When a client asks ‘what time is it,’ you don’t teach them how to make a clock
by Herbert K. Daroff, J.D., CFP, AEPMr. Daroff, a contributing editor to this magazine, is affiliated with Baystate Financial Planning, in Wellesley, Ma. Connect with him by e-mail: [email protected]
Today’s low interest rates makes it a great time to lock in interest on debt, like mortgages. However, it makes it a very bad time to lock in fixed income. An annuity, once it begins its payout period, produces level income for a period of years or for a measuring life. As the costs of goods increases (with inflation), your income does not. You assure yourself a diminished standard of living.
Annuities come in lots of flavors. First, the payout period can either be immediate or deferred. A single premium immediate annuity (SPIA) produces a set amount of income based on the lump sum deposit. The payout can be over a series of years. For example, a 10-year certain annuity, pays out a specified amount to the annuitant, or beneficiary, for exactly 10 years, usually 120 monthly payments.
Therefore, the payout is not affected by the annuitant’s age. Ten years is ten years for a 35-year old or an 85-year old. The payout can be for a specified series or years or the life of the annuitant, whichever is longer. An example of that is a 10-year certain and continuous (or 10 C&C) annuity. If an 85-year old buys one and dies at 90, his or her beneficiary receives the remaining payments until a total of 120 are received.
The Measuring Life
However, if that 85-year old lives to be 100, he or she receives income for 15 years, the measuring life. The payout differs by age. The annuity income can be based solely on a measuring life. A single life annuity stops distributing income when the measuring life dies. An 85-year old who dies at 87 loses a lot of money for his or her family. A joint and survivor annuity pays out until both measuring lives have died. The amount that the surviving annuitant receives can be 100% of what the first annuitant received or some lesser percentage, such as Joint and 50% Survivor.
You can add a refund option that assures that you, or your beneficiary, receive at least the full amount that you deposited. You lose the interest you could have earned. In order of income, highest to lowest, the same amount deposited produces the most from a single life annuity, without a refund option. It has the greatest risk that the annuity company may keep the most of your money. A 10-year certain annuity would have a higher monthly payout than a 10-year certain and continuous annuity, because it may payout less total income. In a deferred annuity, the same options, as above, are available once the payout begins.
Second, deferred annuities provide options for how the funds deposited grow until the payout period begins. The fund growth can be fixed, variable, or indexed. A fixed annuity in today’s low interest rates gives you today’s low interest rates as the fuel for your income.
Managing The ‘Fuel’
A variable annuity gives you the ability to manage the fuel like a 401(k) plan, changing the mix as you wish. As a result, you can earn more, but you can also lose more. Even in today’s low interest rates, the value won’t go down in a fixed annuity. With a variable annuity, the value can go down if the underlying investments decline in value.
However, most variable annuities provide a series of income benefit riders that provide a “hedge” on the investment return used to measure the income once payout begins. These riders come with additional fees, like buying fire insurance on your retirement income. If the markets keep climbing, you didn’t need to buy the insurance.
But, in a market downturn, you appreciate the added cost, given the added value (or loss of value). If your house never burns down, did you waste the insurance money? Or, did it provide you some comfort that has some value to you. The more risk averse you are to investment market risk, the more you would be willing to pay the variable annuity income rider fee. The indexed annuity gives you return based on the performance of a selected index, such as the S&P 500, but does not actually invest in the S&P 500 so you don’t get the benefit of dividends, just the index value. And, these annuities usually limit the upside growth to some fixed percentage amount, because they also limit the downside risk, also by some fixed percentage. For example, the indexed annuity may provide that your value can increase by no more than 12% in any given year, but will not go down, at all, or will only go down by say 5% in any given year, regardless of the actual performance of that index.
How confused are your clients now?
Are you confused yet? And, if you are reading this, you are likely a financial advisor. Just imagine how complicated all of this is to your clients.
What’s the best choice? The answer is always, it depends! It depends on the answers to so many questions about risk tolerance and risk capacity, the value of other assets, the sources of other income, and so much more. As I have said many time, “prescription without diagnosis is malpractice.” A financial plan showing the various options in up and down market conditions may help a client make a choice, or may just confuse them further. When a client asks, “what time is it?” don’t teach them how to make a clock.
The annuity portion of an optimal income portfolio for each client may very well be a well-diversified combination of fixed, variable, and indexed annuities.
So, what are the other income tools, besides annuities? Insurance and Investments. The longer you work, the less funds you will need for your income once you stop. Work until you drop. I plan to work until I die and my wife will live on my life insurance proceeds. Life insurance cash value is a living benefit and provides an interesting substitute for cash in today’s low interest rates. What type of life insurance should you have? It depends! It may very well be a combination of term, universal life, and whole life. Don’t forget about adding access to the life insurance values during lifetime for long term custodial care needs. And, make sure you have adequate disability income protection insurance while you are working. It, too, is an important income tool.
Savings and investments round out the total income portfolio. Each client should have a well-diversified asset allocation based on their risk profile, goals, needs, and priorities. ◊