanks for being here.
Danielle Corey: Thank you.
Stephen Weber: Great to be here.
Akweli Parker: Now we’re going to spend most of our webcast answering questions from you, our audience. But before we begin, there are two quick items that we’d like to point out. There’s a widget at the bottom of your screen for accessing technical help. It’s the blue widget on the far left. And if you’d like to read some of Vanguard’s thought leadership material that relates to tonight’s topic or view replays of past webcasts, click on the green and white Resource List widget on the far right of the player. Sound good?
Danielle Corey: Sounds great.
Stephen Weber: Great.
Akweli Parker: All right, fantastic. But before we get into our discussion, we’d like to ask you in our audience a question. On your screen right now you should see our first poll question, which is, “Do you own an annuity?” Now your options are, “yes, no, or no but I’m considering it.” So please just take a second right now to respond, and we’ll share your answers in just a few minutes.
Now while we’re waiting for those results to be tabulated, why don’t we go into our previously submitted questions, and thank you to our viewers for sending these questions in advance.
I want to give this first one to you, Danielle. It comes from Nancy in The Villages, Florida, and asks for us to please explain the various types of annuities.
Danielle Corey: It’s a great place to start, Akweli, because there are different types of annuities. So setting that as a baseline up front is a great idea. The different types of annuities all have one thing in common, and it’s they’re all a contract between an insurance company and a client. But they may have very different purposes that could range from accumulation and growth to a stream of income.
So there are four main types that I’ll cover briefly, and then we’ll go into those in more depth throughout the rest of the webcast. First is income annuities. So you can think of these as sort of like a personal pension that people can purchase. It provides a stream of income, either starting immediately or could be deferred for several years, and the income could continue for someone’s life and after a set period of time.
The second type is a variable annuity, and this is a type of investment option that allows folks to have additional tax-deferred savings primarily, so very different than income annuities. In this instance a client would be selecting from different sub-portfolios, choosing investments, and then the value of their variable annuity contract is going to be based on the investment performance of those sub-portfolios.
Now folks may be able to purchase riders or additional benefits on that variable annuity that allows for some sorts of guaranteed benefits on top of the variable performance. But that’s the variable annuity in general.
The third type is a fixed deferred annuity, and folks can think of this as a fixed interest investment from the insurance company, kind of similar to a CD, only it’s backed by the insurance company as opposed to the FDIC.
And the final type is an indexed annuity. This type of annuity provides market-linked growth but also protects for the downside.
Akweli Parker: Got it. Well, it appears that our poll results are in, so let’s see how you responded. The question, once again, was, “Do you own an annuity?” And it appears that about 25% said yes, 45%, 46% responded no, and then 28% said no, but I’m considering it. So almost half of our respondents said that they do not know own an annuity. Any surprises there or what do you think of those results?
Danielle Corey: No, you know, I think not overly surprising, and it’s great to hear that a portion of the folks are thinking about potentially purchasing an annuity. Hopefully we can provide some information to help them tonight.
Akweli Parker: Great, great. So let’s dig a little deeper and ask our audience once more poll question. This time we’d like to know if you purchased an annuity, why did you purchase one? So your options are: to receive income, to save for retirement, to defer taxes, to diversify my retirement investments, or, of course, you can answer I do not own an annuity. So please just take a quick second now to respond, and we’ll get to your answers in just a few minutes.
All right, why don’t we go back to our previously submitted questions. This one comes from Catherine in Bethesda, Maryland, and she wants to know when and for whom are annuities a good idea? Now, Stephen, we talked about this a little bit, so why don’t you take this one.
Stephen Weber: Sure. Getting back again to what Danielle was saying, you’ve really got to think about annuity as two different kinds of things. There’s the annuity that’s an investment and an annuity that’s an income stream. The annuity that’s an investment is, when we asked the question when and for whom are they a good idea, the answer is not very often and for not very many people. There’s a few instances where if you’re really looking for tax deferral and you’ve used up your 401(k) and your IRA and the other vehicles that you might use to get tax deferral and you’re a high income type earner, an annuity may be appropriate as an investment in that situation or maybe not.
