The big investment companies see the guaranteed lifetime benefit riders as a way to increase the appeal of their own variable annuity products. They already offer variable annuities so they typically partner up with an insurance company to provide the rider.\

Vanguard has now done this with Monumental Life Insurance Company to offer its version of guaranteed lifetime retirement income to variable annuity owners. The marketing approach is that the annuity purchaser can withdraw a fixed percentage of a”total withdrawal base” during his or her lifetime, even if markets are bad or the annuity’s principal runs out. They also say that the “total withdrawal base” can increase if the market performs well. The withdrawal percentage is based on the age of the first withdrawal which can be as early as age 59.

To make this product more attractive to a married couple, the purchaser can choose a joint life option. This extend the lifetime income benefit to the spouse, although at a lower annual withdrawal percentage compared to a single life benefit.

Vanguard is currently charging a rider fee of 0.95% of the annuity’s total withdrawal base each year. I would certainly investigate whether this fee is locked or can increase. Keep in mind that 0.95% is a significant cost over time, particularly given the low investment returns now being offered. You are allowed to drop the rider and the fee any time.

Here is one example of how the guaranteed lifetime retirement income benefit works, as provided by Vanguard:

The annuitant of a variable annuity with a total withdrawal base of $150,000 elects to purchase the GLWB rider when he’s 65, and he immediately begins taking withdrawals at a 5% withdrawal rate. He could then be assured of annual withdrawals totaling at least $7,500 per year for life, based on the value of his designated investments when he elected the benefit. Even if the total value of the investments falls because of poor market performance, the $7,500 of withdrawals could continue.

One feature of the variable annuity product compared to a fixed annuity product is that in many cases, you are allowed to withdraw more than your guaranteed annual withdrawal amount, if you need the money and are willing to accept lower future benefits.

Vanguard is known as an investment company with low costs. That’s what interests me about its entry into this guaranteed lifetime income space.

Here is a link to the Vanguard brochure on this new product. (And no, I receive no benefit from Vanguard.)

Have any of you considered a variable annuity with a guaranteed lifetime income benefit?

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I have no personal interest in variable annuities as part of a retirement portfolio. Years ago our firm’s 401(k) plan was wrapped in a variable annuity product. When I closely examined the high costs relative to other investments, I successfully lobbied for a change in our plan.

I have more interest in fixed annuities because of their potential for providing “pension-like” retirement income for life. Therefore, I read a lot about immediate and deferred fixed annuities, including newer products intended to address some of the cost and liquidity concerns.

Recently the Best Life column in the U.S.  News and World Report Money section ran a short series titled “What You Need to Know About Annuities.”

The National Association of Fixed Annuities (NAFA) read the U.S. News piece and published a “reply” article. The reply document focused on clarifying the important differences between variable and fixed annuities. Obviously, these clarifications were intended to project fixed annuities in a more favorable light.

In summary, these are some of the points I found important as told in both stories:

• An annuity – fixed or variable – is not a true investment. Rather, it is a contract between you and the insurance company that issues the annuity.
• Fixed annuities protect against market declines whereas conventional variable annuities do not. This explains why retirees with fixed annuities fared better during the recession compared to owners of variable annuities.
• Although conventional fixed annuities carry a risk of principal loss from an early death, there are income riders and optional policy terms that can reduce this risk, for a price.
• Mutual insurance companies (owned by policy holders) may have better financial stability than stock insurance companies.

I encourage you to read more about fixed annuities yourself, rather than relying on a sales person to educate you.

The first article in the U.S. News annuity series can be found here. The second article is here.

The reply paper from NAFA can be downloaded here.

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Recently, I discovered a 2007 paper written by two finance professors at the Wharton School, University of Pennsylvania. It is one of the best and most objective articles I have read that specifically addresses the value to a typical retiree of purchasing a life income annuity. Granted, the research was co-sponsored by the New York Life Insurance Company, but the conclusions and data are hard to argue with.

