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Showing posts with label annuities. Show all posts

Saturday, October 17, 2009

Investing for Retirement: Retirement Accounts Overview

Retirement Basics: Common Sources of Retirement Income

Social Security Benefits
Though the future of social security is uncertain to say the least, right now the deal is that you pay into the system for as long as you work (6.2% up to the "wage base"--$102,00 in 2008), whether you're an employee or self-employed. In the case of the employed, the employer must also pay the same 6.2% on the worker's wages. In addition, both the employee and the employer must pay another 1.45% each on the total yearly income of the worker. The self-employed do not pay Social Security tax as such, but under a separate law are required to pay 15.3% of their total income; they basically pay both the employee and the employer shares of the Social Security tax, though they can deduct half (the employer's share) when they file their federal income taxes.

The calculation process for how much Social Security benefits a person will receive is ridiculously complex, so I won't get into it here, suffice it to say that it's based on the average of the worker's covered earnings (the largest amount covered in 2008 was $102,000) for the 35 years in which the worker earned the most.

Workers can begin receiving benefits at age 62, but they will be "reduced benefits." Workers are not eligible to receive the full benefits until the normal retirement age, which is currently defined as 67 years old for anyone born after 1960. For ever year after normal retirement age that a worker delays receiving benefits, the benefit amount will increase when they do begin accepting them.

Social Security also provides for the worker's spouse (though currently same-sex spouses are not covered) and children, and with a little maneuvering, it is even possible for the spouse and children to receive benefits even if the worker decides to continue working after his or her retirement age. A worker's widow or widower is similarly provided for, as is, in some cases, even a divorced spouse or divorced widow(er).

The problem is that even if (and it's a big IF) social security benefits are still around by the time we get to retirement age, it's doubtful they'll be enough to live comfortably on. Even now, the average individual's monthly social security check is only around $950, and it's taxable. Obviously, you're going to want to secure other sources of retirement income.

For more information about Social Security benefits visit their website.

Work Pension Plans/Employer-Sponsored Benefit Plans
There are two main types of employer-sponsored retirement plans: defined benefit plans and defined contribution plans.

A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service--for example, 1 percent of average salary for the last 5 years of employment for every year of service with an employer. The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).

A Cash Balance Plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance. In a typical cash balance plan, a participant's account is credited each year with a "pay credit" (such as 5 percent of compensation from his or her employer) and an "interest credit" (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer. When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).

A defined contribution plan, on the other hand, does not promise a specific amount of benefits at retirement. In these plans, the employee or the employer (or both) contribute to the employee's individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually. These contributions generally are invested on the employee's behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.

A Simplified Employee Pension Plan (SEP) is a relatively uncomplicated defined contribution plan geared towards the self-employed and owners of small businesses. A SEP allows individuals to make contributions (up to 25% of their annual earnings with a maximum of $49,000) on a tax-deferred basis to individual retirement accounts (IRAs). Fidelity has a good site with more detailed information regarding SEPs and even an SEP-IRA Contribution Calculator.

Savings Incentive Match Plan for Employees of Small Employers (SIMPLE)
Don't get confused, you're right--whoever thought up the acronym for this defined contribution plan cheated a bit. Nevertheless, that's what it is, even though it's easy to confuse with the Simplified Employee Pension Plan above. Whatever. There are two main options for this type of tax-deferred IRA: 1) the employer contributes 2% of the employee's pay each year and the employee is able to contribute up to $10,500 per year. 2) The employee contributes to the plan (with the same maximum contribution) by deferring a percentage of their salary, and the employer must match that contribution (up to 3% of the employee's salary).

A Profit Sharing Plan or Stock Bonus Plan is a defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution.

A 401(k) plan is a defined contribution plan where employees can elect to defer receiving a portion of their salary which is instead contributed on their behalf, before taxes, to the 401(k) account. Sometimes the employer may match these contributions. The money in the account is then invested in stocks, mutual funds, and/or other securities. There are special rules governing the operation of a 401(k) plan. For example, there is a dollar limit on the amount an employee may elect to defer each year. An employer must advise employees of any limits that may apply. Employees who participate in 401(k) plans assume responsibility for their retirement income by contributing part of their salary and, in many instances, by directing their own investments.

