MONEY Master the Game: 7 Simple Steps to Financial Freedom (65 page)

The other type of annuity is called a deferred annuity.
This simply means you give the insurance company money either in one lump sum or over a period of years, and instead of receiving an immediate income, your returns are reinvested in a tax-deferred environment so that when you’re ready you can, at will, turn on the income stream you want for the rest of your life. You literally have a schedule for what your income will be when you’re 40, 50, 60—for every year of your life.

While there are many different versions of immediate annuities, with different terms and rewards that vary by the company that puts them out, similarly, there are a variety of types of deferred annuities.
Here’s the good news, though: there are roughly only three primary types of deferred annuities.
Once you know these three different types, along with your understanding of immediate annuities, you will fundamentally understand what your options are, and you will be able to
tap into the power of this safe-money vehicle.

So let’s make it as simple as 1, 2, 3. There are three types of deferred annuities. They are:

1. 
Fixed annuity
: This is where you get a fixed, guaranteed rate of return every year (independent of any stock market ups or downs), very much like you would receive with a CD or bond, but the rates are different.

2. 
Indexed annuity:
This is where your rate of return is tied to how the stock market does, but you get a percentage of the upside of the market (not all) with no downside and no possibility of loss.

3. 
Hybrid “indexed” annuity:
This is where you get the benefits of an indexed annuity with the addition of a “lifetime income” rider.
This lifetime income feature gives you the ability to turn on a paycheck for life!
(Note: technically
speaking, there isn’t a product called a “hybrid.” However, it has become a common name among professionals to describe the category, which includes the lifetime income feature.)

HOW SAFE ARE ANNUITIES? THE POWER OF INCOME INSURANCE

A guarantee is only as good as the insurance company that issues it, so highly rated insurance companies are key. Many of the top companies have over 100 years in the business, succeeding in spite of depressions, recessions, and world wars. But with over 1,000 insurance companies in the United States, it’s really only a handful that command the top ratings. I asked Dr. Jeffrey Brown about the safety of annuities and people’s concern that the insurance company could go under.

“Yes, this is a concern that a lot of people have,” he acknowledged. “I start by reassuring the people that to my knowledge—and I’ve been studying this for, you know, fifteen years or more—I don’t know of anyone who’s ever actually lost money in an annuity product, and there are a lot of reasons for that. Depending on what state you’re in, there are
insurance guaranty associations
run by the state insurance departments that will guarantee up to a certain amount/deposit of the product you buy. And the way these work is essentially every insurance company that operates in that state is basically agreeing to insure all the other ones.”

Each state has its own limits, but
the guarantee can be as high as $500,000,
for which you are insured against loss in the rare event of an insurance company failure. How rare? According to the FDIC (Federal Deposit Insurance Corporation), there were 140 bank closures in 2009 alone, yet not a single major insurance company went under.

VARIABLE ANNUITIES

There is one type of deferred annuity I deliberately didn’t mention above, and that is the variable annuity. The reason for that is,
nearly every expert I interviewed for this book agreed that variable annuities should be avoided.
They are extremely expensive, and the underlying deposits are invested in mutual funds (also known as sub accounts).

So not only are you paying fees for stock-picking mutual funds (which don’t beat the market and can average upward of 3% in annual fees), you are also paying the insurance company (between 1% and 2% annually). These products can be toxic, and yet brokers manage to sell about $150 billion in new deposits each year. I spent more time addressing variable annuities in chapter 2.7, “Myth 7: ‘I Hate Annuities, and You Should Too.’ ” Feel free to flip back for a refresher.

So let’s take a few moments and go a little deeper with each of these three options.

FIXED ANNUITIES

A
fixed deferred annuity
offers a specific guaranteed rate of return (for instance, 3% or 4%) for a specific period of time (such as five or ten years). The money grows tax deferred, and at the end of the term, you have a few options. You can walk away with your money, you can “roll your money” into a new annuity and keep the tax protection, or you can convert your account balance into a guaranteed lifetime income. There are no annual fees in a fixed deferred annuity. You will know in advance what your growth will be at the end of the term.

Pretty simple, right? These rates of return might not be terribly exciting in today’s market, but they change with interest rates. And at least this type of annuity has tax efficiency, so handled properly, this can increase your net rate of return significantly.

But let me share with you something quite a bit more interesting:

THE LONGER YOU WAIT, THE MORE YOU GET

What if you’re young and just getting started building your financial future, or you’re at a stage of life where you don’t need income today but you’re
concerned that your investment income may not last as long as you live? Remember, if someone retires today at 65, he or she may have 20 or 30 years of income needs. Trying to figure out how to make your money last that long is a fairly daunting task. So a new approach called
longevity insurance
has become increasingly popular. These products allow you to create income insurance so that you have guaranteed rates of income from, for example, age 80 or 85 until your passing. Knowing you have an income starting at that later stage gives you the freedom to have to plan for only 15 years of retirement instead of 20 or 30. Let me give you an example:

In a 2012
Wall Street Journal
article titled “How to Create a Pension (with a Few Catches),” writer Anne Tergesen highlights the benefits of putting away $100,000 today (for a male age 65) into a
deferred fixed-income annuity.
This man has other savings and investments, which he thinks will last him to age 85 and get him down the mountain safely.
But
if he lives past 85, his income insurance payments will begin, and the amounts he receives will be staggeringly large compared with how much he put in.