You should read the entire article (linked below) but first consider these statements by the authors:

[E]conomists have come to agreement from Germany to New Zealand, and from Israel to Canada, that annuitization of a substantial portion of retirement wealth is the best way to go. The list of economists who have discovered this includes some of the most prominent in the world, among whom are Nobel Prize winners.

Studies supporting this conclusion have been conducted at such heralded universities and business schools as MIT, The Wharton School, Berkeley, Chicago, Yale, Harvard, London Business School, Illinois, Hebrew University, and Carnegie Mellon, just to name a few. The value of annuities in retirement seems to be a rare area of consensus among economists.

A recent National Bureau of Economics study, which appeared in the prestigious American Economic Review, demonstrated under much more plausible conditions than had ever been supposed, that full annuitization was optimal for people who had no desire to leave a bequest to their heirs or charitable organizations. It also concluded that for those with bequest motives, substantial annuitization of retirement wealth was still the most prudent way to act.

Considering the recent unexplained gyrations in the markets, combining one or more annuities with our other plans for guaranteed retirement income is more interesting. In particular, an annuity laddering strategy may be the best path for maximizing the benefits of a life annuity while minimizing the risk.

Here is the link to the full article.

Note that the authors recommend using a “minimal level of acceptable retirement income” as a basis for making an initial annuity purpose, taking into account Social Security and other guaranteed income. This is something that I have advocated repeatedly.

Another key point from the research is that unless you’re willing to assume more  investment risk, an individual cannot match the guaranteed income that an immediate annuity can provide. Forget the stock market. Research shows that it can work for you over the long term – maybe – but only if you take on more risk.

What do you think of the conclusions and recommendations from this article?

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How do these combined annuity and long term care products work? Each is different but the general concept is as follows:

A purchaser may be looking for a lifetime retirement income with additional protection if long term care is needed. The purchaser buys this hybrid annuity product with a single premium payment. The product functions exactly like a fixed annuity, providing a lifetime of annuity income. There is also a long term care multiplier built into the policy. In some cases, the long term care rider means the purchase would require medical underwriting, e.g, a health questionnaire and maybe a physical.  A portion of the internal investment return in the contract is used to pay for the long term care benefit. The long term care coverage is calculated based on the amount of coverage selected when the policy is purchased.

The insurance company may offer a payout of two to three times the initial policy value over two or three years after the annuity account value is depleted. For example, a purchaser of a $100,000 annuity who had selected a benefit limit 300% and a two-year long term care benefit factor would have an additional $200,000 available for long term care expenses, even after the initial $100,000 annuity policy value was depleted. The policy owner would spend down the $100,000 annuity value over a two-year period and then receive the additional $200,000 over a four year period or longer. In other words an annuity purchased with $100,000 could potentially payout LTC benefits of $300,000.

One feature that may make on of these hybrid annuity/long term care products attractive is a provision in the Pension Protection Act of 2006 that became effective on January 1, 2010. This provision allows long-term-care benefits to be paid from an annuity tax-free.

There are variable annuity products that also can include a long term care benefit. Generally, these products allow the owner to use the LTC benefit up until the time that the value of the annuity account is annuitized.

I think we will see more products that combine fixed annuity features with long term care benefits. The different products from different companies will probably carry a dizzying array of confusing features. Careful study and consideration of the costs and benefits will be important.

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To pay for the health care reform legislation, the bill included new taxes on “unearned income.” This includes investment income, interest, dividends, royalties and even rental income. Annuity income is included within the definition of “investment income.”

The original bill that passed the Senate and more recently the House included a new 2.9% tax on unearned income. The more recent reconciliation bill increased the new tax rate to 3.8%.

The new tax on unearned income will be imposed beginning in 2013. The 3.8% tax applies to investment income received by married couples filing a joint return (and surviving spouses) and having a taxable income of at least $250,000. The tax will also apply to married taxpayers filing separately with an income of $125,000, and to other single taxpayers with an income of $200,000.

The new tax will continue present law and will be applied only to income that is currently taxable. For annuities, that means only income that is above the owner’s cost basis. For a life annuity, this considers your life expectancy. (More information about taxation of annuity income.)