When you talk about as an income stream, however, there really is a lot more general applicability. Almost everyone who saves for retirement, one of the reasons that they’re saving for retirement is to get income. So one of the most efficient ways to get income from a portfolio is to purchase an income annuity. So if you ask yourself the question if I really needed to, I could live on as little as, fill in the blank number, right? And you could ask yourself, “Well, do I have the income that gets me at least that far?” Through my Social Security, through pensions that I have through my employer, any other types of guaranteed income sources. If your answer to that question is yes, then there’s a good chance you don’t even, that you wouldn’t need or really even consider an income annuity. But if the answer to that question is no, you have money that you’re going to need to spend anyway, and an income annuity might be a good way to do that. And I’m sure as we go through this webcast, we’ll get more into the reasons why it might or might not be appropriate.
Akweli Parker: Absolutely, absolutely. I really want to take this question from Paul in Verona, Wisconsin, and he asks something that I think is on a lot of people’s minds. He wants to know, “Don’t most annuities charge excessively high fees?” What do you think?
Danielle Corey: So it’s a great question, and as you mentioned, it’s atop of a lot of folks’ minds. In fact, I think for the signup for this webcast, we asked people to just plug in one word that you associate with annuity. I think the number one word association was income, but a close second was costly, excessive fees, commissions, things of that nature. So definitely on a lot of people’s minds, and I think it’s fair for folks to be skeptical about the different charges that they might incur with an annuity.
And I think the first thing to cover is that the insurance costs associated with annuities do lead to higher fees than typically Vanguard clients are used to paying on a mutual fund, in an IRA, or a taxable account. The question is how high are the fees, and depending on the product, are those fees fair?
The fee structure can be very complex, so if you’re considering an annuity, it’s important to make sure you’re really understanding what you’re paying. Are there also going to be redemption fees or, in annuities, they’re called surrender fees that will keep you locked into—
Akweli Parker: That’s a pretty ominous name.
Danielle Corey: —that will keep you locked into a product. And at Vanguard, we don’t have surrender fees on our variable annuity, but a lot of products out there do. And then, you know, of course, there’s the commissions piece. It’s important to understand how the person that you’re working with is being compensated, and that when you do all of the cost analysis and all of the benefit analysis that you feel like the benefits outweigh the costs.
Akweli Parker: Those are some really important points. Thank you, Paul, for asking that question. I hope we answered it for you.
Let’s see how you responded now to our second poll question, and the question, once again, is “Why did you purchase an annuity?” Your options were: to receive income, to save for retirement, defer taxes, diversify investments, or you don’t own one.
So it appears that the vast majority of you, almost 70%, said that they don’t own an annuity. Another approximately 10% said to diversify retirement investments, 5% to defer taxes, another 10% to save for retirement, and about 8% to receive income. So, by and large, most people don’t own one; and then the next largest category was to diversify retirement investments. What do you guys think of that, the diversification angle?
Stephen Weber: I’m going to be a little skeptical on that from a broad perspective. The reputation of cost in some of these things that people have for annuities is earned, right?
Akweli Parker: Why do you say that?
Stephen Weber: Well, there are a lot of people that get sold annuities, right? So there’s like an old saw that says annuities are sold, not bought, or things like that.
Akweli Parker: I’ve never heard that.
Stephen Weber: And there is some truth on that out in the world, and annuities are sort of like the timeshares of investments. So a lot of people have them. They feel like they got sold them. They didn’t really understand how much they were going to cost, and they wished they knew how to get out of them.
So there’s a little bit of an analogy there. They’re not the same in that regard, but when you think of them as investment products, they’re very high cost. There’s no free lunch in investing. If you think about the thing that is a free lunch in investing, it’s really reducing costs. As sort of higher cost investments annuities, again, there’s often an alternative that can be a better alternative as an investment.
The interesting thing to me on that was that so few people said income, which is really, if you’re going to think about the justification of an annuity as an investment product it really is, that an annuity, by definition, is sort of a stream of payments. It’s an income product, and it’s interesting that so few people said income.
Akweli Parker: Right, right.
Danielle Corey: And if I could just add a little bit to that, just to kind of clarify an example around investment diversification. A lot of the sub-portfolios that are available within the Vanguard Variable Annuity are clones of mutual funds that are available through your IRA or your taxable account.
Akweli Parker: That’s probably lower cost, right?
Danielle Corey: That are lower cost. So, now, you know, there’s certainly for a portion of folks who are in high tax brackets and want that additional tax-deferred savings, an annuity can make sense. But when you think about the underlying investments, they’re probably going to be pretty similar to what you could get in a different type of account.
Stephen Weber: Right, those are some really great points. We’re starting to get some live questions right now, so thank you for sending those in. I want to take this question from Joe who asks, “Does Vanguard offer an annuity that is low cost?” Can you talk about what we offer?
