Are Annuities Better Than CDs

Anytime a question is poses as “are XYZs better than ABCs?” it invites controversy especially when it involves a comparison of “apples and oranges”.  No one will argue against the notion that annuities, or, for that matter, any particular investment vehicle, aren’t for everybody. This presupposes, using the same rationale in reverse that CDs are also not for everybody.  The only way the question can be answered meaningfully is when is posed in the context of any one person’s personal financial situation. Only with a good understanding of your own financial objective, needs, priorities and tolerance for risk, can you address the question of “Are annuities better than CDs.”

 

Comparing the Two as Apples

Let’s first examine the characteristics that are somewhat “apples to apples”:

Certificates of Deposit (CD)

CDs are a bank savings instrument structured as timed deposits which pays a fixed rate of interest over a set period of time.  The length of maturity terms varies between months and years, the shortest being three months and the longest being 5 years. Minimum deposits can be as low as $500 for a short term CD and as high as $10,000 for a “jumbo” CD. Smaller CDs with shorter maturity periods are credited with the smallest interest rates. Conversely, the larger CDs, such as jumbo CDs, with longer maturities earn a higher rate.   If you want to withdraw your money before the maturity date, you will be charged a penalty which typically comes in the form of a reduced interest rate credit on the entire balance.  The interest earned on CDs is taxed as ordinary income. When a CD matures, it can be renewed for another term.

CDs are issued by commercial banks, and if the issuing bank is member of Federal Deposit Insurance Corp (FDIC), its deposits, up to $250,000 per depositor, per bank, is protected against default.  Deposits on account with a bank are generally used in the bank’s lending business.  Essentially, your CD deposit is loaned out to bank clients or to other banks. The Federal Reserve only requires that banks keep a small fraction of the deposits on reserve because the Federal Reserve system will ensure their liquidity.

 

Annuities

Annuities are a form of an insurance contract issued by a life insurance company. In exchange for a deposit of money by an investor, the insurer guarantees either a minimum savings accumulation or a minimum income for a specified period of time.  The initial interest yield is guaranteed for a specified term of one year to 10 years, and is adjusted when the term expires. The contract does include a minimum rate guarantee that acts as a floor should interest rates drop below it.   Longer term annuities can earn higher initial rates and there are also deposit breakpoints which pay a bonus rate for larger deposits.

Annuities do allow for access to funds. Investors can withdraw funds once annually, but funds withdrawn in excess of 10% of the account value will be charged a surrender fee of up to 10%.  The surrender fee is reduced annually until it reached zero after which any amount may be withdrawn. Accumulated earnings are not currently taxed until they are withdrawn.  And, if withdrawals are taken prior to age 59 ½ the IRS may assess a 10% penalty unless certain conditions are met.

Annuities are also considered to be among the safest of savings vehicles. The life insurance industry is considered to be the strongest and most financial stable of all financial institutions. The very strict reserve requirements for life insurers ensure that there is sufficient liquidity to meet their obligations.  Although insurer deposits are not insured by the FDIC, each state maintains a guaranty fund that acts in much the same way. But unlike the FDIC which only maintains a small fraction of reserves to cover defaults, the guaranty funds are fully funded.

 

Comparison Based on Investment Need or Preferences

When comparing the two against specific investment needs or preferences, the distinction between the two become clearer.

Prefer the Most Competitive Rates

In both cases, interest yields are based on prevailing short term interest rates. Bank CD rates are generally derived from the prevailing market and also sensitive to short term movements in the rate.  Life insurers derive the interest yield on annuities from the yield generated on its investment portfolio.  Because the portfolios to invest in a range of long, medium and short term bonds, the yield tends to be higher than those of bank CDs and they are not quite as sensitive to short term rates.  Overall, annuities tend to have more competitive interest rates.

Prefer Tax Advantaged Growth

Bank CD interest earnings are fully taxable as ordinary income. Earnings inside of an annuity are taxed until they are withdrawn.

Long-term Safety

Both are extremely safe and provide investors with layers of protection. The recent failure of hundreds of banks during the economic crisis as compared with zero failures of life insurers during that same time points to the vulnerability of the banking system. Some economic experts have expressed concern over the ability of the Federal Reserve system to withstand another big economic crisis.  And, the FDIC is, essentially, broke.  Historically, the life insurance industry has always fared better during difficult economic times.