Although the annuity industry will work hard to get this tax repealed, I would plan on the tax being around when baby boomers retire.

If you have or are considering purchasing an annuity for retirement, keep this tax in mind when putting together your retirement income plan. If you are fortunate enough to have a six-figure taxable income when the annuity begins, you will pay the extra 3.8%.

More taxes are likely coming for retirees who plan and invest well and will have some wealth to show for it. Tax planning will be increasingly important for them.

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In his State of the Union address, President Obama talked about economically supporting middle class families. Part of that support includes the issue of retirement security. The President didn’t mention annuities in his speech but in this report from the middle class task force, the White House openly suggests “promoting the availability of annuities and other forms of guaranteed future income.”

Obviously, this statement is made in recognition of the decline of the corporate pension. (Not government pensions – those are golden and sacred!) The government also knows that pressure is building to rein in Social Security. Persuading a worried middle class to use annuities to provide retirement income is one way to take the load and expectations off of the Social Security system.

There are several significant obstacles to convincing baby boomers and the middle class in general to transition to using annuities as a pension substitute. We have discussed most of them before: cost, inflation, and insolvency risk. There is also the risk of losing the full benefit of your annuity investment from a premature death. But that risk is present in all forms of insurance I don’t put a lot of weight on that. A related issue is that many so-called “financial advisors” don’t recommend annuities to their “clients” because they don’t sell them. They prefer to make money by managing your investment portfolio. That portfolio – and their income – shrinks if you use a large chunk of it to purchase an immediate annuity.

The annuity industry is trying to capture and exploit the concept that annuities are an acceptable substitute for a corporate pension. One of the newest annuity information and purchase portals even uses the pension name:  BuyaPension.com. This new site is worth a look if only because: (a) it has a pleasantly interactive user interface; (b) it has lots of links to annuity information resources; (c) it is very easy to quickly obtain an estimate of how much retirement income you can buy for different investment amounts. Of course, if you want a personalized quote, you can request one of those, which is the whole point of having you visit the site.

As I have written many times, we don’t have a pension to fall back on but have our own failsafe plan for providing guaranteed retirement income. But an immediate lifetime annuity is still on my list of options to consider when the time is right.

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The Hybrid Variable Annuity

Axa/Equitable has launched a new variable annuity product that can be termed a “hybrid annuity.”  The product is called “Retirement Cornerstone.”  This product includes two distinctly different accounts.  The first account appeals to an investors’ desire to maximize investment performance. This is called the “Long-Term Accumulation Account.” The second account – called the “Guaranteed Benefit Account” – is intended to protect the investor’s assets. This annuity product offers different investment choices for investors to try to recoup some of their prior losses while also using a lifetime income guarantee.

As you can expect, the hybrid annuity is complex, includes a variety of optional benefits, and carries a number of different fees that can really add up. Nevertheless, if you are inclined toward using variable annuities for growth and income in retirement, products like this should be on your list for consideration. For more information about the Retirement Cornerstone annuity,visit this site.

Simplified Variable Annuities

The trend for some insurance companies is to offer streamlined variable annuity products. This trend seems to be based on two factors. First, the insurance companies are trying to lower the cost of the annuity products by stripping out or watering down costly features, such as guaranteed income riders. Second, the variable annuity sellers want products that look more like mutual funds so that they are easier to explain and sell to consumers.

One of the first of these simplified variable annuity products is the AnnuityNote from John Hancock.  This product is intended specifically for baby boomers planning for retirement. It is sold only to investors between 55 and 75 years of age, with a minimum investment of $25,000. The terms and conditions are relatively simple for a variable annuity.

First, the product guarantees a 5% annual payout for life, after a 5-year waiting period. The amount of the lifetime income payment (paid monthly) will depend on the value of the account after 5 years but that amount is guaranteed not to be less than your initial payment.

Second, there are no surrender charges except that a partial withdrawal during the first 5 years will reduce the level of guaranteed income.

Again, there are significant fees including a 3% upfront sales charge and annual fees approaching 2%.

The simplicity with this variable annuity product resides in that fact that the lifetime income benefit is built-in and is not part of an extra-cost rider.