Danielle Corey: Absolutely. So, again, I’ll try to delineate by type. So starting with the variable annuity, Vanguard does offer a variable annuity that we’re very proud of from a fee perspective. So the average expense ratio of the Vanguard Variable Annuity is going to be 52 basis points versus an industry average of 2.26%, so that’s about an average of 70% savings there, which we think is important to making the value for our investors.*
Akweli Parker: It might not sound like a lot immediately, but over time that makes a big difference, right?
Danielle Corey: Absolutely. And then on the income side, we also offer very competitively priced income annuity options—and I think the overall point though is that if you decide that you want to talk to someone at Vanguard about potentially purchasing an annuity, that our experts are not commissioned and their performance isn’t based on making a sale. It’s based on how well they’re educating our clients and helping them get to the right decision.
Akweli Parker: Great. So we have a wonderful question from John in Philadelphia who asks, “How should we select the company from which to buy an annuity?” So if you’re committing all this money, you want to make sure that the company’s not going to go out of business tomorrow, right? So how do you make that choice?
Danielle Corey: That’s absolutely right. So the main things that clients tend to consider, because especially on the income side, it is so important that that company stay around for 25, 30 years to make the payments to individuals, they’re usually very concerned with the credit rating of the company and use that to determine the creditworthiness and the solvency. Are they going to continue to be in business and be able to pay their liabilities?
Other customers that we see just want to get the best price, and sometimes those two things are in conflict, but it probably makes sense to consider both aspects when you’re thinking about an insurer to potentially have a contract with.
Akweli Parker: Right. Now when you say ratings companies, you mean companies like A.M. Best, Fitch Ratings, and what types of ratings should people be looking for?
Danielle Corey: They should be looking for very high ratings. So, you know, that’s going to be different for each person, but those are the companies. And then look at how—
Akweli Parker: And they’re, what, like letter grades?
Danielle Corey: That’s right. They are letter grades. And so more As the better, in simple terms, and they each have a little bit of a different rating scheme. But the more As the better and then you probably want to avoid once you start getting down into the Bs.
Akweli Parker: Absolutely. Okay, we do have another live question. This one is from Richard, and Richard asks, “How do annuities differ from a person managing their own portfolio and setting up monthly withdrawals?” So I mean what is the real advantage to going this route?
Stephen Weber: So, that’s a great question. It’s really the heart of deciding whether or not an income annuity is for you. And even if you do choose an income annuity, there probably will be some use of both withdrawing down from a portfolio and using an annuity.
But the basic difference is how you feel about the need for guaranteed income. So if you think about what I said before about sort of that basic level of what you’re going to spend anyway, you can draw down from a portfolio and use whatever portfolio drawdown rate you need. And you’re probably fine, and you probably won’t run out of money. Well, not for whatever rate, but a good withdrawal strategy can help you in that regard.
But life conditions can happen. You could end up in a long-term care situation. The market could go the wrong way. There’s a lot of things that could happen that if you just want to make sure that you have sort of a basic income that lasts for life, you may want to pull back on that a little bit with a portion of your portfolio that you know you’re going to spend anyway because again, this is the basic amount of money that you think you need to live. Right, so it’s going to have to come out of your portfolio. It’s not like you have the choice to spend it or not to spend it.
So some people would like to guarantee sort of a floor for the amount of money that they have so that they’re secure in the knowledge that if anything were to go wrong, they would always have at least that basic amount of income.
Now some people, on the other side, right, you’re going to say, “Well, I don’t need that because I’m a good money manager and I’m only going to need to withdraw 2% of my portfolio in order to get sort of a basic level of income and things like that.” And that’s fine. You know, it’s not for everybody. It is for some people though, and really the basic difference is do you really feel like you need a guarantee? And the place that most people are going to feel like they need a guarantee is for this sort of minimum income level that they want to have to survive so that they just don’t have to worry about it. And if the market crashes, at least they don’t need to worry that their basic income is going to be in jeopardy as a result.
Akweli Parker: Right, got it. All right, we do have another live question. This one is from Alvin, and Alvin asks, “I’ve heard that with interest rates so low, now is not a good time to buy an annuity.” Is that right and what do overall market interest rates have to do with annuities?”
Stephen Weber: Well, it is true that if interest rates are higher, you’re going to get a bigger payout if you’re getting an income annuity, right? So I’m back to income annuities here. But on the other hand, not to draw too many analogies, but it’s similar to the kind of questions someone might ask with housing prices so high, should I buy a house, right? If you want a house, you’re going to buy a house, and the price of housing isn’t really probably the reason that you’re going to choose to buy or not buy a house.
