Mouthful of an investment made for a long life

By Matthew Lubanko, financial columnist for the Hartford Courant September 12, 2004

This article appears at the following website: chicagotribune.com

Lifetime-fixed-immediate annuity offers steady return, but age matters

There's one annuity that doesn't have a mile-long rap sheet - the lifetime-fixed-immediate annuity. And despite its mouthful of a name, it's the easiest annuity to understand, the cheapest to buy and for some people the most desirable to own.

The product is simple.

You surrender a sum of cash today in exchange for a fixed stream of regular payments--either immediately or at a later date. The payments continue until you die, no matter how long you live. If you die before life-expectancy tables say you would, the insurer uses your cash to pay annuity holders who live a long time. If you live a long time, you can receive far more cash than you originally put up.

This guarantee--income for life no matter how long you live--makes lifetime-fixed-immediate annuities worth investigating, especially for people over age 65.

"It's one of the few life insurance products that are not oversold," said Glenn Daily, a life insurance consultant based in New York.

Yet before you rush out and buy a lifetime-fixed-immediate annuity, take the time to learn more about the product's promises and perils. Risks loom on several fronts, life insurance analysts said.

So investors should carefully weigh two "on the one hand/on the other hand" scenarios.

Buy at too young an age--when insurers expect you'll live for a very long time--and your lump of cash generates a comparatively low monthly income. Buy at too old an age, and if you die soon thereafter, you've surrendered a sizable sum of cash and gotten little of it back.

Invest a large sum of cash all at once, and you make an irrevocable bet on long-term interest rates, because the yield on your annuity is fixed for life. On the other hand, resist the temptation to buy at all, and you risk outliving your savings.

Age and amount

Before reviewing each risk and reward, begin your fixed-immediate-annuity shopping with two simple facts: your age and the amount of cash you can afford to surrender for life.

In mid-July, a 70-year-old man who put down $100,000 could expect a monthly payout of between $700 and $800 a month, according to The Annuity Shopper newsletter (see www.annuityshopper.com for details).

"Look for the biggest payout you can get, from an insurer that can stand behind its guarantee to pay you for life," said Hersh Stern, publisher of The Annuity Shopper.

A.M. Best, Standard and Poor’s, Moody's Investor Services, Fitch Inc. and Weiss Ratings Inc. all rank life insurers for financial fitness.

After you've found a few life insurers offering attractive monthly payments, consider whether it is the best time to buy an annuity.

Rates on 10-year U.S. Treasury notes stood at around 4.25 percent in early September, better than the 3.1 percent yield 10-year U.S. Treasuries delivered in June 2003 but below the average yield of 6.8 percent established over the 20-year period ended Aug. 31.

Profiting from the spread

Treasury yields matter because they often influence the rates insurers pay to annuity owners. In today's low-rate climate, for example, annuitants can expect to receive from 2.75 percent to 4.25 percent, depending on the expected life span of the person buying the contract, said Stern, who also edits the Total Return Annuities.com Web site.

Insurers pay close attention to the U.S. Treasury markets for a reason. When they write annuity contracts, they expect to make money from the spread--the difference between the interest they pay you and the annual returns they expect to receive from fairly conservative investments.

With rates as low as they are today, it might be a better idea to invest in bank CDs, U.S. Treasury bills or short-term corporate bonds in expectation that rates--and annuity payouts--will rise in the future, said Peter Katt, a life insurance consultant based in Kalamazoo, Mich.

But don't get caught up in the waiting game forever, especially if you're approaching age 75, in good health and short of other guaranteed sources of income.

"Studies show that annuitized payments consistently last longer than lump sums," said Eric Sondergeld, director of retirement research at Limra Inc., a life insurance consulting firm based in Windsor, Conn.

Studies on annuities and why they're worth considering, especially for people expecting to live more than 15 years in retirement, can be viewed on the Internet at www.ifid.ca/research.htm.

If you are in good health, it's important to overcome the worry that if you buy a fixed-immediate-lifetime annuity today, and die tomorrow, you'll "lose your bet," said Rebecca Cohen, a spokeswoman for Vanguard Group.

"A lifetime-fixed-immediate annuity is a form of insurance," Cohen said, one that continuously delivers income if you live well beyond your expected life span.

Guaranteed payments can go to many lengths

There are many ways to structure annuity payments from a fixed-sum investment.

Some guarantee a fixed income for life. If the contract holder, or annuitant, dies, the insurance company keeps part of the lump sum yet to be paid out.

Other annuities, however, can guarantee regular payments for specific time frames: 5, 10, 15, 20 years or more. When the time period expires, the annuitized payments stop.

So-called period-certain payments present additional options. An annuitant can take a lower monthly payment for a fixed period (typically 5, 10, 15 or 20 years) in exchange for the privilege of leaving money to heirs if the annuitant dies before the period expires.

If, for example, an annuitant buys a 10-year certain period, then dies in seven years, the heirs named in beneficiary forms would receive the remaining unpaid sums.

If, on the other hand, the annuitant or contract holder lives for 20 years--10 years beyond the 10-year contract--and has a life contingency clause in the annuity, the payments continue. But this flexibility often comes at a price. The payments usually are lower than what one could receive from a fixed-immediate-lifetime annuity, with its irrevocable terms.

Funding source determines taxable amount

Along with the rewards of an income stream for life, a lifetime-fixed-immediate annuity carries the penalty of taxation until death.

Some accountholders pay quarterly or yearly taxes on every penny they receive from an annuity. Others pay taxes on just a portion of each payment.

How payments from lifetime-fixed-immediate annuities are taxed ultimately depend on a number of factors such as the age of the annuitant, the size of the original investment in the annuity and the means by which the account was funded.

Let's review two common cases: a lifetime-fixed-immediate annuity funded with pretax dollars from a 401(k) or other employer-sponsored retirement plan, and an identical annuity funded with after-tax dollars, such as savings in a taxable account.

Figuring out the taxes for 401(k)-funded annuities is quite simple.

Because no income taxes were paid on money that originally went into the account, everything that comes out of it is taxed as ordinary income. If, for example, you receive $9,000 a year from an annuity funded with pretax dollars, that $9,000 is taxed as ordinary income, said Jim Magner, a tax attorney and head of the advanced-annuity sales department at Lincoln National Corp.

With lifetime-fixed-immediate annuities funded by savings outside of a retirement account, taxation becomes a more difficult proposition.

Part of the payment is taxed as income and part is treated as a "return of premium" and not taxed. It boils down to a two-step arithmetic equation, said Michael Berry, a certified financial planner and senior marketing consultant with ING Group's advanced-annuity sales. (For further details, see IRS Publication 939: General Rule for Pensions and Annuities).

You first multiply the monthly payout (say $750) by the number of annual payments (12) by the number of years that person is expected to live (say 15 years). That comes to $135,000 in total payments.

Then divide the value of the original investment (say $100,000) by the product in Step 1. The $100,000 (the original investment) divided by expected lifetime payments ($135,000) gives you a so-called "exclusion ratio" of 74 percent.

"The exclusion ratio determines which portion of the payment (74 percent in our hypothetical case) is return of premium," Berry said. On a $9,000 annual payment, therefore, $6,660 would be treated as a return of premium, and $2,340 would be taxed as ordinary income.