The following is an excerpt from

Big Picture Retirement Planning

Les Goldstein, M.B.A.

Personal Financial Strategies, Inc. PARK RIDGE, ILLINOIS

Copyright © 2018 by Les Goldstein.

The following content is for non-commercial educational use only. All rights reserved. No part of this publication may be reproduced, distributed or transmitted in any form or by any means, including photocopying, recording, or other electronic or mechanical methods, without the prior written permission of the publisher, except in the case of brief quotations embodied in critical reviews and certain other non-commercial uses permitted by copyright law. For permission requests, write to the publisher at the address below.
Les Goldstein/Personal Financial Strategies, Inc.
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Park Ridge, IL 60068
Book layout ©2013
Big Picture Retirement Planning/ Les Goldstein. —1st ed.
ISBN 978-0-0000000-0-0


Investment Tools – Annuities

An annuity is a contract issued by and backed by the claims-paying ability of the insurance company. In its purest form, an annuity is simply a stream of payments that is backed by an insurance company for a specific period of time. Let’s discuss the many forms of annuities now.

Immediate Annuities

An immediate annuity works like this. You give a lump sum of dollars to a specific insurance company. The insurance company promises to pay you a certain amount of dollars either for your life, for your life jointly with your spouse, or for a specific number of years. Here are some examples of immediate annuity structures:

1. Life only: the immediate annuity will pay for as long as you are alive.

2. Joint life: the immediate annuity will pay as long as you and/or your spouse are alive.

3. Life with 20-year period certain: The immediate annuity will pay for as long as you are alive or for 20 years, which-ever is greater. If you live for 17 years and pass away, the immediate annuity will pay three more years to your named beneficiaries. If you live 41 years, the annuity will pay you for 41 years. Congratulations, you have most likely outlived the insurance company’s mortality tables!

4. Joint and 50 percent survivor: The immediate annuity will pay you a certain sum every single year for as long as you’re alive. Then the immediate annuity will continue to pay half as much to your survivor-beneficiary for as long as he or she is alive.

5. Joint and 75 percent survivor: The immediate annuity will pay you a certain sum every single year for as long as you’re alive. Then the immediate annuity will continue to pay 75 percent of the original amount paid to your survivor-beneficiary for as long as he or she is alive.

6. Joint and 100 percent survivor: The immediate annuity will pay you a certain sum every single year for as long as you’re alive. Then the immediate annuity will continue to pay 100 percent of the original amount paid to your survivor-beneficiary for as long as he or she is alive.

It certainly seems that item 6 would be the best choice. As always, however, there is a catch. The joint and 100 percent survivor option always pays less on a monthly or annual basis than the other choices listed before. That should make sense. There is no reduction in benefits to the surviving spouse upon the death of the annuity owner. So the insurance company will pay both of you less money than if you had elected life only or a joint option with a reduction upon the death of the first spouse. In the world of in-vestments, there is never a free lunch!

Comments on immediate annuities: I believe that most folks use immediate annuities incorrectly. Here’s why. At the end of the in-come option you choose, there is no remainder interest for other beneficiaries. That is, let’s say you select the joint life option for you and your spouse. That means you and your spouse will receive a fixed sum of dollars every single month (or year, depending up-on the payment frequency you select), typically without an in-crease for inflation. After the death of the second spouse, nothing is left for any of your beneficiaries, such as your children. Immediate annuities, when used alone, not in combination with a comprehensive retirement income strategy, result in nothing being left for your heirs. Immediate annuities can be an excellent planning tool if used properly. Just be sure you understand that an immediate annuity is simply the payment stream you select in exchange for a lump sum of principal.

Deferred Annuities

Deferred means waiting. That is, you turn your money over to an insurance company in exchange for some promises based upon the claims-paying ability of that insurance company. You wait to take income out of your annuity until a later date.