In the same sense here, the price of a stream of income, which is really what it boils down to, is probably not the determinant of whether or not you should buy that or not, right? The issue is do you need guaranteed income? Do you want guaranteed income? If so, there’s going to be a cost associated with it or cost might not be exactly the right word, but you’re going to put a certain amount of money out in order to get that stream of income. And waiting doesn’t get you your stream of income. Just like if you were talking about a house, it wouldn’t get you a house.
Akweli Parker: It depends on how immediate your needs are.
Stephen Weber: It really is sort of a market timing context. It’s like people saying, “I shouldn’t buy bonds because interest rates are so low.” But to have an asset allocation, you need to have bonds. So it’s the same kind of thing, and you shouldn’t let whatever current interest rates levels are be the determinant factor on that.
And just as another aside, I’ve been hearing various forms of the question, “Because interest rates are so low, shouldn’t I … ?” for a good 15 or 20 years now. So, I mean, interest rates are never so low that they can’t go lower. Right, it’s one of the things that we’ve learned over recent times. They might go up, and the point is, it won’t change the income that you’ve already bought as a result of them going up. You’ll still have purchased that income stream.
Akweli Parker: Great, thanks, Alvin, for that question. I hope we answered it for you.
Let’s go to a question from Adrian in Olney, Maryland, and I’m sure a lot of people have this question on their mind as well. “Is there a tax benefit to annuities?” and you kind of alluded to this earlier, Stephen. And the follow-up to that is, “Is the payout tax-free?” So what can we tell Adrian?
Danielle Corey: Yes, so happy to cover that one, and I think particularly thinking about the variable annuity. I already covered that that will provide you with additional tax-deferred savings. I think it’s important to know when you start making withdrawals that is taxed as ordinary income, of course, everybody’s tax situation is different. So if you have specific tax questions, definitely make sure you work with a professional. It’s important that folks keep that in mind.
Akweli Parker: Absolutely. All right, our next question is from Joe in Manchester, New Jersey, and Joe asks, “Can [annuities] protect you from market downturns?”
Stephen Weber: So that’s an interesting question. As an investment product, I think we’ve kind of explained that annuities are more like an account type than they are a specific investment product. So there’s some investment products that are designed to be stable, similar to a CD in a bank or a money market or whatever, right, and in that sense. But I think probably the better thing to get at is, again, why do you want guaranteed income?
One of the reasons why you might want to buy an income annuity is for protection against market downturns in the sense of, again, the sort of basic floor of income that you have. If you are spending yourself in order to provide yourself income, when there’s a market downturn, you’re still going to have to continue to spend out of that. If you’ve met a certain floor, it sort of gives you some leeway to not spend or to do whatever you need because you know that sort of this basic level of income is already covered.
In some ways it’s like having that pension that a lot of people don’t have anymore. So there are a lot of people out there today that have significant retirement plan balances that rarely spend from them. They spend from them when they want to, not when they have to. So because of that, they have a certain market protection because they want to spend when the markets are good and when they feel like they have money. And they don’t want to spend when markets are tight. It’s difficult to spend from your portfolio, and it’s really difficult to spend from your portfolio when you’re seeing it drop.
Akweli Parker: Right.
Stephen Weber: And so the protection that’s there, it might not be any more than say if you think of it as almost a fixed-income part of your portfolio, it might not be any different than you could get with asset allocation. But psychologically, I think it’s a little bit different because you’ve already sort of pre-committed to get that money spent for you or sent to you as income.
Akweli Parker: Right, so the short answer would be, yes, that it can?
Stephen Weber: It does offer protection against market declines because you’re going to get the payout from an income annuity regardless of what happens in the markets.
Akweli Parker: All right, thank you. This next question is from Robert in West Kingston, Rhode Island, and he poses the question, “I have an annuity that I purchased seven years ago, but I have no idea if it’s right for me. How can I figure out if this was the right choice to invest my money?” Now, Danielle, I’m sure you have these conversations. What would you tell him?
Danielle Corey: Yes, absolutely. So it really depends on the type of annuity and the terms of his contract with the insurer. Again, are there going to be surrender fees associated? On the income annuity side, when you’re making that decision, it is intended to be a permanent decision—so there’s not a ton of great options for folks if you change your mind after the fact. So you want to make sure you’re really sure when you’re going into that purchase decision.