An Employee Stock Ownership Plan (ESOP) is a form of defined contribution plan in which the investments are primarily in employer stock.

A Money Purchase Pension Plan is a defined contribution plan that requires fixed annual contributions from the employer to the employee's individual account.

For non-retirement specific investment information, see our Investments Primer.

Annuities: What Are They and How Do I Find the Right One For Me?

When you buy an annuity, the bank or insurance company invests your money and agrees to pay you back according to the annuity's contract terms. In very basic terms, you make one or more (depending on the contract) payment to the bank/insurer as your investment, and they in turn agree to make a series of income payments to you, starting immediately or at some point in the future, for as long as you live.

Fixed annuities guarantee a set payment amount and are similar to CDs in that they have a fixed interest rate. Check around; often fixed annuities have higher interest rates than CDs.
Note: Always read the contract carefully. Some so-called fixed annuities only fix the interest rate for a specified period, such as one year, and the rate is variable after that.

Advantages

Promises a steady stream of income when you retire.
Guarantees a fixed payment amount and interest rate.
Tax-deferred growth—interest is not taxed until you collect your money.
Typically low investment minimums (as little as $1,000).

Disadvantages

Not insured by the U.S. government or by the insurance company/bank where you buy them.
Often come with high fees and a heavy penalty, called a surrender charge, for cashing before a designated period of time has passed.
Payment amounts do not rise to keep pace with inflation, i.e. they will be worth less as time goes by.

Taxes
Some annuities help you set aside money on a tax-deferred basis. You don't pay taxes on the income (interest) earned by this money until you retire. Other annuities allow you to receive income immediately, but it won't be tax deferred.

How they work
An annuity has two phases: an accumulation phase and a payout phase. During the accumulation phase, you make purchase payments, which you can allocate to a number of investment options. For example, you could designate 40% of your purchase payments to a bond fund, 40% to a U.S. stock fund, and 20% to an international stock fund. In addition, variable annuities often allow you to allocate part of your purchase payments to a fixed account, which unlike a mutual fund, pays a fixed rate of interest. The insurance company may reset this interest rate periodically, but it will usually provide a guaranteed minimum. During the accumulation phase, you can typically transfer your money from one investment option to another without paying tax on your investment income and gains, although you may be charged transfer fees by the insurance company.

At the beginning of the payout phase, you may receive your purchase payments plus investment income and gains (if any) as a lump-sum payment, or you may choose to receive them as a stream of payments at regular intervals. If you choose to receive a stream of payments, you will often be able to choose how long the payments will last, e.g. for 20 years or for your lifetime. In addition, you may be able to choose to receive fixed payments or payments that vary based on the performance of your funds. The amount of each periodic payment will depend, in part, on the time period that you select for receiving payments.
Note: Some annuity contracts are structured as immediate annuities, which means that there is no accumulation phase and you start receiving payments as soon as you purchase the annuity. Annuities with an accumulation phase are called deferred annuities.
Many annuities carry a death benefit: if you die before the insurer has started making payments to you, your beneficiary is guaranteed to receive a specified amount—typically equal to your total payments. They also sometimes offer optional features (that carry extra charges), such as a guaranteed minimum income benefit, which guarantees a minimum payment amount even if you do not have enough money in your account (perhaps because of investment losses) to support that level of payments.

Fees, Charges, and Penalties
Annuities carry a number of standard fees as well as extra charges and penalties that can be incurred. Like mutual funds, variable annuities often carry some administrative fees (in addition to the administrative fees of the mutual funds it contains!).