“Currently, a 65-year-old man paying $100,000 for an immediate fixed annuity can get about $7,600 a year for life . . . But with a longevity policy [a long-term deferred fixed-income annuity—I know the language is long] that starts issuing payments at age 85, his annual payout will be $63,990, New York Life says.”

Wow.
At age 65, if he makes a onetime deposit of just $100,000, his payments at age 85 are close to $64,000 per year! Why is this so valuable? Because at age 85, if he lives another ten or 15 years, he will get $64,000
every
year, dwarfing his initial investment.
But the best part is that he has to make his initial savings and investments last only 20 years, not 30 or 35. And with the volatility of markets and the inevitable challenge of sequence of returns, this task can be challenging for almost anyone.

I ran these numbers myself, and since I am only 54, my payments at age 85 would be $83,000 per year for the same onetime $100,000 deposit today! (And you don’t have to have a $100,000 lump-sum payment. It can be sizably smaller, which would also provide a smaller income.) That means if I live until I am 95, I would receive $830,000 in payments (10 years × $83,000) for my $100,000 deposit. And I don’t have to wait until age 85 to turn on the income. The day I make the deposit, I’m given a schedule of what the annual income payments will be at any age I want to begin taking income. If I felt I needed or wanted money at age 65 or 75, I know exactly how much that’s worth to me.
¹⁹

Income insurance, when structured correctly and as part of an overall plan, is an incredible tool that reverses or eliminates the risk of living too long and becoming a burden on your family members. When I met with Alicia Munnell, director of the Center for Retirement Research at Boston College, she echoed my enthusiasm: “So many people that I work with are very excited about and positive about the advanced-life deferred annuity, which is essentially longevity insurance.”

At my annual financial event in Sun Valley, Idaho, I interviewed famed publisher Steve Forbes. I asked him about his own approach to personal finance, and even he said that he has longevity insurance in place!

One more very cool thing? The IRS looks very favorably on these deferred income annuities, so you don’t have to pay tax on the entire income payment (because a good chunk of the payment is considered a return of your original deposit).

THE ULTIMATE INCOME SOLUTION

It’s been said that if you give a man a hammer, everything becomes a nail. This is to say that the solution outlined below, as exciting as it is, is not the be-all and end-all solution, nor is it for everyone or every situation. It’s part of an overall asset allocation. My objective here is to outline a powerful financial product, a hybrid annuity, that gives us great upside potential during its growth phase but also provides a guaranteed lifetime income down the road, when we crest the top of the mountain and begin the “second act” of our lives. It’s called a
fixed indexed annuity (FIA).

To be clear, there are two relatively new types of deferred annuities that have surged in popularity since they were introduced in the early 1990s:

1. the indexed annuity, where the rate of your return is tied to a stock index, and . . .

2. 
the even more popular hybrid version, where you get both a fixed rate of return and the option of a return tied to the growth of the stock market index as well as a guaranteed lifetime income feature.
These hybrid annuities are more commonly known as fixed indexed annuities, with a lifetime income rider or a guaranteed minimum withdrawal benefit. (I told you we’d make sense of this alphabet soup of financial terms.)

In 2013 alone, these annuities collected over $35 billion in deposits. In fact, as we were wrapping up this book, fixed indexed annuity deposits were at record levels through the first half of 2014, with over $24 billion in new deposits, a 41% growth over 2013.
Why this record growth?

• 
In a fixed indexed annuity, your deposits remain entirely in your control. You are
not
giving up access to your cash.

• 
It offers the potential for significantly higher annual returns than other safe-money solutions such as CDs or bonds.

• 
It provides a 100% guarantee
²⁰
of your principal—you can’t lose money.

• 
The growth is tax-deferred, providing maximum compounded growth for the expansion of your Freedom Fund.

• 
It provides income insurance, or a guaranteed income for life, when you select an optional income rider.

As I alluded to earlier, these structures offer upside without the downside. Gains with no losses. In many ways, they are an antidote to the problem of sequence of returns.

How do they work?

First of all, a fixed indexed annuity is
fixed, which means your account is guaranteed never to go down. No matter what happens, you will not lose your original deposit.
That’s half the battle! However, instead of getting a small guaranteed rate of return like a traditional fixed annuity, your “base account” growth is determined by tracking the gains of a stock market index such as the S&P 500. As an example, if the S&P 500 goes up 8% in a given year, you would get to keep (or “participate in”) a certain
percentage of that gain, which is typically subject to a cap. For example, if your cap was 5%, you would receive a 5% credit to your base account value.
²¹
In other words, there is a “cap” or a “ceiling” in most annuities on how much of the gain you get to keep.
But conversely, if the market goes down in that year, you don’t lose a dime!

In recent years, there have been a few unique products that allow you to keep 100% of the market/index gains and, yes, still avoid the down years!
There is no cap on your upside. What’s the catch? Instead of putting a cap on your annual gains, the insurance company will share in a small portion of your gains (1.5%, in many cases). So let’s say the index/market was up 8% in a given year; you would receive 6.5% added to your account, and the insurance company keeps 1.5%. Or if the market has a stronger year, with gains of 14%, you get to keep 12.5%. Many experts I spoke with anticipate that these uncapped annuities may be the future.