On the variable annuity side, there are options. There’s something called a 1035 exchange that can be done, that allows you to take your money from one company and move it to another if there’s the opportunity to save on fees or something like that. And most of our cash flow into the Vanguard Variable Annuity is actually 1035 exchanges. Someone either purchased or was sold an annuity that maybe had high fees elsewhere, and because of the tax penalties that could be associated if you withdraw before 59½, they want to keep a variable annuity but decide to move it over to Vanguard to save on the fees overall.
Again, you know, folks can call us if that’s an option that they want to discuss, and the experts that they would talk with are going to be able to give them nonbiased guidance and help them decide what the best option is for them.
Akweli Parker: Interesting. With the 1035 exchange, is there a waiting period associated with that or is that something that people can do pretty much immediately?
Danielle Corey: So, again, it depends on the terms of the contract and how long the surrender period is. So for each individual situation, you would need to assess that.
Akweli Parker: We have a related question from Giles in Bradenton, Florida, who wants to know about withdraw options. The question is what are the withdraw options associated with an annuity. So you’ve got this big mess, and then how do you actually get that income?
Danielle Corey: Sure. So when you think about income annuities, again, that’s going to be a stream of income payments. When you think about the variable annuity, the options there, it provides a lot more flexibility. Again, you want to likely wait until after you’re 59½ so that you don’t pay a tax penalty because this is intended to provide additional tax-deferred retirement savings. But some folks decide to surrender their policy and use it in some way, and surrender again means redeem in annuity terms. Some folks decide to slowly withdraw from their account over time, and yet other folks decide to annuitize, which means take your variable annuity and then turn it into an income stream in a way that’s very similar to purchasing an income annuity.
Stephen Weber: Great, great.
Our next question comes from David in Newark, Delaware, and, Steve, why don’t you take a shot at this one. David asks, “Are there guidelines for how much of retirement money should be allocated to an annuity?”
Stephen Weber: So, yes, I’m going to answer that a little bit differently from the way that it was asked though. I’m guessing that we’re talking about an income annuity here because if you were talking about a variable annuity, you’d just be talking about buying an asset.
So if you had some big balance that you’ve accumulated through your life and you want to turn some of that into an income, through an annuity, how do you think about how to do that? And I’m going to go back to where I was before. It’s really not what percentage of your balance should you annuitize, right. It’s more how much income do you need should be the first thought that you have.
Now if it turns out that the answer is, in order to get the amount of income I need, I’m going to have to use half or more or something like that of my balance, then you’re probably overextending in a situation like that. But at least the starting point for understanding how much of your balance you might want to turn into an annuity is to start with how much income you want and find out how much assets it requires to get the amount of income that you need. That’s probably a better guideline than, you know, sometimes economists say things like, “Oh, people should annuitize 20%,” or something like that, but that’s not really probably the best way to think about that because it’s probably not best to think about that as an alternative to investments. It’s probably best to think of it as a source of income. And the real question is how much income do you need to have guaranteed?
Akweli Parker: Right, right. So you’re not just looking for a raw percentage.
Stephen Weber: Right. A lot of people like to play this game, which will I die with more money with, if I annuitize or if I invest it myself? And that’s probably the wrong game to play when we’re talking about something like an income annuity. There are different questions to that, different answers to that, and it’s going to depend on markets and a whole bunch of other different things. But the point of an income annuity is not to die with the most money. It’s to give yourself a stream of income that’s guaranteed to last for life.
Danielle Corey: And the peace of mind associated with that.
Stephen Weber: And the peace of mind associated with that, exactly. So it’s not really about which comes out on top in an investment simulation game. It’s really about giving yourself the freedom to not worry about a basic level of income and then potentially manage your other portfolio without having the worry about that constraint on your portfolio.
Danielle Corey: Steve did touch on an important topic within the answer to that question and this idea of liquidity and access. So folks who are considering an income annuity, it is a tradeoff that you’re giving up the liquidity and the access for that guaranteed stream of income. So it’s really important that they’re comfortable with the remainder of their retirement savings and that that provides them with adequate liquidity in case of emergency and to give them discretionary spending.
Akweli Parker: Excellent point.