A deferred annuity has two phases, the accumulation phase and the distribution phase. During the accumulation phase, the annuity is supposed to increase in value on a tax-deferred basis. During the distribution phase, the annuity is paid out. The payment may be made as one lump sum or as a series of scheduled payouts over a specific period or a lifetime. This latter payout methodology is known as “annuitization.” The recipient (beneficiary) of the payment stream is known as the annuitant. When you annuitize an annuity, there is no lump sum available to you or your beneficiaries at a later date. As we learned previously, there are many ways an annuitant can annuitize his or her annuity, such as life only, joint life, period certain, life with period certain, and more. And always remember that annuities should be used as a pension-like asset. As such, annuities are long-term retirement funding vehicles. There can be withdrawal fees for early withdrawals as well as IRS tax penalties for pre-59 ½ withdrawals.

Over the last eight or nine years, another potentially more attractive payout methodology has become popular with financial advisors and their clients. Instead of annuitization, insurance companies have created lifetime income withdrawal programs to allow annuity owners to take income payments from annuities without annuitization. This feature is often described as an in-come benefit rider or guaranteed annual withdrawal rider.

When you invest in a deferred annuity, you can include an in-come benefit rider as part of the annuity contract. This is an optional benefit, and there is always an additional cost to include this rider. This rider can be a valuable benefit when appropriate, and we use income benefit riders with both variable annuities and fixed index annuities as a tool to help meet minimum income needs for our clients. The income benefit rider creates a floor under your income, that is, an income level that cannot decrease in the event the value of the annuity decreases. Since retirement is all about cash flow, having an income floor creates a “sleep at night” factor that can be important when a certain minimum level of in-come is required to meet your gotta-haves during retirement. Remember that the income floor is guaranteed by the claims-paying ability of the issuing insurance company, not the US government or the FDIC. You can lose money.

Fixed Annuities

The fixed annuity is the easiest type of annuity contract to explain. Again, you turn a lump sum of dollars over to an insurance company. Unlike an immediate annuity, the principal is owned by you, not the insurance company. The insurance company promises to pay you a stated minimum rate of return over a stated number of years. At the end of the term, your original investment plus the interest paid will be available for withdrawal, reinvestment, or continuation of the contract. Or you can take out the annuity interest along the way, and the annuity principal out upon the annuity’s maturity. Again, withdrawals before your age 59 ½ may result in taxes and IRS penalties.

Here’s an example. You invest $100,000 in a fixed annuity contract. The holding period is five years. The minimum stated rate of interest is 3 percent per year. At the end of five years, you can withdraw your $100,000 plus your accrued interest. Or you can take the $3,000 out each year during the term of the annuity contract.

Fixed Index Annuities

Also known as an equity index annuity (EIA), a fixed index annuity (FIA) is a bit of a hybrid. Just like the fixed annuity described before, your original principal is guaranteed by the claims-paying ability of the issuing insurance company. However, your return (how much you can earn on the annuity contract) is a function of the performance of various stock and bond market indices that you select from when you purchase the annuity contract. Here’s an example, for clarification purposes.

You decide to invest in a FIA issued by XYZ Insurance Company. You can select from the following stock market and bond market indexes: the S&P 500, the NASDAQ, the Barclays Capital US Aggregate Bond Index, or a fixed account that pays 2 percent per year. If desired, you can put some money in all of these. The stock and bond market index returns are subject to either a spread fee or a cap, as described in the following.

One of the most significant benefits of FIAs and the “plain vanilla” fixed annuity is that your principal and all interest credited for the contract are guaranteed by the claims-paying ability of the issuing insurance company. This is a very comforting factor for many people, since other investment tools, such as stocks, bonds, mutual funds, real estate, precious metals, and commodities, have no guarantees. However, you must always remember that the guarantees are issued by insurance companies, not the US government. Insurance companies can and do fail, although this has happened very rarely here in the US. Therefore, it is absolutely possible to lose money in fixed annuities and FIAs.
All annuities are complicated tools. Very frequently, we have seen fixed index annuities improperly presented to potential annuity buyers. Here are some very important FIA need to knows:

1. All FIAs either have a cap on their growth potential or a fee, known as a spread fee. The spread fee is subtracted from any interest earned on your FIA, prior to that interest being credited to your FIA contract.