A fairly standard charge for variable annuities is the mortality and expense risk charge, which is expressed as a percentage of your account value, typically around 1.25% per year. This charge compensates the insurance company for insurance risks it assumes under the annuity contract and is sometimes applied toward your financial professional's commission for selling the variable annuity to you. (Yes, they get commission; financial professionals get commissions from every investment product they sell you—which is why you need to make sure you understand for yourself the terms of any prospective investment and not just let your planner delegate your money to best suit their pocketbooks.)

Many variable annuities also have penalties for certain actions, such as early withdrawal. For instance, if you withdraw money from your account during the early years of the accumulation phase, you may have to pay a surrender charge, which is usually a percentage of the amount you withdraw (sometimes up to 15%), though many contracts allow for withdrawal of a certain percentage of your account value without incurring surrender charges. Surrender charges, when they do apply, generally decrease over time; for example, a 7% charge might apply in the first year after a purchase payment, 6% in the second year, 5% in the third year, and so on until the surrender period is over. In addition to surrender charges, you may have to pay a 10% federal tax penalty if you withdraw anything before the age of 59½.

Other fees, such as initial sales loads and transfer fees may also apply. Plus, any special features or options you choose for your variable annuity, such as a stepped-up death benefit, long-term care insurance, or the guaranteed minimum income benefit, normally carry additional charges. As with mutual funds, you can find a description of all charges in the prospectus.

Equity-Indexed Annuities (EIA)

The first thing you need to know about EIAs is to be careful with them. Investment advisers get big commissions when they sign people up for an EIA, so some unscrupulous advisers will push EIAs even when they're not the best option for their client. Furthermore, EIAs are not regulated by the National Association of Securities Dealers or the Securities and Exchange Commission (until 2011).

How they work
EIAs are almost always deferred annuities, and during the accumulation period, they credit your account with a return whose rate is based on the performance of a particular stock index. Most EIAs guarantee a minimum return, often 3%, during this period. After the accumulation period, the insurance company will make periodic payments (or one lump sum) to you under the terms of your contract.

It is important to note, however, that even with a guaranteed minimum return, you can lose money with an EIA if your guarantee is based on an amount that is less than the full amount of your purchase payments.

Factors affecting rate of return
The index
Some EIAs use a simple price index, which means they calculate the rate without counting reinvested dividends. This can make quite a difference to your ROR. For example, in the past forty years, the average S&P 500 gain is 3.8 percentage points higher with reinvested dividends than without.

Method of Calculating Index Changes
EIAs also employ different methods for calculating yearly changes in an index, which can produce wide disparities in returns. Three common methods are:

Annual Reset (or Ratchet) - This method credits index-linked interest based on any increase in index value from the beginning to the end of the year.
Point-to-Point - This method credits index-linked interest based on any increase in index value from the beginning to the end of the contract's term.
High Water Mark - This method credits index-linked interest based on any increase in index value from the index level at the beginning of the contract's term to the highest index value at various points during the contract's term, often the anniversaries of the annuity's purchase date.

Caps
Caps are limits on the rate of interest the EIA can earn, regardless of the performance of the index.

Participation rates
The participation rate determines how much of the index's gain will be used to compute the index-linked interest rate. If it is less than 100%, you won't be getting the full index gain. For example, if the participation rate is 80% and the index increases 9%, the return credited to your annuity would be 7.2% (9% × 80% = 7.2%).

Between participation rates and caps, an EIA's earnings can be significantly lower than you might expect. Participation rates and caps may be changed annually, depending on your contract.

Principal Guarantee
Many EIAs provide that you'll receive at least 100% of your invested funds; others guarantee only 90%.

Taxes
Your EIA earnings are tax-deferred until you withdraw them, at which time they are taxed as income; gains from an S&P 500 index fund are taxed at lower capital gains rates.

Fees, Charges, and Penalties
Spread / Margin / Asset Fee
Some EIAs annually subtract a certain percentage of the index gain and call it a "margin," "spread," or "administrative fee." In the case of an annuity with a "spread" of 3%, assuming no cap and a participation rate of 100%, if the index gained 9%, the return credited to the annuity would be 6% (9% - 3% = 6%).