Stephen Weber: And to build on that just a little bit more, right, we always think of that as sort of a risk, if you will, of buying an income annuity, right, that you’re going to lose access to your portfolio. But I think it is possible to almost flip that on its head and think about the opportunity that is associated with losing access to that money. And it’s going to sound, what are you talking about, Steve? That sounds weird. But the idea there being that you’ve already given that up. It’s going to come in as an income stream, and whatever happens down the road … so people are afraid to spend from their portfolios during retirement. It’s really hard to spend from your portfolio during retirement. You’ve built this thing up, you’ve been a saver your whole life. Every time that you want to take money out, it hurts for a lot of people, because it’s the opposite of what they’re taught themselves to do their whole life.
Akweli Parker: Right, that’s how they built that up.
Stephen Weber: So as a pre-commitment device, you could take a significant piece and say, “This is money I saved so I would have income. This is money that is there to provide income. I’m going to make this decision once. I’m not going to have the ability to not make that decision again in the future. Right, I’m going to give up control of that essentially by pre-committing to giving that up.” And now what’s the rest of my portfolio? The rest of my portfolio doesn’t have to meet that basic income amount, and I can start thinking about what I want to spend on, rather than what I need to spend on. And that changes a little bit the dynamic of what I might need to spend.
So to some extent, of course, everybody wants to have access to their money. It feels hard in the same way, right. Not that many people buy income annuities. One of the reasons people don’t buy income annuities is it’s hard to part with the money that buys that income stream. But there is a flip side to that which is that you’re not bound by the constant decision-making to withdraw small amounts to meet basic needs.
Akweli Parker: Right, right. This is some really great information, and I just want to remind viewers that if you want to dive deeper on this topic, just click on the green and white Resource List widget on your player.
Now we do have a live follow-up question. I think this one might be for you, Danielle. Martin asks, “I’m still not clear on what a variable annuity is, so could you just explain that a little bit further?”
Danielle Corey: Sure, sure. I mean a good way to explain it is to think about it as, and it’s not exactly this, but sort of a metaphor. It’s almost like a different type of account. So you have tax-deferred savings in an IRA, in a 401(k). Think of a variable annuity as a different type of account, and then within that account, you’re going to make an investment selection. And so while it technically is a contract between a client and insurance company because it is an insurance product, an annuity is an insurance product, and while we don’t call the underlying investment options mutual funds, they’re sub-portfolios, you can think of them in much the same way.
Akweli Parker: Great, great. Why don’t we take our next question from Joan in Bullhead City, Arizona, who asks, “What happens with money left in the annuity after my death?” That’s not a pleasant thing to think about our own mortality, but we definitely had that in mind when you purchase one of these. So what do you think to John’s question?
Danielle Corey: So on the variable annuity side, we covered some of those options previously. But the important point is the value that has accumulated in that variable annuity based on your investment performance is available to your heirs, whoever you’re designating as your beneficiary. And then they can select what option they want, whether it’s a lump sum or something else.
Akweli Parker: Can you talk about what happens as far as probate or it doesn’t go through that process. Is that correct?
Danielle Corey: That is correct, yes. On the income annuity side, however, I do think it’s important to note that when you’re setting up that decision, what happens upon your death is already predetermined. So is the income stream going to stop upon my death? Or is it going to continue, a portion of that continue to my spouse, are there a set number of payments that need to be reached, something of that nature. But that’s all predetermined. So as opposed to selecting options, that’s set up at the outset of the contract.
Akweli Parker: Excellent, thank you.
Let’s take our next question from Kevin in Tafton, PA, and Kevin asks, “Would a recent college graduate be interested in an annuity?” So I think we ought to tip our hat to Kevin for thinking so far ahead, but what are your thoughts about doing that?
Stephen Weber: Probably not, so Kevin, what I’m going to say is max out your 401(k), look at IRAs, Roth IRAs. If you still have money left over after that, do you have an emergency fund? There’s so many things that I could talk about that’s probably not something that is really going to be likely to be part of what a young person is going to be thinking about as part of their thing.
Annuities, in general, are vehicles that are at the nearing retirement, retirement stage. Again, especially when we think about them as income products and less of them as investment products. It’s not likely to be something that if you’re young you need to be thinking much about. And if somebody’s trying to sell you one and you’re young, there’s a good chance that you should get a second opinion.
Akweli Parker: Well there you go, Kevin. So our next question comes from Jeffrey in Washington, and I think this is a great question from Jeffrey. He asks if we can comment on using annuities to provide long-term care benefits. You know, people are living much longer. This is something that a lot of people have to think about. Where do annuities fit in?
Stephen Weber: So let me address this one a little bit because I’ve also been doing a lot of work on long-term care and things like that recently.
