ROTH IRA conversion to Annuities

[Guest Stiggy]

Hi folks, I've been reading some articles recently about why it's prudent to convert your IRA's, 401k's, etc to an annuity for when you're wanting to retire and establish systematic monthly retirement income. I was wondering if those that are experts in this arena could provide the pros/cons to this approach. If this is the wrong forum, I apologize. Thx.

[John G]

I am not an expert on annuities, but I will offer my quick take.

Annuities are blend products: a mix of insurance, investment, and guarentees. These are complicated products, and the insurance industry likes to keep them that way so you will rely heavily on the sales person. Expenses and fees are often over 2% a year - which is way too high. A sales person may steer you towards a package that gives him a nice commission rather than be best suited for you. Annuities may not keep up with inflation. You may purchase from a company that is sound today but is weaker many years down the road. There are often surrender fees if you change your mind in less than 7 years. Distribibutions are treated as ordinary income, not taxed at the lower capital gains and qualified dividends rates. Many annuities have stiff surrender fees, especially if you change your mind in the first 7 years. You are penalized for withdrawals before age 59 1/2. In my experience, many people who buy annuities do not understand what they own. Products with guarentees tend to offer lower performance because they appeal to folks who want certainty and may not understand longer term risks of inflation.

Locked up, high fee, surrender charges, possible lower performance.... hey, what's not to like! Frankly, a reasonably educated investor can accomplish much of the same features by direct investing in bonds, dividend playing stocks and mutual funds.

There are some positives:

- no limit on contributions

- tax deferred compounding

- guarenteed income stream (perhaps suitable for someone who can't manage there finances)

- some options for variable annuities to address the inflation concern

[Bird]

I pretty much agree with John G's conclusion that there are a lot of negatives that generally outweigh the positives.

It's also important to distinguish between an immediate annuity and a deferred annuity. The immediate annuity is where you give an insurance company a lump sum and they promise you a monthly income for life. I think that's what you're referring to. Generally, I'm not a fan, but sometimes they might be appropriate to provide a guaranteed base income. The younger you are, though, the less likely this is to make sense since the difference between the pure income that could be generated outside an annuity versus the annuity payout is going to be less at younger starting ages. One of the big negatives is that if inflation increases, you're stuck with the same payout (yes, you can buy a variable immediate annuity that at least has the potential to increase the payout but the fees tend to eat away at any of the potential advantages).

A deferred annuity is where you give the insurance company a lump sum and they will invest it for you, with no immediate payout; there might be a guaranteed or fixed rate, or you might be able to invest in mutual funds. I think these are very seldom the best choice, primarily because of the fees typically associated with them. But they are usually "appropriate" (i.e. acceptable, even if not the best option) and they are sold pretty heavily because it's a fairly easy sell and they pay a nice commission.

[John G]

Good points on immmediate vs delayed types - I should have covered it.

I think when you know more about alternatives (laddering bonds, bond fund, dividend paying stocks, growth and income mutual funds, etc.) annuities look less attractive annuities. Like many insurance products, they are sold heavily based upon a combination of fear and guarentees.

[Guest Stiggy]

Thx to both of you in respect to my posting. I was wondering myself why I would go the annuity approach as I get older vs continued mutual funds with no loads and low costs(obviously taking into consideration risk as I get older with inflation in mind as well). I understand the philosophy behind the guaranteed monthly income, but as you pointed out--there's many negatives that have me currently steering away from them. Regards.

[John G]

More info on annuities can be found in the Jane Bryant Quinn article, page 55 of the Sept 11 Newsweek titled "Cracking open the nest egg".

For the ambitous, you can do annuity shopping at www.annuityshopper.com and with info on age, gender and deposit amount find out what you would get.

Lets look at one example: couple age 55, $500,000 to purchase an immediate annuity.

Here is the result: $2,562 per month, guarenteed for life. If you don't get the income stream, your spouse will. If not the surviving spouse, then the next beneficiary until 20 years have passed.

A 6.15% annual return on the annuity, but the principal goes POOF. I have five stocks in my portfolio that have dividend yields over 6%. There are bonds that pay more than 6%. It is just not that hard to design a portfolio of stocks, bonds and mutual funds to support a 6.15% payout stream where there is enough of a growth component to provide some inflation protection. This annuity looks like a crappy option to me.

Read the Quinn article for some scary examples of hidden fees and convoluted annuity language.

[dh003i]

I have five stocks in my portfolio that have dividend yields over 6%. There are bonds that pay more than 6%. It is just not that hard to design a portfolio of stocks, bonds and mutual funds to support a 6.15% payout stream where there is enough of a growth component to provide some inflation protection. This annuity looks like a crappy option to me.

Almost universally ignored in the comparisons of annuities to higher growth-rate, less expensive, options is risk, as understood by the efficient market theory and the CAPM model. I don't consider standard deviation and correlation with the market to be perefect indicators of risk, but in some cases, I do think they quite accurately describe the risks investors are concerned about.

I think they are particularly applicable when investors want a steady income stream -- that is, want to dip into an account on a regular basis. In this case, volatility over the time-period from one distribution to the next is very important.

A portfolio of mutual funds, corporate bonds, and high dividend-paying stocks, designed for regular payout streams, is very likely to be more risky than an annuity. Of course, one can overpay for additional security...

An alternative to annuities that does consider risk is to invest in "risk-free" securities, namely government bonds (t-bills, I-bonds, etc). These do not include "death benefits".

[John G]

DH, you talk as if annuities have no risk. That is misleading. There is NO investment with zero risk, none.

The biggest risk with annuities is that they just doesn't keep you ahead of inflation, especially if the annuity is expected to pay out over a long time. Yeah, there are annuities that increase payments over time, and that's often because they have a partial stock market component to them... so they have risks that are just like stock market risk. A third type of risk is related to the insurance companies themselves. As one of my lawyer friends found out with liability settlements, not all insurance companies thrive over the long haul. When he uses annuities (typically for a handicapped person who can not take charge of their investments), he breaks up large settlements into at least 5 pieces and spreads the funds across five unrelated insurance companies.

I'm no big fan of theoretical arguments about X,Y or Z. Every investment option has both positive and negative attributes. When someone beats the table for one option as superior... well we call him a salesperson. I reiterate that it is possible to develop a well balanced portfolio of dividend paying stocks, bonds, and laddered CDs to address virtually any circumstance or drawdown scenario such as short term fixed, delayed variable, and long term escalating. A blend approach where you never give up your core value sure seems to have significant advantages to a plan where you turn over your assets on day 1. One part of a portfolio approach is that you can arrange assets to "manage" risk or to choose an acceptable level of risk.

[joel]

The immediate payout annuity should disclose in fat juicy lettering:

"You have irrevocably transferred the title to your principal (expressed in dollars) to the insurance company. In return the insurance company agrees to provide you with a monthly income of X $ for the remainder of your life. Upon your death all payments stop; there is no provision for a beneficiary. During your lifetime there is no provision to access your account beyond the guaranteed monthly payment."

I feel sales would plumet if these facts were disclosed. If you wish to disinherit your family buy an immediate annuity!

[Guest allancoleman]

And I'll add to that , joel , IF you want to make a insurance annuity sales rep , ESPECIALLY the sales rep , and company extremely happy , buy an annuity .