Reader Question: Please address the pros and cons of placing retirement funds in an annuity. The market has been volatile and there is talk of another drastic drop in the stock market. I’m looking for a sustainable investment. We would also like to pass on to children and grandchildren an inheritance if anything is left. I am 68 and my wife is 67 and together we have $950,000 invested in stocks, bonds, equities, and mutual funds. B.C.
Answer: I am not a fan of investing retirement funds into a retirement annuity for several reasons:
- High expenses. According to research firm Morningstar, the average annuity sports annual fees of 2.5%. If you go the no-load route, you cut that average to 1.5%…still a lot of fees to overcome before you’re earning a real rate of return.
- Shelter-in-a-shelter. An annuity, in itself, is a tax sheltered investment. Meaning when you invest in one, your money grows tax deferred (no immediate income taxes). So by transferring IRA money into a retirement annuity, you’ve taken a tax sheltered IRA and placed into a tax sheltered annuity resulting in higher expenses. It is true that most annuities have a ‘death benefit’ element…typically stating that at death, the value will always be at least what you invested…but you pay a price for that…a price I think is too high.
- Annuitization leaves nothing for heirs. If you choose to convert your annuity into a lifetime income stream, at the death of the last annuitant (you or you and your spouse if you choose a joint life annuity), the contract ends and there is nothing for heirs. This goes against one of your stated goals…to leave something for your children or grandchildren.
Regarding your concern about the volatility of the stock market, with a variable annuity you must choose between a variety of stock and bond mutual funds, all of which are subject to the same risks you’d have if you simply invested in mutual funds through your IRA. You could choose a fixed annuity whereby you avoid the stock market in favor of a fixed interest rate but your returns will be very low and you could have made a similar investment in your IRA using CDs or similar investments and avoided the high fees.
My outlook for the stock market over the next three to five years is very optimistic. Will there be significant market pull-backs? Almost certainly! In the end, though, I expect the stock market to outperform the bond market and money market. At your age, consider allocating 40% to 60% of your funds in high quality short-to-intermediate bonds with the balance in a conservative basket of stocks or stock mutual funds. The bond portion should help mitigate stock market corrections and serve as a ready source of funds if needed.
Correction: In a recent column about making gifts to children, I stated that for gifts exceeding the annual limit ($14,000 for 2014), you could either pay the gift tax or use a portion of your lifetime exemption amount ($5,340,000 for 2014). A law professor correctly pointed out that you do not have the option of paying the gift tax. Rather you must use your lifetime exemption amount until it is used up.