ANNUITIES

Brad Baker: “I've read your books countless times and kept many people away from annuities for the reasons you outline.  Now I’m wondering how to tell them that an annuity may be a good idea (is it because it's not a variable annuity, or because it's immediate vs. deferred, or absent of high sales charges?).”

F Great question.  Most annuities are sold to young(ish) people as investments.  Beware for all the reasons you’ve read countless times.  But what annuities used to be, and still can be, are . . . well, annuities – that is, a monthly payment for the rest of your life.  Which is particularly handy if you don’t know how long you’re going to live.  (The downside, as I say, is that most annuities don’t cover you for inflation.)  So in the case of the widow with $250,000 to supplement her Social Security, addressed here recently, this could make sense.

David Ellis: “When an annuity is a good solution for a problem, there may be a way to get a better annuity” – namely, David suggests, the extra inflation-adjusted annuity you get, in effect, by opting for “maximized Social Security benefits” rather than the reduced benefits you get if you elect to have them begin at age 62. 

“Maximized Social Security benefits can cost less than half the price of conventional annuities,” writes David, and can be attained two ways:

1.  Spend your own money from age 62 until you are eligible for the full retirement benefit at 65.

2.  Collect benefits at age 62, but at age 65, withdraw the Social Security claim, pay back all Social Security benefits received, and resubmit a claim for maximum benefits.

“I chose that second option.  Worked real well for me, especially the income tax deduction I got for Social Security income I had paid taxes on in prior years.  This amount went straight to ‘miscellaneous adjustments’ on the Itemized Deduction sheet.” 

F I had not been aware of David’s “option #2” above or the tax treatment.  I haven’t had time to verify its accuracy, but it sure sounds as if he knows whereof he speaks.

There are also advantages in delaying the start of benefits past age 65.  Waiting to age 69 to collect will increase the eventual pay-outs by 32% or more.  Here is a helpful calculator to help you see the penalty or bonus in beginning to collect benefits early or late.  Clearly, if you can afford to wait, it is the more conservative thing to do.  Then again, only after you have passed on to your reward (which, because you are a reader of this clumn I can almost guarantee will involve harps), will you be able to calculate with certainty who made out better by deciding to delay, you or Uncle Sam.  The longer you live, the more sense it makes to delay the start of benefits.  (Conversely, if you eschew the benefits at 62, waiting to 65, but die at age 64, Uncle Sam wins.)

Bob Sanderson: “As part of this discussion, Elliot Raphaelson recommended ‘Another option is for her to invest the majority (say 90%) in a high yield corporate bond fund, either PIMCO, or Vanguard.’   Two very good companies, but in my opinion a very high-risk strategy for someone looking for income.  High-yield bonds yield more than other bonds because they are lower quality and more prone to default than higher-rated bonds.  The default rate on these bonds has been increasing as interest rates have risen, and as I understand it, is projected to continue to increase.  From what I read, the high-yield bond market has a lower-than-normal spread relative to US government bonds, which means you aren't being compensated for their risk as much as you historically were.  Maybe not the best time to roll the dice.  And 90% in one asset class?  Has Mr. Raphaelson read your book?”

F Now, now.  You definitely have a point . . . and I think the annuity could suit her situation if it’s not important to her to leave an inheritance (if, that is, she’s okay consuming all her assets during her lifetime) . . . a another reader writes: “Eliot’s suggestion re the Vanguard Hi Yield Bond Fund in lieu of an annuity is further strengthened by the higher quality junk bonds used by Vanguard.”  (Quality junk.  But knowing Vanguard, I wouldn’t be surprised.)

Mike Albert:  “You passed on a recommendation by Tobias Brown for the Vanguard inflation protected annuity.  I think Vanguard is a great organization, and their products are fantastic: all our investment funds are with them.  I also think that an annuity that is adjusted for the CPI would be a wonderful thing, and have been looking for one for some time.  Unfortunately there’s a problem with the Vanguard offering.  Here's what

I wrote in my letter to Vanguard last October regarding their product:

    As part of my analysis I checked the safety of the insurance

    company you use (AIG Life Insurance Company located in Delaware) via

    Weiss Ratings (at http://www.weissratings.com.)  Although this

    rating service is not widely known, its ratings have been found by

    the GAO and others to detect financial vulnerability much more

    reliably than other rating services (as described at

    http://www.weissratings.com/gao_study.asp.)

    Weiss Ratings assigns AIG Insurance Company a rating of C+.  It

    describes this rating as "Fair Financial Strength: ... during an

    economic downturn or financial pressures, we feel it may encounter

    difficulties in maintaining its financial stability."

    I would never trust an insurance company with such a low Weiss

    rating.  This rating indicates way too much risk to be acceptable

    for my assets, no matter what other benefits are provided.  If I do

    decide to annuitize at some time, I will only use Vanguard if the

    insurance company you employ has a much better rating.

“In the eighties I purchased Single Premium Deferred Annuities from Executive Life of New York and Fidelity Bankers Life because they were providing great returns.  Knowing that there was some risk involved, I kept watch over my investment by periodically checking the Best ratings, which never indicated a problem.  Nevertheless, both companies failed before I could do anything.  Weiss, on the other hand, detected each company’s weakness over a year before it failed.  If I had known about Weiss at the time, I’d have avoided a significant loss.

“A manager at Vanguard called me to discuss my letter.  He told me that they continually examine the financial health of their insurers, and are confident in the level of safety they provide.  That may be, but when a big chunk of my money is irrevocably tied up in a company for THE REST OF MY LIFE, I want maximum safety.  A grade of C+ isn't even close.  You might want to mention this concern to readers who might be tempted to employ the Vanguard offering.  If they’d all write letters to Vanguard asking them to use a safer insurance company for this product, that would be nice too.”

Peter Kaczowka: “Beware of annuities or other investments such as bonds that claim to be ‘inflation protected’.  They are pegged to the CPI which grossly underestimates true inflation.  If you had invested in them (say) 10 years ago, you would not have matched the rising cost of housing, energy, college or health care; the major expenses to families if not to retirees. Economists consider rising home prices a plus: tell that to my 25-year-old son who wants to buy a house! CPI is a bogus measure of costs, rigged to make the economy (and therefore the current administration) look good.  Real inflation is running about 8%; GDP and income growth are negative.”

F Here is a more moderate overview of the situation, suggesting that the CPI does understate inflation, as Peter asserts, if perhaps not so egregiously.  Either way, if you go back to that April 2 column, you’ll see a suggestion that our widow not put the full $250,000 into an annuity all at once.