Flexibility and Access to Funds

Both CDs and annuities offer access to funds but with penalties attached prior to their maturity.  CDs must be held to maturity in order to receive the full amount of interest credited. Early withdrawals can result in the loss of six months of interest. Annuity funds may be accessed once annually, free of penalties as long as the amount doesn’t exceed 10% of the account value.  If you place $100,000 in a CD you can’t just access a part of it – the whole certificate would have to be redeemed. With an annuity you can withdraw $10,000 without penalty and without having to surrender the contract.

Summary

The same test applying a different set of investment needs or preferences might produce an analysis more in favor of bank CDs.  It really comes down to what’s important in your financial situation.  Before making any similar comparison between any two investment products, make sure that it is done in light of your specific investment profile.

Alternatives to Annuity Investment

Investors who consider annuities for their investment portfolio need to do so in the context of an overall strategy that is based on their long term objectives, time horizon, and their financial concerns. They should also be viewed as but one component of an asset allocation plan that achieves optimum diversification and balance for their investment profile. Some investors may find that annuities may not work in their strategy even though they like the basic features they offer. Others may find that annuities are a good fit for their portfolio, but want to diversify by adding similar investment products. In either case, it would be important to know the alternative to annuity investments in order to make the best decisions for your investment strategy.

Bank CDs

Bank CDs are often compared with annuities when the issues of safety and competitive fixed yields are considered. CDs have always been considered to be safe investments due largely to the fact that they are issued by banks and backed by the Federal Deposit Insurance Corporation. The rates offered by banks on their CDs are comparable to those offered on annuities. Because the methods for determining yields on CDs and on annuities differ, CDs yields tend to be slightly lower than annuity yields. However, CDs with long maturity terms can offer rates significantly higher than those with shorter terms. A five year CD will yield as much as a point more than a one or two year CD. Larger deposits (i.e. $100,000 or more) can also earn a much higher rate in a jumbo CD. If you try to cash out a CD before its maturity, the yield will be adjusted downward as a penalty. Interest earned from CDs is always taxed as ordinary income except if it is earned inside of a qualified retirement plan.

Tax Free Bonds

The interest generated from bonds issued by state and municipal governments are exempt from federal taxes. Tax free bonds purchased from within your resident state are also exempt from state income taxes. While the yields on tax free bonds are lower than those on taxable bonds issued by the federal government or corporations, their tax treatment can make them more attractive for investors in higher income tax brackets. For instance, a tax free bond yielding 3% would be equivalent to earning 4.5% on a taxable bond for someone in the 28% tax bracket. If you are in the highest tax bracket – 38%, you would a taxable bond would need to yield 5.3% to match the tax free yield of 3%.

Until recently, bonds issued by state and local governments have been considered to among the safer investments. State general obligation bonds were considered to be the safest. In view of the recent fiscal difficulties many states and municipalities are facing, this may no longer be true. Still, you can probably count on the ratings assigned by the ratings agencies, such as Standard & Poor’s’ or Moody’s to guide you to the highest quality issues. Additionally, tax free bonds are interest rate sensitive, meaning that, if interest rates increase, the value of the bonds will decrease. So, even though the income from the bonds can be considered safe, the actual bond values will fluctuate. Tax free income is hard to beat for investors in the top brackets. The important consideration for retirees is the fact that tax exempt income is included in the calculation to determine how much of their Social Security income is taxable. Alternatively, annuity income, which is partially tax exempt is not includable in the Social Security calculation.

Mutual Funds

Mutual funds are often compared with variable annuities for investors seeking investment diversification and professional management. With literally thousands of funds from which to choose, there is no shortage of options for investors who seek the broadest diversification. Some mutual fund families consist of dozens of different funds from a range of asset categories, such as growth stocks, aggressive growth stocks, international equities, individual industry sectors, corporate bonds, government bonds, real estate, and many more. The number of “no-load” funds offerings continues to grow, so the only cost consideration are the management fees which can vary widely depending on the type of fund and how actively it is managed. The earnings from mutual funds are taxable in the year they occur either in the form of capital gains taxes or ordinary income taxes on interest and dividends. Most mutual funds require a small initial investment ($500 or $1,000) and allow for even smaller monthly investments.

Is there such thing as an Alternative Annuity Investment?

Certainly any one of these investment provide a viable alternative for an investor looking for diversification and stability in an overall investment strategy. And, through a combination of these products, it is possible to achieve some tax advantages along with long term growth potential. All of them should be a part of any investor’s consideration for inclusion in a properly allocated portfolio. The question remains whether any one of them, or some combination, contain the unique characteristics of an annuity that can provide the same level of safety, stability, savings guarantees, income guarantees, tax advantages, and flexibility. Those familiar with annuity investments would probably conclude that they don’t, however, investors must determine for themselves just how important these benefits are in the grand scheme of their investment strategy.