There are products that have long-term care, but that’s not really where I’m going to go with this. I’m going to talk again about why you might want guaranteed income. And one reason you might want guaranteed income is this issue of protecting the second to die in the case of a long-term care thing.
So what actually does put your balance at risk? If you’re spending from your own assets, one of the things that can really put your balance at risk is an extended long-term care stay. And if you think about the surviving spouse in that situation, their Social Security will go down because you’ll only have, you know, Social Security gives the higher of your two benefits—but it doesn’t continue both your benefits into death. And your assets may be significantly depleted as a result of having gone through a long-term care stay for the first to die.
So one of the reasons, I think, that is maybe one of the most compelling reasons why people think about the need for a guaranteed income source is for that surviving spouse. So she was talking about with an income annuity you can set up your options for what happens after your death, and you can set it up so that the money continues for your spouse. And as protection, you know, it’s not going to pay for your long-term care in that kind of tax rate; but if you think about protecting the income of the survivor of a long-term care situation at at least a minimum level, when I talked about what you can really live on as little as, it’s important not only to think about that in terms of today’s thought but in terms of sort of that second-to-die situation potentially.
Akweli Parker: Really helpful. I just want to thank our viewers for continuing to send in your live questions. We’ve got another one now from Kathleen, and I think this one might be for you, Danielle. It’s a follow-up, and it has to do with tax implications. She asks, “If you inherited a deferred annuity, can you move it to your own annuity without any penalty or tax charge?”
Danielle Corey: So that, again, if there’s a specific situation, make sure that you’re consulting a tax professional on this.
Akweli Parker: Absolutely.
Danielle Corey: But, generally, it depends. I think one of the options would be, again, to stretch out your withdrawals so you could move that over to your own annuity. But then basically spread out withdrawals over the lifetime. You could annuitize, and this is talking about a nonspouse-inherited annuity, and so it just really depends on what options you’re looking for specifically. But there should be options available to you that would at least lessen the tax impact.
Akweli Parker: Right, always important. Okay, our next question comes from Robert who asks, “Can IRA funds be used to open an annuity, and what would be the advantages and disadvantages of doing so?” What do you think about using IRAs to fund these?
Stephen Weber: If you’re doing it to get investments, let’s review. What’s the main reason that you think about buying an annuity as an investment? It’s tax deferral. Well your IRA is already tax deferred, so probably not in that circumstance.
If you’re talking about income annuities though, there’s certainly, you’re going to pay with them with the money that you have. Most people, the bulk of their retirement savings is in IRAs or 401(k) type qualified money, so that money can be used to purchase an income annuity. And, again, when you get to some things like inheritances and things like that, the fact that you’ve actually used that for income annuity rather than as an asset that you pass on that has all these tax implications when you pass it on, it can actually be a smart thing to do in that regard, right, because you’re already using that money that you would end up having to take RMDs from and all that other stuff anyway for that income purpose anyway.
So there can be a reason to have it. Just if somebody’s trying to do it because they think you need an investment product in there, that’s where I would start to be a little bit skeptical about it.
Akweli Parker: All right. Our next question is from Dan in Tega Cay, South Carolina. Hope I’m pronouncing that correctly. Dan asks, “Does Vanguard offer fixed-indexed annuities, and what are the pros and cons of this particular vehicle?
Danielle Corey: Sure, I’ll take that one. So I did mention fixed-indexed annuities when I covered the four types. Vanguard does not offer fixed-indexed annuities, but we do get a lot of questions on them. I think a lot of clients either read articles or hear about them on the radio or they know someone who bought one, and I think with these, again, the purpose for the product is to participate in some of the market upside with having protections on the downside. And fixed-indexed annuities are linked to market performance, but you’re not exactly participating in that fully.
Back to what Steve said earlier, there is really no free lunch, and so you just have to keep in mind with these products some of the considerations or disadvantages. There are high fees that tend to be associated with them. A lot of times there’s some sort of cap on the upside, so your own—
Akweli Parker: So that’s why you’re not participating fully?
Danielle Corey: That’s right.
Akweli Parker: Because you’re missing out on some of that.
Danielle Corey: That’s right. So if the upside is limited at 7% or 8%, then in these years where the market’s doing really well, you’re not capturing all of that return. And then when you purchase a mutual fund or ETF, the stocks that are associated with that, let’s say you’re comparing an S&P 500 mutual fund or ETF to a fixed-indexed annuity that’s linked to the S&P 500, well, the stocks in that mutual fund throw off dividends, and that really goes to the total return that the investor’s going to receive at the end of the day. While they’re not experiencing those dividends, that’s not included in the return calculation for the fixed-indexed annuity.
