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Beware of Deferred Annuity Salesmen: A Case Study in Generating Retirement Income

I recently received a question from Pauline of Mission Viejo, California regarding the money she's saved for retirement. I think both her question and my answer can help readers with the hot topic of investing your retirement savings.

I am a 64-going-on-65-year-old single female, self-employed right now. I'm in good health and have no dependents nor a spouse.

I have accumulated retirement savings of about $600,000, most of it in cash or bonds (CDs and money market accounts). It has been parked in the cash accounts for more than two years after the stock market scare. About $200,000 is in an IRA. I know this is not an efficient way of managing my money; that's why I'm asking for help.

I need about $1,200 per month more than what I am receiving now, which is about $2,000 per month from Social Security and a small pension. I was thinking about an immediate annuity. However, three different male financial planners -- who would be happy to sell me deferred annuities -- recommend that I don't annuitize. The financial planners are paid in a variety of ways, including commission. I haven't paid them anything yet.

I am just starting my own business, so I'm not yet in a position for a SEP-IRA. I was laid off from a job in April. Because of my age and the employment climate, I think it's better to do contract work from home and do it for the next 20 years.

Thanks for any guidance you can provide me.
First, congratulations to Pauline for arriving at age 64 in good health and with $600,000 in retirement savings -- she's in much better shape than most Americans her age. She's also got the right idea when it comes to being willing to work to supplement her retirement income. Not only will it bring in more money, but it might improve her health, increase her longevity, and provide social contacts, even if she's working from home. It also seems she can live on a little more than $3,200 per month, so she's doing a good job of managing her living expenses.

But Pauline faces a few important decisions:

  • Should she buy a deferred annuity?
  • What's the best way to deploy her retirement savings to generate the additional income she needs?
  • Should she change the way she's currently invested her retirement savings?
  • What's the best way to work with -- and pay for-- a financial professional?
While I don't have all the facts of Pauline's situation in order to provide personalized recommendations, I do have some thoughts to share that might help Pauline and my readers. Please keep reading to see my answers.

Next: Should Pauline buy a deferred annuity?

Should Pauline buy a deferred annuity?
No! Most deferred annuities have early surrender charges during the first five to ten years of investment. Most likely, Pauline won't be able to access her savings during that time without incurring a penalty, unless she converts her deferred annuity into an income annuity (which wasn't recommended by the salesmen).

Furthermore, there's no reason for her to use a deferred annuity. The only advantage that deferred annuities have over conventional savings is to shelter the investment income from income taxes. At her income level, she's most likely paying very little in federal and state income taxes, particularly since most, if not all, of her Social Security income won't be subject to income taxes. Her tax bracket isn't high enough to justify the additional fees and commissions that normally go with deferred annuities, and she doesn't fit the profile of a person who should consider a deferred annuity. And certainly the $200,000 she currently has in an IRA should never be invested in a deferred annuity, since the IRA already shelters her investment income from income taxes.

If Pauline starts making enough money from her self-employment to generate additional retirement savings, she should consider setting up an IRA or a SEP-IRA with a reputable mutual fund company that has funds with low expenses, good performance, and extensive services. Examples include Fidelity Investments, Schwab, T. Rowe Price, and Vanguard.

Next: What's the best way Pauline can deploy her retirement savings to generate the additional income she needs?

How can Pauline best deploy her retirement savings to generate the additional income she needs?
Pauline needs an additional $1,200 per month to supplement her Social Security and pension. Here are two ways she can do this:

  • Buy an immediate inflation-adjusted annuity. This is a do-it-yourself pension that pays you for the rest of your life, no matter what happens in the economy and no matter how long you live. And the inflation protection will make sure that your income maintains its buying power. With an immediate inflation-adjusted annuity, Pauline won't need to monitor her investments as she gets older -- it's a very user-friendly investment. As of late July, 2011, Vanguard's Annuity Access program shows that Pauline would need about $275,000 to buy an immediate inflation-adjusted annuity of $1,200 per month. If she wanted to save a little money, she could buy an annuity that increases at three percent per year instead of being indexed to inflation; such an annuity would cost about $235,000. She won't have access to the money that she commits to the annuity, but she'll still have well over $300,000 left after buying the annuity. That money could remain invested as described on the next page, and she'll also have access to that money in case of emergencies or if she encounters high bills for medical or long-term care expenses.
  • Invest in a balanced mutual fund and live on just the investment earnings. There are a number of funds that provide a moderate level of income, some potential for appreciation, and moderate protection from future stock market crashes. For example, Vanguard's Wellesley Fund is currently yielding a bit more than three percent of invested assets. At three percent, Pauline's $600,000 in retirement savings could generate $18,000 per year, or $1,500 per month -- $300 more than what she needs. The asset allocation for the Wellesley Fund is currently just over 60 percent in bonds, with the remainder invested in stocks. Pauline has the potential for appreciation in assets and increases in the dividend payout rate, and she can access her savings at any time without penalty.
So what are the considerations for choosing one of the above approaches?
  • An annuity neatly takes care of Pauline's need for retirement income. She doesn't need to worry that she'll outlive her money, monitor her investments, or be concerned about fraud or theft (a real problem when people get into their 80s and 90s). The price she pays for this peace of mind is that her money is locked up -- she can't access the money she pays to the insurance company.
  • With the investment solution, Pauline has access to her money, but she still needs to periodically monitor her investments. And there's no guarantee that she won't outlive her money, although that's a remote possibility if she continues to withdraw just the investment income.
  • If Pauline chooses to invest her savings, she could still buy an annuity at a later age to gain the security of an annuity.
Next: Should Pauline change the way she's invested her retirement savings?

