A Reporter’s Guide To Fixed Annuities
It seems like whenever some reporters or financial writers attempt to talk about fixed annuities – whether fixed rate or fixed index – they get it really screwed up. They’ll often write about fixed annuity fees – although fixed annuities don’t have fees. Or they’ll say that the consumer is locked into an unchanging income stream – which is not the case. Or they’ll try to balance the story by asking stockbrokers and securities analysts what they think of fixed annuities – which is somewhat akin to asking a Boston Red Sox fan what he thinks the New York Yankees chances are this year.
I was somewhat confused about these reporters and their sometimes negative approach to fixed annuities, so I asked a financial writer I know for his perspective. My friend explained it was possible that these writers, instead of taking the time to thoroughly investigate and learn about fixed annuities, were trying to force this new fixed annuity information to meet the preconceived conclusions they’d already developed from other areas.
Some reporters have done real research on fixed annuities and simply decided they like other alternatives better than fixed annuities. I thank them for their dedication and appreciate their analysis. For the others, in an attempt to increase general knowledge of the fourth estate I have prepared a little piece, designed for reporters, on what fixed annuities are and how they work.
Fixed Annuities Don’t Have Fees
The way a fixed annuity credits interest may best be compared with the way a bank credits certificate of deposit interest. The bank says they will pay 4% interest on the CD. Okay, what are the bank’s fees and expenses on this CD? If your answer is you can’t tell and it doesn’t matter because all you really care about is the final rate you get on your money, the same logic applies to fixed annuities.
The insurance company doesn’t deduct a management fee and share a net return with the customer. Instead, just like the bank, the insurer pays a fixed return, and this may be stated as a fixed rate or as fixed participation in an index.
Might some banks have lower operating costs or higher revenues than another and thus offer a higher rate? Yes, and an insurer could spend less on office supplies than another insurer and thereby ultimately be able to pay a higher rate on fixed annuities. But I don’t know how you translate all of this into fees?
Do some annuities have fees? Yes. These are called variable annuities and they work a lot like mutual funds.
Fixed Annuities Are Not Variable Annuities
A fixed rate annuity pays a stated rate of interest that is no less than the minimum guaranteed rate of interest. A fixed index annuity pays a minimum rate of interest and bases the crediting of excess interest on the movement of an external index. With a fixed index annuity the rate of participation in the index interest crediting for the period is fixed and known; the minimum guaranteed interest rate is fixed and known; the only unknown is how the index will move. Neither fixed rate nor fixed index annuities can lose principal or credited interest if the stock market goes down. And yet reporters always try to segment fixed annuities as variable annuities - let’s look at the differences.
►Variable annuity principal is subject to market risk. Fixed annuity principal is not subject to market risk.
►Variable annuity returns may be lost due to market risk. Fixed annuity credited interest cannot be lost due to market risk.
►Variable annuities have mortality charges and management fees. Fixed annuities do not charge mortality and management fees.
►Variable annuities do not pay minimum interest rates. Fixed annuities do credit minimum guaranteed interest rates.
99% Of Annuities Are Not Annuitized
Every definition of an annuity I’ve read starts out “An annuity is a contract in which an insurance company makes a series of income payments at regular intervals”, but the reality is with a fixed annuity this is almost never the case. And yet reporters often try to dismiss fixed annuities as poorly performing pensions. A consumer can annuitize a fixed annuity and receive an income they can never outlive – and this is a wonderful benefit – but anecdotal evidence says that 99% of annuities are not annuitized, and the owner either spends the accumulated value in later years or passes the entire annuity along to their heirs.
A fixed annuity is an accumulation vehicle. It should be compared on that basis with other savings instruments. Unlike other instruments fixed annuities provide the option of a guaranteed income, but it is a choice not a mandate.
A Maturity Date Is Not Life Without Parole
One of the stranger conclusions I read once was that annuities lock up your money for 40 or 50 years. Fixed annuities have maturity dates that permit the consumer to keep an annuity until age 85 or 95. However, saying that this locks you in is like saying if you get on Interstate 80 in New York you can’t get off until you reach San Francisco. A fixed annuity is a financial highway, and just like on the Interstate the driver can choose to exit at any time.
Fixed Annuities Are Not Subject To Capital Gain Taxes
I once saw a reporter argue that fixed annuities had higher taxes than mutual funds. I think the argument the writer was trying to make is that money taken out of fixed annuities is taxed as ordinary taxable income while long-held mutual funds may be taxed at lower capital gain rates. Let’s not respond by showing how grossly tax-inefficient some mutual funds are, or how a long-term comparison of tax-deferral versus capital gains often tilts the scales in favor of tax-deferral, because the real problem here is that the reporter was trying to compare two entirely different things.
Savings vehicles are subject to ordinary income tax, not capital gain tax. One wouldn’t tell someone that they shouldn’t open a bank savings account or buy a CD or purchase Savings Bonds because the earnings were taxed at a higher rate than if they invested in a growth fund. Fixed annuities aren’t a capital investment; they are interest paying savings instruments.
Fixed Annuities Are Almost Always Appropriate For Seniors
Let’s understand what a fixed annuity is. A fixed annuity is a savings vehicle. A fixed annuity pays a fixed interest rate or index-linked interested based on fixed participation for the period. A fixed annuity gives the annuity owner control over when taxes are paid on interest earned. If your goal was to maximize portfolio growth you wouldn’t put all of your money into a fixed annuity.
But let’s compare fixed annuities to other savings vehicles. A fixed annuity – whether it is a fixed rate or fixed index – offers the potential for higher interest than you might receive from a bank or savings bonds.
●Neither principal nor credited interest is subject to market risk.
●Although fixed annuities aren’t federally insured, their track record of principal protection and safety is extraordinary.
And unlike bank accounts or taxable bonds fixed annuity owners decide when to take the interest and pay the tax – not the IRS. If seniors want an instrument that is very safe, may pay higher interest than other savings vehicles, and gives them control over their taxes, then fixed annuities are appropriate.
Fixed Annuities Pay Fixed Annuity Returns
A couple of years ago I saw reporters criticize fixed annuities because they were “only” paying 7%, 8% 9% interest and instead reporters trumpeted the double-digit returns of mutual funds. It’s 2002. No fixed annuity has given back any credited interest and we know what happened to the double-digit mutual fund gains.
Fixed annuities aim for savings instrument-like returns while providing savings instrument-like protection of principal. Once again, variable annuities and mutual funds are investments; certificates of deposit and fixed annuities are savings instruments. Reporters should keep any comparisons valid and consistent.
Fixed Annuities Aren’t Perfect
As savings vehicles fixed annuities have imperfections. If you’re under age 59½ the IRS will hit you with a 10% penalty in additional to normal taxes on interest taken. Although fixed annuity surrender periods can be as short as one year, you could find yourself facing some stiff charges if you want to get out of some fixed annuities early. And although there is a minimum return, there’s no guarantee that the insurance company will always be able to credit a competitive interest rate – future rates to a large part depend on the economy and the management decisions of the insurance company.
Fixed annuities are a valid saving vehicle with strengths and weaknesses and should be explored and written about in that context. Variable annuities are investments. And frankly, if a reporter is not going to take the time to understand the basic difference between investments and savings instruments they shouldn’t write the article.