Surrender charges and tax penalties
You also may have to pay a significant surrender charge and/or tax penalties if you cancel early. In addition, in some cases insurance companies may not credit you with index-linked interest if you do not hold your contract to maturity. Also, if you make any withdrawals before the age of 59 1/2, you'll be charged a 10% tax penalty in addition to the income tax on the amount withdrawn.

The final word: Be very careful with EIAs. Read the contract meticulously, and do not rely solely on the assurances of the adviser or salesperson.

Variable Annuities
A variable annuity is part insurance/part security investment; the "variable" means that its value and your income from it is variable—it can move up and down, i.e. you can lose money. Since variable annuities are long-term investments that can tie up your money for many years, the younger you are, the better.

Taxes
Like 401(k)s and traditional IRAs, variable annuities are tax-deferred, which means you pay no taxes on the income and investment gains from your annuity until you withdraw your money. You may also transfer your money from one investment option to another within a variable annuity without paying tax at the time of the transfer. When you take your money out of a variable annuity, however, you will be taxed on the earnings at ordinary income tax rates rather than lower capital gains rates. In general, the benefits of tax deferral will outweigh the costs of a variable annuity only if you hold it as a long-term investment to meet retirement and other long-range goals.

Choosing an annuity
Like with any investment, before buying an annuity you should request and read the prospectus and compare the costs and earning potential to other variable annuities and to other types of investments, such as mutual funds. You'll also want to consider the financial strength of the insurance company, which can affect their ability to pay any benefits that are greater than the value of your account in mutual fund investment options, such as a death benefit, guaranteed minimum income benefit, or amounts you have allocated to a fixed account investment option.

For more information and helpful examples, see the SEC's page on variable annuities.

See also:
Stocks: What To Look For, How to Trade For Long-Term Gains

Bonds: The Basics

Funds: Mutual Funds, ETFs, Closed-end Funds, Hedge Funds , Oh My!

Investing main

Friday, October 16, 2009

Investments Primer

An investment is anything you acquire for future income or other financial benefit. Investments increase by generating income (interest or dividends) and/or by growing (appreciating) in value.

It's important that you go into any investment in stocks, bonds, annuities, or mutual funds with a full understanding that you could lose some or all of your money in any one investment.

As you can see in the chart below, different kinds of investments generally provide different rates of return (as well as different risks—highest to lowest in the chart below). Note that average rates of return are not guaranteed; they only show what has happened historically.

Asset Class	Rate of Return*
Stocks of smaller companies	14%-16%
Common stocks	10%-13%
Long term corporate bonds	6.5%-8%
Long term US government bonds	5%-7.5%
Short term US Treasury bills	3.5%-5%

*Average rate of return since 1926, Ibbotson and Associates

When choosing an investment type (stocks, bonds, annuities, funds, etc.), start by figuring out how much risk you want to take. Yes, yes, obviously we all want low risk, but low risk generally means low returns, so in some cases it's worth the added risk to earn the added cash. Here are some questions to ask yourself to determine the amount of risk you should take:

Do you have a specific financial goal? An amount you need to accumulate over a given period? If not, ask yourself how much you'd like (realistically) to have in ten years, twenty years, forty years, etc. If you're hell-bent on becoming a millionaire (and good luck!), you might decide to opt for higher risk, higher return investments. Also, if you're saving for retirement and it's a ways away, you have more freedom to go with higher risk investments because you have longer to recoup your losses if things don't go your way.
When are you going to need money the most? In other words, how long can you leave your savings tied up in investments before you start needing to spend it? Are saving for your first house in a few years or are you planning on leaving your investments grow to support you in your retirement? Generally, the longer time horizon you have, the more risk you can tolerate because investments tend to have more even growth over long period of time.
How financial stable are you? Can you afford to lose some of your investment or will that leave you completely destitute? If you absolutely cannot take the chance of losing any of your money even if it means the chance of gaining more (yes, it's a gamble that way), choose lower risk investments.