So you have to just think about some of these considerations and make the decision, if you are considering that type of product, is that really going to meet your goals?
Akweli Parker: Right. So not necessarily saying they’re good or bad, but you really have to consider whether they fit your needs.
Danielle Corey: Exactly.
Akweli Parker: Great.
Stephen Weber: They can be hard to understand, and it’s important if you’re going to invest in something like that, that you really understand what the costs are and what the risks are associated with it.
Akweli Parker: Great point. Okay, so we have a question from Scott in North Oaks, Minnesota, and Scott asks, “If you have enough money to last through retirement,” and you talked about this Stephen, “is a self-managed portfolio superior to an immediate annuity?”
Stephen Weber: So I had sort of talked about this a little bit. So, again, if you have enough money to make it through retirement and you feel comfortable living on a 4% withdrawal rate to use sort of that example, that sort of classic example that’s oversimplified, but people understand that.
Akweli Parker: Yes, the old 4% rule.
Stephen Weber: Then by all means do so. There’s nothing wrong with withdrawal. Not everybody needs an income annuity to feel good about how they’re going to live their retirement and be able to have income during retirement.
The difference there is really more one of psychology than it is, in some ways, of an economic decision in that context. So the question is, do you want the guarantee? Why do you want the guarantee? What do you want the guarantee for?
The one thing that an income annuity does take into account that’s a little bit different than what you get through traditional investments in this kind of thing is that because they go on for as long as you live, people probably should be aware that there’s a good chance you’re going to live a long time, and people tend to underestimate how long they’re going to live.
So if you’re a healthy 65-year-old couple, or even not even healthy, average health, 65-year-old couple, there’s about a 50% chance that at least one person in that couple will live to age 92. And there’s a 25% chance that at least one person in that couple will live to age 97. And most people don’t think about things like that because they think, “Oh, well I know life expectancy is 85” or something like that, that they’ve pulled out of their head. But you’ve already made it to 65, and there’s two of you that made it to 65. So when you combine people as a couple, for one thing, and you already take into account that you’ve already made it this far, those life expectancies actually extend quite a bit.
So sometimes that aspect of guaranteed for life, we overestimate what it means to, “Oh, I might die early, and I won’t get all my money back” or some context around that. But we underestimate the flip side of that, which is there’s a reasonably good chance that we’ll live a long time.
And the other aspect to managing your own portfolio is managing your own portfolio. So think about how involved you want to be in managing your portfolio when you’re 92.
Akweli Parker: That can be a lot of work.
Stephen Weber: Right, yes. So there’s an aspect to this that is sort of hands off. That’s another reason we sort of talked about the giving up control might actually be useful in some context when you think about some of these basic needs.
The real biggest risk of your retirement is not your finances. It’s the fact that you’re getting older. We know that you’re going to continue to get older. Your health is going to decline; eventually you’ll die.
That’s a risk that sometimes people who are thinking about managing their own portfolios don’t always take fully into account, that it’s going to get harder to manage your own portfolio as you get older.
Akweli Parker: Right, great. Well I never thought I’d utter the words “annuities and time flies” in the same sentence, but with you two it really has. So I just want to thank you for your excellent insights.
Before we sign off tonight, any final thoughts you’d like to share?
Danielle Corey: Sure, I’ll start. You know, I think we covered a lot of really important topics. But just to reiterate some of the keys. Make sure if you’re considering an annuity that you understand the fees, you understand the structures and the details of the product, and make sure it’s really meeting your needs.
That caveat said, not all annuities are bad. They can have a place in investors’ toolkits as they’re thinking about retirement. It’s just that they need to make sure that it’s the right decision for them and take the time to do that.
Akweli Parker: Great. Anything to add, Stephen?
Stephen Weber: Yes, I guess I’ll just go back to the point almost that we started with. There’s this term that we use that’s called annuity, and it’s really used for many different things. So annuities have a little bit of a reputation, but that’s not everything that’s called an annuity is deserving of that reputation, is to some extent what it boils down to.
So be careful. It’s healthy to be skeptical when you hear something called an annuity. Just be aware that it’s more than one thing when we say annuity.
Akweli Parker: Right. Well thanks again so much to the both of you, and thank you for joining us to explore this topic tonight and for all of your great questions. They really added to the discussion. We hope you found this discussion very helpful.
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