2. Because of caps and spread fees, FIAs do not have the same growth potential as individual common stocks, common stock mutual funds, or variable annuities. It is also true that FIAs, with their guaranteed principal, do not have the same principal risk as common stocks and stock mutual funds or variable annuities.

3. Gains on FIAs are typically locked in once a year, on the anniversary of the date your FIA contract became effective. Once you have locked in a gain on your FIA contract, that gain can never be lost. The gain and your initial principal can only be reduced by contract fees and withdrawals you take from the FIA. Always read the annuity contract and all addendums prior to investing in an annuity. In the event that you feel the annuity investment contract differs from the features, benefits, risks, rewards, and expenses that were described to you by the annuity salesperson, you can “free look” the contract. You can literally return your annuity policy to the issuing in-surer as long as not more than 30 days (typically) have passed from the date you accepted delivery of the annuity in writing. This free look provision is the insurance industry equivalent of the do-over that we used to ask for when playing games when we were growing up.

Technically speaking, fixed annuities and FIAs are not even in-vestments. They are insurance contracts, and are regulated by the insurance industry, not the Securities Exchange Commission. In addition to the guarantees provided by each issuing insurance company, each state has a guaranty association. In Illinois, this association is known as the Illinois Life and Health Insurance Guaranty Association. All insurance companies that issue life insurance and annuities must belong to this association, and the association is the guarantor of these annuity contracts.

An interesting point to remember is that an insurance agent or annuity salesperson is not allowed to mention this association in connection with the sale of an annuity or life insurance policy. So keep your ears open for any mention of this association during a sales presentation. Agents should know better, but there are always aggressive salespeople in the world who want to close the business and will do what it takes to get you to say yes.

Qualified Longevity Annuity Contracts (QLACS)

This is a brand-new type of annuity that just became available in 2014. A QLAC is a deferred immediate annuity. That is, it is a payment stream that begins at a future date in exchange for a lump sum right now. QLACs can be purchased in IRAs and in a 401(k), 403(b), and 457 plan. QLACs have some interesting features that are worth summarizing here:

1. A person can invest the lesser of 25 percent of their overall account balance but not more than $125,000, and use that amount to fund a QLAC.

2. Roth IRA and Roth conversions do not allow QLACs.

3. Amounts designated to QLACs are removed from the RMD calculations. In other words, if an IRA had $500,000, and $125,000 was used to fund a QLAC, the remaining $375,000 balance would be used to calculate RMDs, not $500,000.

4. The QLAC investor must start the annuity by no later than the first day of the month following the attainment of age 85, or earlier as desired.

5. QLACs cannot include variable annuity contracts nor equity indexed contracts.

6. QLACs also cannot have a commutation or surrender value benefit.

7. QLACs can also offer a return of premium (ROP) feature both before and after the annuitant’s start date, as well as a lump-sum death benefit to an annuitant’s beneficiary that is the difference of premiums paid versus benefits received.

8. There are specific QLAC beneficiary rules that must be followed.
As of the writing of this book, we are in the process of re-searching QLACs and have not reached a decision as to whether we will use this tool for our clients. As always, comprehensive due diligence must be completed before offering a specific investment tool to our clients.

Variable Annuities

A variable annuity (VA) is an investment tool, different than a fixed annuity, fixed index annuity, or QLAC. This is because with a VA, your principal is at risk. That is, you can lose money. Be-cause of this, variable annuities are sold only by financial advisors who are affiliated with broker dealers that are members of the Financial Industry Regulatory Authority, also known as FINRA.
Here are some important “need to knows” on VAs:

1. Just like fixed annuities and fixed index annuities, VAs of-fer income tax deferral until withdrawals are taken. And, just like other annuities, pre-59½ penalties, taxes, and surrender fees for early or excess withdrawals may apply.

2. Just like common stocks and common stock mutual funds, VAs have unlimited growth potential. Unlike FIAs, VAs do not have caps on their upside potential.