For more information about the AnnuityNote product, use this link.

Final Thoughts on New Types of Variable Annuities

Annuity-type products have become popular because of their different “guarantee” provisions. Investors looking at retirement are nervous. Many are willing to pay dearly for peace of mind and guaranteed income. For these folks, the newer annuity products may be helpful because they are easier to understand and use. For me, I’m not so sure but I will continue to study and learn.

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Sellers of fixed and variable annuities are trying to exploit the fear and fill the gap. They are having to develop new annuity products with novel features. At the same time, these new products have to include protection for the insurance companies against another market hit like they experienced in 2008. In other words, the annuity sellers need to make more money. This means that they will be building more protections (for them) into the annuity products against downside risk.

One example of such a new product is the AnnuityNote variable annuity from John Hancock. There are some good features in this product, such as guaranteed for life annual withdrawals beginning after five years. The guaranteed amount is 5% of your initial contribution or 5% of the contract value of the annuity at the end of five years. Also, you can make withdrawals from the contract value at any time without a surrender charge.  Any contract value remaining at your death passes to your beneficiary.

The downside are the fees: a 3% front end sales charge plus an annual expense charge of 1.99%. Then there’s that little inflation problem that slowly but surely eats away at the spending power of those 5% withdrawal payments.

But I can see why these products are appealing to many people.

Here are some a fews items I read this week that you may like:

The IRS announced that contribution limits for 401(k) plans, IRAs and other qualified retirement plans will not be increased for 2010. This is unfortunate but reflects that reality that the cost of living formula used by the government does not fully reflect the actual cost of living. They could at least let us over-50 folks contribute more!

Long term care insurance continues to an enigma. We now have it but some insurers are taking heat for their huge premium increases for existing policy holders. This just adds fuel to the fire of belief that the insurance companies are deliberately underpricing the policies at the front end to get folks to sign on. Is it any wonder that no one trusts insurance companies in the health care debate?

The Department of Energy’s energy savings blog published a comprehensive round-up of prior posts covering all aspects of saving money on energy use this winter.

Retirement Revised offers a short summary of expert tips on how to transition from a corporate environment to a finding job in the non-profit sector.

At my Tough Money Love blog, I wrote a follow-up to the hard truth about stocks for retirement investors and at my Failsafe Retirement blog, check out this update on developments for TIPS and I-Bonds.

Don’t overlook this week’s Carnival of Personal Finance.

Enjoy the rest of your weekend.

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3. Vanguard Enters the Guaranteed Lifetime Income Space

The big-player insurance companies are scrambling to design new annuity products. They do this in part to respond to concerns that the lower risks (and lower) returns of an annuity do not justify the high costs. These new products also gives aggressive annuity sales people something new to talk about when a prospect complains that they’ve heard it all before.

One example is the equity indexed annuity (EIA) which has characteristics of both fixed and traditional variable annuities. Typically, the returns from the EIA are tied to the stock market but with some minimum floor or payback offered.

Other sellers of variable annuities are promoting new “living benefit” features that guarantee certain payouts for life or other lifetime benefit, regardless of what happens in the stock market. That has been one of the biggest complaints about variable annuities. Annuities with guaranteed living benefits (GLB) come in different flavors. One flavor is a “guaranteed minimum income benefit” which guarantees that the owner will receive a minimum income stream starting at particular future point in time.

A second type of annuity living benefit is the “guaranteed minimum accumulation benefit.” In this version, the insurance company guarantees that the account will have a minimum value at a certain point in the future.

A third type of annuity living benefit is the “guaranteed minimum withdrawal benefit.” In this variation, there is a guaranteed income benefit, but it does not require annuitizing. (“Annuitizing” is the process of converting an annuity from being a cash accumulation product into one that provides a guaranteed or variable payout.)

Finally, there is the “guaranteed-for-life income benefit.” With this form of annuity life benefit, income withdrawals start and last until the cash value of the annuity reaches zero. At that point the withdrawals stop. Annuitization then occurs on a guaranteed benefit for life, the amount of which is not determined until the time of annuitization.