How to Find a Financial Advisor

Financial planning tools are now ubiquitous across the Web. There are very few things an individual can’t do in calculating their needs and searching for solutions when they know how to access these tools online. Still, most people should seek the guidance of a financial professional, if for no other reason to validate their own findings and ensure that their solutions are best suited for their financial situation. If a person wants to truly address all of their financial needs, it may involve different disciplines, such as retirement planning, tax planning, insurance planning, and investment planning, that are beyond the scope of most people’s knowledge. A qualified, and trust financial advisor can ensure that your decisions are on the right track to meet your objectives.

What to Look for in a Financial Advisor

Financial advisors come in all shapes and sizes. What may pass as an “advisor” in some instances may be a product salesperson, such as a stockbroker or a life insurance agent. A true advisor should be a well-educated, credentialed, experienced, financial professional who works on behalf of his or her clients as opposed to serving the interests of a financial institution.  Generally, a financial advisor is an independent practitioner who operates in a fiduciary capacity in which a client’s interests come first.  Only registered investment advisors (RIA), who are governed by the Investment Advisers Act of 1940 are held to a true fiduciary standard. You can find some agents and brokers who try to practice in this capacity, however, their compensation structure is such that they are bound by the contracts of their companies.

How are they paid?

Many advisors actually work for a financial institution, such as a brokerage firm or a life insurance company, and they are compensated based on the sale of products offered or manufactured by these companies.  With this type of compensation, there are inherent conflicts of interest as products could be recommended that aren’t necessarily in the best interest of the client. Some financial reps are affiliated with an independent broker-dealer that provides the advisor with a product platform from which the rep can choose for his clients.  While they may have more flexibility in the way they can work with their clients, they are still paid commission for the sale of these products.  Some of these independent reps are RIAs who also charge fees for offering objective advice, but they also sell products for commissions. These are referred to as “hybrid” RIAs.

If you are looking for truly objective, conflict-free advice, it’s best to work with an independent, fee-only RIA.  Some RIAs charge fees based on assets under management. For instance, if a client has $500,000 of asset placed in the trust of an RIA, the RIA would charge a flat percent of around 1% annually. In this case, the RIA would earn $5,000 a year for advising the client without regard to the type of investments purchased.  Under this fee structure, most RIAs won’t work with anyone with less than $250,000 to $500,000 of assets to manage.  Other fee-only advisors charge an hourly rate, which may make sense for people with fewer assets who only need advice periodically.  In either case, fee-only RIAs will analyze your situation without any product bias and recommend investment and insurance products for which they are not compensated.

If all you need is some sound advice on how to allocate your retirement assets, or which life insurance strategy is best, it may be less expensive to work with a commission-based financial rep. But you should still look for one who is has the qualification, the knowledge and a client-centric approach in their practice.

Dedicated to Client Interests?

Regardless of whether they are independent, captive to a company, fee-only or commission-based, it is important that your advisor demonstrate a commitment to his excellence and your interest.  Advisors who commit themselves to rigorous and continuing education are best positioned to advise you and they clearly demonstrate their desire to provide superior service.  At a minimum, your advisor should be credentialed with designations from one or more of the financial professional schools, such as the College for Financial Planning (CFP), the American College (CLU, ChFC), a financial planning masters program (MFS), or any number of accredited professional colleges.

Background and Experience

There are more than 500,000 financial professionals in the U.S., so you can certainly afford to sift through those in your area that have the requisite background and experience. Look to those advisors with at least five years of experience in working with clients similar to your own profile. Also, you can check for any disciplinary actions by checking with the regulatory or governing agencies, such as FINRA, the state insurance commissioner, or the CFP Board of Standards.

Can they pass your interview?

That’s right – you need to interview them. You should meet with at least three candidates and ask them a series of questions regarding their practice – how they assess your situation; how they are compensated; how they make recommendations; their client profile, etc.  You’ll know if you are talking with a “client-centric” advisor when they skillfully turn the conversation to you and start asking you meaningful questions about your goals, dreams and concerns. If all you get from an interviewee is a sales pitch and brochure, you may want to move on to the next one.  Don’t be afraid to ask for references. A good indication of how well the advisor understands your situation is if they refer you to clients who have profiles similar to your own.