3. Just like common stocks and common stock mutual funds, you can lose all of your money when you invest in VAs.

4. A VA can often be invested in many different ways, through the investment choices offered by the issuing insurance company. The investment choices inside a VA are known as “subaccounts.” By selecting various subaccounts, one can build an investment portfolio inside a VA that meets your risk tolerance, time frame, and personal financial objectives.

Here are some facts that apply to both VAs and FIAs:

1. Both accumulate gains on a tax-deferred basis. This can give you the opportunity to defer paying taxes until a later date, when you may be in a lower income tax bracket.

2. Both come with a death benefit. This benefit is often over-looked, but it can be valuable when needed. Here’s how it works: Let’s say you invest $400,000 in a variable annuity. Due to poor stock market performance, the value of your variable annuity goes down to $280,000. Let’s also say that you have never taken any withdrawals of income or principal from this annuity. Now you pass away. Your named beneficiary will receive $400,000 in a lump sum from the issuing insurance company. Or if it is more beneficial to your spousal beneficiary, he or she may be able to step right into the variable annuity contract and continue the contract for his or her life. Always review the offering documents when deciding upon the benefits you desire. Optional benefits may result in higher annuity fees.

3. In my opinion, never invest in an annuity inside an IRA or Roth IRA without using some form of income benefit rider. The additional cost of the tax-deferred wrapper that comes with every annuity is simply worthless inside an IRA, Roth IRA, or other retirement plan. Our clients collectively own millions of dollars in annuities inside IRAs. This is because of the available income benefit riders as well as the long-term potential for capital appreciation, not any tax deferral.

4. All annuities have limited liquidity. Typically, you can access up to 10 percent per year of your invested principal without a surrender charge. If you take out more than 10 percent in any one year, especially early in the life of the annuity contract, there will be a surrender charge. Surrender charges decrease every year during the life of an annuity until the surrender charge reaches zero percent, usually after 7 to 10 years. This should not be a problem if your annuity investments were made with a specific plan of action in mind; that is, you invested in the annuities to create a lifetime income stream scheduled to begin at a specific time in the future.

5. Do not invest in annuities (other than an immediate annuity or QLAC) if you want income right away. You need to let the selected income benefit rider “percolate” so your future income has the potential to increase over time.

6. Annuities create clarity. If you want to know exactly how much the minimum annual income you will receive be-ginning on a specific date in the future is, an annuity can do this for you. Of course, this clarity is based upon the claims-paying ability of the issuing insurance company.

Important Disclosures For This Chapter

Annuity contracts and life insurance policies are guaranteed as to payment of principal and interest by the issuing insurance company.
Equity indexed annuities are long-term investments subject to possible surrender charges and 10 percent IRS early withdrawal penalty prior to age 59½. Current minimum return, principal value, and prior earnings guaranteed by the issuing insurance company are subject to their claims-paying ability and contract provisions.
Variable annuities are long-term investments designed for retirement purposes. Withdrawals of taxable amounts are subject to income tax and, if taken prior to age 59½, a 10 percent federal tax penalty may apply. Withdrawals will reduce the living benefits, death benefits, and account values. Early withdrawals may be subject to withdrawal charges. An investment in the securities underlying a variable annuity involves investment risk, including possible loss of principal. The contract, when redeemed, may be worth more or less than the original investment. Optional riders have limitations and come at an additional cost through the purchase of a variable annuity contract. Guarantees are backed by the claims-paying ability of the issuer.
Variable annuities are sold by prospectus only. Investors should carefully consider objectives, risks, charges, and expenses before investing. The contract prospectus and the underlying fund prospectus contain this and other important information. Investors should read the prospectus carefully before investing. For a copy of the prospectus, contact your financial advisor.
It is important to work with your tax or legal advisor to address your specific situation. At our company, Personal Financial Strategies, Inc., tax planning services are provided by Lawrence P. Brown, CPA, and Robert Koza, CPA, MSFT. Estate planning services are provided by Gregory P Turza, JD, Anthony Madonia, JD, and Bill Ensing, JD.