Investors best protect themselves against risk by spreading their money among various investments, hoping that if one investment loses money, the other investments will more than make up for those losses. This strategy, called diversification, can be neatly summed up as, "Don't put all your eggs in one basket." Investors also protect themselves from the risk of investing all their money at the wrong time (think 1929--or recently) by following a consistent pattern of adding new money to their investments over long periods of time.

Monitoring Your Investments
Some people like to look at the stock quotations every day to see how their investments have done. That's probably too often. You may get too caught up in the ups and downs of the "trading" value of your investment, and sell when its value goes down temporarily--even though the performance of the company is still stellar. Remember, you're in for the long haul. Check monthly or quarterly instead.

Keep in mind, though, that it's not enough to simply check an investment's performance. You should compare that performance against an index of similar investments over the same period of time to see if you are getting the proper returns for the amount of risk that you are assuming. You should also compare the fees and commissions that you're paying to what other investment professionals charge. Look for a low expense ratio (below 1%).

Invest Wisely / Don't be stupid (adapted from SEC's "Invest Wisely")
Never:

Send money to purchase an investment based simply on a telephone sales pitch.
Make a check out to a sales representative personally.
Send checks to an address different from the business address of the brokerage firm or a designated address listed in the prospectus.
Allow your transaction confirmations and account statements to be delivered or mailed to your sales representative as a substitute for receiving them yourself. These documents are your official record of the date, time, amount, and price of each security purchased or sold. When you receive them you should verify that the information in these statements is correct and file them away safely.
Trust anyone who tells you, "Invest quickly or you will miss out on a once in a lifetime opportunity!"or otherwise puts pressure on you to make an investment quickly.

If your sales representative asks you to do any of these things, contact the branch manager or compliance officer of the brokerage firm.

Certain activities may indicate problems in the handling of your account and, possibly, violations of state and federal securities laws, such as:

Recommendations from a sales representative based on "inside" or "confidential information," an "upcoming favorable research report," a "prospective merger or acquisition," or the announcement of a "dynamic new product."
Representations of spectacular or specific profit, such as, "Your money will double in six months." Remember, if it sounds too good to be true, it probably is!
"Guarantees" that you will not lose money on a particular securities transaction, or agreements by a sales representative to share in any losses in your account.
An excessive number of transactions in your account. Such activity generates additional commissions for your sales representative, but may provide no better investment opportunities for you.
A recommendation from your sales representative that you make a dramatic change in your investment strategy, such as moving from low risk investments to speculative securities, or concentrating your investments exclusively in a single product.
Switching your investment in a mutual fund to a different fund with the same or similar investment objectives. Unless there is a legitimate investment purpose, a switch recommended by your sales representative may simply be an attempt to generate additional commissions for the sales representative.
Pressure to trade the account in a manner that is inconsistent with your investment goals and the risk you want or can afford to take.
Assurances from your sales representative that an error in your account is due solely to computer or clerical error. Insist that the branch manager or compliance officer promptly send you a written explanation. Verify that the problem has been corrected on your next account statement.

If You Have a Problem (adapted from SEC's "Invest Wisely")
If you have a problem with your sales representative or your account, promptly talk to the sales representative's manager or the firm's compliance officer. Confirm your complaint to the firm in writing. Keep written records of all conversations. Ask for written explanations.

If the problem is not resolved to your satisfaction, contact the appropriate regulators listed at the end of this document. Investor complaint information assists these regulators in identifying violations of the securities laws and prosecuting violators. However, none of these organizations is authorized to provide legal representation to individual investors or to get your money back for you.

Obtain information on using arbitration to resolve your dispute by contacting FINRA, the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board, or the Chicago Board Options Exchange. Each of these organizations operates a forum to resolve disputes between brokerage firms and their customers. You may also wish to consult an attorney knowledgeable about securities laws. Your local bar association can assist you in locating a securities attorney.

Securities Regulators to Contact:

U.S. Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549
Office of Investor Education and Advocacy
Online Complaint Form

North American Securities Administrators Association, Inc.
Suite 710
10 G Street, NE
Washington, DC 20002
(202) 737-0900
Web site