So the question now is whether buying a variable annuity with a living benefit is a smart option? Scott Burns, one of my favorite personal finance writers, says no.

To appreciate Scott’s analysis and views on variable annuities, consider that in many cases, adding a living benefit to a variable annuity can increase the annual cost of the annuity to as high as 3% of the value. That is huge. The other problem is that the cost of purchasing a variable annuity with living benefits can be substantially higher than buying a life annuity with the same monthly benefit.

This is what Scott Burns wrote about this comparison:

The purchase of a $100,000 variable annuity contract with such a guarantee means a 65-year-old man can have an income of $5,000 a year, or $417 a month for life, from his investment. He will get this regardless of what happens to the market. He might even get more if his account can rise over the burden of 3 percent in expenses and $5,000 annual withdrawals.

According to www.immediateannuities.com, the same 65-year-old man can buy a life annuity that will pay $417 a month for life for about $61,000. That means he’d have $39,000 “left over” to invest for more income later.

I have to agree with Scott on this. If you want to make an annuity part of your retirement income plan for the monthly payout, it makes a lot more sense to do it with a life annuity. The living benefit feature with a variable annuity is attractive but is just too expensive.

Photo credit:  GarySmith70

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Eliminating Retirement Income Inflation Risk

One strategy for removing inflation risk from your retirement planning is to invest in assets that are inflation protected. Conventional examples of these include TIPS and I-Bonds. Owning TIPS and TIPS funds and ETFs can generate tax obligations unless they are inside a tax deferred account, such as an IRA or 401k. I-Bonds are tax deferred but do not typically provide an interest rate yield to match a Treasury Inflation Protected Security.

Also, maintaining a steady income out of a TIPS or I-Bond portfolio can mean constant monitoring, selling, and buying as bonds mature.

Finally, a retirement income plan based on TIPS and I-Bonds usually involves periodic liquidation of principal, not just living off interest. This means that there is a potential for outliving your income.

Using Inflation Indexed Annuities

One strategy for completely eliminating inflation risk from your retirement is to supplement Social Security (which is inflation protected) and TIPS/I-Bond income with an inflation indexed annuity.

What is an inflation indexed annuity? It is a single premium annuity that provides income to the beneficiary for life.  Most single premium or life annuities are sold as fixed-income products. The income that you receive each month never changes. This can be a serious problem because of inflation. An annuity that is inflation indexed adjusts the monthly payment upward based on the annual inflation rate.

I will give you one significant example from our baby boomer years. During the period 1973-1982, our calculated cost of living increased 130%, with inflation averaging 8.7% each year. If we were to experience a similar period during our retirement years, a $1000/month fixed annuity income could fall to $420 in purchasing power in just ten years. Ouch.

Many sellers of life income annuities offer inflation indexing options.  These options include automatically increasing the income each year by a fixed percentage, often between 1%-5%.

A better and more secure option is to index the annuity income amount to an inflation indicator, such as the Consumer Price Index as determined by the Department of Labor. Most such annuity products will increase the monthly payment each year based on a CPI increase during the prior year but not decrease the payment if the CPI declines. Instead, a decrease in CPI will be used to offset any future annual increases.

Obviously, a life income annuity that is indexed to inflation will either have a higher premium or lower initial payout compared to a non-indexed annuity.

To give you one example of comparative annuity income payouts, a single life annuity from the Principal Financial Group with a $100,000 premium will pay $570/month for life if purchased today by a 60 year old male. If that income is indexed to inflation, the initial income payout amount drops to $402/month. But with an extended run of inflation, the income could grow easily to exceed the income paid by the non-indexed annuity.

Final Thoughts on Inflation Indexed Annuities

Ideally, we would all know how exactly much money we will need to live on in retirement and where it we are going to find it. Nothing is for certain in the retirement income calculation, but eliminating inflation goes a long way. Combining Social Security, inflation-protected securities, and a life income annuity indexed to inflation could be a smart strategy for accomplishing that goal.

Image credit: Gregor Rohrig

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