Where to look for the ideal financial advisor

Your best sources for finding a financial advisor are your trusted friends, relatives or colleagues. Additionally, you can search the directories of the professional organizations in your area. Look for advisors in your area with professional designations. You can then Google their names to learn more about their background, community involvement, and their stature in their industry.

 

Understanding Annuity Costs

There have been enough written and said about annuities to know that they do include certain costs that you wouldn’t ordinarily encounter with other types of investment products. Still, it is interesting that annuity critics try to illustrate cost disparities by comparing them with the other products. It’s not a fair comparison considering that annuities include many features and guarantees not found in other products, so there really is no equivalency. People buy annuities because they are looking for more guarantees, more safety, less taxes and, generally, more assurance that their savings or income will be there even if all heck break loose around them.  There is significant economic value and psychic value to that proposition which, for many people, far outweighs the additional costs.

Value vs. Cost

Volumes have been written in attempts to define “value” in the context of consumer decision-making.  While no standard definition emerges, the consensus among consumer behaviorists is that it is formed individually as a perception based on a personal frame of reference.  Perceived value is enhanced when a person feels that the benefits he or she receives exceed the monetary sacrifice in terms of money, time, and energy.  Most experts agree that perceived value equates to an emotional payoff for the consumer, which, if it is high, will lead to an entrenchment of favorable attitudes toward a product or service.

 

As with any type of product, investment or otherwise, it is always important to weigh annuity costs against the value received.  Annuity costs are transparently presented to prospective buyers through sample annuity contracts and prospectuses. It is up to the prospective buyer to determine whether these additional costs are a fair exchange of value for the additional benefits they receive in their annuity investment.  Essentially, prospective buyers need to determine how valuable annuity features are in addressing their own concerns, preferences and priorities. Specifically:

How important is it that my principal be protected for my family? Survivors of the market crash of 2008 may be asking themselves, “what if I had died and my family received just a fraction of my investment?” Annuity owners are assured that their family survivors will receive at least their principal investment, and in most cases, the gains in the account value regardless of the market performance.

How important is it that I can rely on a minimum amount of growth on my investment? Investors who struggled through the lost decade of 2000 to 2010 in which stocks returned an anemic 1.5%, probably wished they had a fixed annuity that returned, on average, 3.8%, or an indexed annuity that returned, on average, 4.6%.  And, looking into the uncertainty of the current market, they may be wishing for more stable returns.

How important is it for me to sleep at night knowing my principal is safe?  If you ask any of the customers of the more than 500 banks that failed in the economic crisis how well they slept, you may get stares from bloodshot eyes.  Life insurance companies are still the strongest and most financially stable of all financial institutions, and the regulations that govern their financial management are much stricter than those that apply to the banks.

How important that is it that I can count on an income that I can’t outlive? Just ask three out of four Baby Boomers who, by their own admission, are very concerned with the possibility of outliving their income.

Weighing the Costs

The perceived value of an annuity can only be measured by the individual addressing these concerns.  With that, the costs can be considered in the context of the value received.

Mortality and Expense Charges,

All annuities are essentially insurance contracts. They include a death benefit, and, in the case of an immediate annuity, a lifetime income guarantee. The mortality is the risk cost to the insurer in guaranteeing these benefits.  Additionally, the insurer deducts a portion to cover its administrative and marketing costs. The total mortality and expense charge typically ranges from 1 to 1.5 percent.

Investment Management Fees

With variable annuities, the accumulation account is comprised of separate investment accounts, similar to mutual funds. Fees are charged for the professional management of the accounts. As with mutual funds, the fees are higher for more actively managed accounts such as growth stock accounts. Fees range from .5 percent for bond accounts to 1.5% for aggressively managed accounts. These fees are generally in line with the fees charged in mutual fund accounts.

Surrender Charges

Even though investors look to annuities as long term investments, they take comfort knowing that, should their circumstances change, they can still access their funds if necessary. Deferred annuities include provisions which allow for annual withdrawals without charge if they don’t exceed 10% of the account values. Excess withdrawals are charged a surrender fee of 5% to 10% initially. The fees decline by one point each year of the contract, so that, at the end of the surrender period, there is no charge.  Most long term investors can live with this, but there is value in knowing their funds are available.

Optional Features and Guarantees

Annuities offer additional options that can enhance the guarantees, such as inflation riders, or principal step-up options. Generally, these options come at an additional cost. Consumers are used to evaluating extra features to determine if their value outweighs the costs.