Should Pauline change the way she's invested her retirement savings?
Pauline has invested her savings in CDs and money market funds for the past two years, following the stock market crash. Most likely, she's earning very low interest rates. How should she invest going forward?

This is an important decision, because even if Pauline chooses to annuitize a portion of her retirement savings, she'll still have a substantial amount of retirement savings to invest.

If Pauline pulled her retirement savings out of stocks following the crash, it's too late to tell her that she's missed the stock market rebound following the crash. History has shown that people who sell after a stock market crash usually miss the rebound -- most people are better off if they simply remain invested and wait for the rebound.

At this point, however, that's spilt milk -- you can't change the past, and you can only look forward. The fact that she's still totally invested in CDs and bonds indicates to me that Pauline has a low risk tolerance. That's why I suggested a balanced fund like the Vanguard Wellesley fund that's mostly invested in bonds with less than 40 percent invested in stocks. This allocation provides a moderate level of income, some potential for appreciation, and moderate protection from future stock market crashes. For instance, the Vanguard Wellesley fund is currently 21 percent above its pre-crash levels.

Of course, other investments could work for Pauline, too -- she could invest more in stocks if she has a tolerance for market risk, or less in stocks, if investing any money in stocks would cause her to lie awake at night.

The next question is whether to move her retirement savings all at once into such a fund or to buy in gradually -- a form of dollar cost averaging. The current dilemma that all investors are facing today is that there aren't any investments that look great right now. Interest rates on CDs are virtually zero while rates on bonds are at historic lows, and the stock market is near an all-time high.

The argument for buying in gradually is that Pauline would be hedging against the possibility that in the near future, the stock market will decline and/or bond interest rates will rise. But nobody knows this for sure.

The argument for moving her retirement savings all at once is that if she'd always been invested in such a fund, all of her money would be there and the smart thing would be to stay invested. So she should just put herself in that same position as soon as possible.

I can't tell you which strategy would be better, because I can't tell you what will happen in the near future with the stock market or bond interest rates. If you're consulting investment professionals, I would caution you to be very skeptical of anybody who does act as if they know for sure what will happen in the near future.

Next: How should Pauline work with and pay for financial professionals?

How should Pauline pay for her financial advice?
It would seem that Pauline is getting "free" advice from advisors who take commissions on investments -- they're not charging her upfront for their recommendations. However, I prefer to get advice from professionals who don't have any financial stake in your decision whether to annuitize or invest your money. I would avoid:

  • Financial advisors who are paid commissions -- these types of advisors are motivated to sell you investments or insurance that pay them the best, not you.
  • Financial advisors who charge a percentage of your assets under management. These types of advisors won't be motivated to recommend buying an annuity, since these assets are no longer under their management and aren't subject to their charges.
It's possible to find qualified advisors in the categories I described above who have integrity and will make recommendations with your best interests in mind, but how can you really be sure? And why take the chance?

I prefer working with financial advisors who are paid by the hour -- typical hourly rates might range from $150 to $300. While this might give you sticker shock, look at the alternatives:

  • Commissions typically range from two to six percent of your invested assets -- for each transaction. Two percent of your $600,000 retirement savings is $12,000 -- and that's charged each time you make a transaction.
  • A typical charge for assets under management is one percent. That amounts to $6,000 on your retirement savings of $600,000 -- year after year after year.
You can find advisors who charge by the hour at Garrett Planning Network or the Alliance of Cambridge Advisors.
I compliment Pauline for challenging the "advice" offered by her financial advisors and for wanting to learn more. The stakes are high enough for Pauline that it might make sense to work with a qualified financial advisor who has her best interests in mind. The best outcomes will result when she's informed about the pros and cons of her decisions, even if she works with a financial advisor.

All of this might be more work and more information than Pauline actually wanted when she originally contacted me. But generating reliable income that will last for the rest of her life is a critical challenge that's well worth the time and effort she puts into it.

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