Summary

Yes, annuities have costs, more so than other investment products. But they also provide economic value and psychic value not available in some of the other products. Consumers today are looking for greater emotional payoff in their investment products, and they are savvy enough to measure the costs versus the long term payoff.  Some won’t perceive the value as great enough to outweigh the costs, while others will. That’s what the free market is all about.

 

How Annuitization Works

When using big term such as, “annuitization,” it’s best to provide a literal definition and then explain what it means in terms that we can all understand. Literally speaking, annuitization is the process of converting a lump sum of capital into a series of periodic payments for specific period of time, or an individual’s lifetime. Used in the context of annuity products, it is a method by which a life insurance company, in exchange for a lump sum of capital, guarantees a stream of income for a set time period or for the life of an individual based on such factors as the amount of capital, the number of payment periods and interest rate assumption.

Annuities Explained

How it Works

When annuitization is to occur for the lifetime of an individual, the number of periods used to determine the income payment is based on the number of periods that occur between the individual’s current age and his or her life expectancy.  The “life insurance” component of income annuities, which is their most prominent feature, is the guarantee that, should the individual live beyond his or her life expectancy, the life insurer will continue to make the payments until the person dies.

Annuitization can take several forms, the most common of which is a lifetime option, in which payments are guaranteed for the life of the annuitant (the person receiving the payments).  Under this arrangement the payments cease and the remaining annuity balance is retained by the life insurer. Other forms include joint life, which guarantees an income on the joint lives of two spouses so that it will continue for the surviving spouse; and a period certain in which payments are made for a stated number of years. With all of these forms, there is also an option to provide the beneficiary with a refund of unused principal in the event the annuitant dies before the end of their annuity period. These refund options are typically selected with a term certain, meaning that, if the annuitant dies within a certain number of years after annuitization, the annuity value is refunded to the beneficiary.

Anytime extra guarantees, such as joint life or period certain with refund are added, it increases the cost of the annuity.  These added costs are recovered by the insurer by means of reducing the income payment by a certain percentage.  A lifetime annuity on a single life with no refund will receive a full payout, while a joint life arrangement will result in a reduced payout as would an annuity option that involves a refund.

Products for Annuitization

Annuitization can occur within two different types of annuities – a deferred annuity or an immediate annuity. With a deferred annuity, funds are accumulated over a period of time during the “accumulation stage” of the annuity. At the time of the annuity contract owner’s choosing, the deferred annuity can be annuitized at which time the annuity account value is committed to the life insurer so that it can establish a rate of payment.  This is called the “distribution stage” of the annuity. The other type, which is used strictly for annuitization, is an immediate annuity. With an immediate annuity, an individual deposits a lump sum of capital with a life insurer which then immediately (immediate could mean within 30 days or within a year), converts it to a stream of income payments.  In both cases, once the funds are annuitized they are irrevocably committed to the insurer (unless a refund option is selected by the annuity owner).

Income Maximization

Because income payments are calculated by dividing the total capital available (plus project interest) by the number of periods, higher income payments can be achieved by shortening the number of periods. For instance, annuitization that occurs over a person’s life expectancy of say, twenty years, would produce a lower monthly payout than one that is set up as a period certain for 10 years.  If one were concerned about maximizing their monthly income they could choose a shorter period certain option, but they would risk outliving their income.

Alternatively, they could delay annuitization as long as possible. Rather than commence lifetime income payments at age 65, which would generate a payout rate based on 17 years of payments, they could instead wait until age 70 which would shorten the number of payment periods resulting in a higher payout rate.  Another strategy is to combine deferred annuities with a series of shorter, period certain annuities which enable the annuitant to receive maximum income from the shorter termed annuities while allowing the remaining capital to continue grow. When the period certain annuity is depleted, another one is annuitized in its place.

Summary

Annuitization, in spite of its big, technical name, is actually a fairly straight forward process. It’s an exchange of capital for income.  Yes, there are a number of actuarial assumptions involved to calculate the income, but it’s not much more complicated than dividing the capital amount, including the interest to be paid over the term of the annuity, by the number of payments a person wants to receive. What set’s annuity products apart from any other type of income strategy or investment product, is that the payments, whether for a period certain, or for a lifetime, are guaranteed. In light of recent troubles in the financial markets and the uncertainty of the economy, a growing number of people find that aspect appealing. At the very least, an annuitization strategy using an annuity can be combined with other, more aggressive income strategies to create the income safety net everyone needs.