The Bogleheads' Guide to Retirement Planning (19 page)

In a basic SPIA, payments continue only while you live. In the case of a joint annuity, payments continue as long as either annuitant lives. If you bought a single-life annuity and you die the day after your first annuity payment arrives, that first payment is the only payment you get. The insurance company keeps the rest of the premium. This is not as big a windfall as it sounds because it is expected to happen on occasion, and that premium is needed to fund payouts to other annuitants.

You could opt for a guaranteed period. This option is also called a period certain or term certain. It guarantees a certain number of payments to your heirs if you die. For example, if you choose a 10-year guaranteed period, payments continue to your heirs until 10 years of payments are made. The payments are made to the annuitants’ named beneficiaries or estate. Another similar option is known as premium refund or guaranteed minimum payment, which provides for payments to continue until an amount equal to the original premium has been paid out. A short guaranteed period does not cost very much and provides some peace of mind regarding the possibility of wasting most of the money spent on the annuity.

When exploring the effect of a guaranteed period, ask for quotations that provide identical payouts and compare the premiums. You can say that a five-year guarantee period reduces a $1,000 monthly payout by $14 a month, or you can say that it adds $1,800 to the cost of the annuity. These amount to the same thing—a 1.4 percent difference—but considering it in relation to the premium shows you the total number of dollars that are really at stake. Opt for a guaranteed period if you want one. But be aware that it does cost money.

If you buy an annuity at age 65, it will hopefully pay out for a long time. Over periods of two or three decades, the effect of inflation on an annuity that pays out the same number of dollars every month can be devastating. From 1942 through 1971, a period of very low inflation, the value of a dollar was reduced to $0.56. From 1966 through 1990, the value of a dollar was reduced to $0.24. A level payout may be acceptable to an older annuitant, but it subjects a younger one to serious inflation risk.

Some insurance companies offer SPIAs that adjust for inflation over time with payment increases. They can be directly indexed to the consumer price index (CPI), or they can provide payments that increase at a specific rate that you choose. A CPI-indexed annuity adjusts your income upward by the same percentage amount as the CPI.

The purpose of an annuity is to reduce longevity risk. An annuity frees you from having to guess about your life span. An inflation-adjusted SPIA also protects your lifelong income from the corrosive effects of inflation. Unfortunately, only a few companies offer CPI-indexed SPIAs. Vanguard’s inflation-adjusted SPIA product is underwritten by a subsidiary of AIG. A similar product by Elm Annuity Group is underwritten by the Principal Financial Group.

Many companies offer a graded payout option that increases the payout every year by a specific percentage that you select. It is usually a compounded increase. If you buy an annuity with a $1,000-a-month payout and a 3 percent graded compound increase, it will pay $1,000 per month in the first year, $1,030 per month in the second year, $1,061 per month in the third year, and so forth. Since this is a fixed increase rather than a variable increase based on inflation, whether your payment keeps up with inflation or not depends on how good you were at guessing future inflation when you chose the policy.

Annual payment step-ups cost you money. Over time, these annuities are expected to pay out more than a level-payment annuity, so they cost more. Assume annuitants live more than 18 years. By the end of that time, a 4 percent graded increase would double their payouts. It should come as no surprise to find that such an increase can add 50 percent to the premium.

Table 7.2
compares an example of premiums quoted recently by one insurance company for a joint annuity for a couple, both age 60. The payments start at $1,000 per month and increase according to different schedules. The premiums change regularly based on interest rates.

This insurer example in
Table 7.2
charges about the same for CPI-U indexing as it does for a 3 percent per year compounded increase. If you buy an inflation-indexed product and there is little inflation—or no inflation—you will receive a smaller number of dollars than if you had purchased a nominal product that pays a defined numbers of dollars.

Since inflation-indexed annuities pay less at the beginning and more later on, you must wait longer for the return of your money. The breakeven point—when the number of dollars paid out equals the premium—occurs later. But the point may be moot. From the point of view of the consumption frame, the usefulness of an annuity should be measured by how well it protects against longevity risk—how well it supports longer-lived annuitants—rather than the total number of dollars it pays out.

A charitable gift annuity (CGA) is a type of SPIA. It can be an attractive way for a person of moderate means to help a charity. A CGA enables you to transfer cash or marketable securities to a charitable organization in exchange for a current income tax deduction and the organization’s promise to make fixed annual payments to you for life. Annuity payments can begin immediately or be deferred to some future date. In 2002, a
New York Times
writer called them “the hottest thing in giving.”

More than 1,000 charities offer CGAs. If you are of retirement age and belong to a church or alumni association, you may have already received a mailing about a CGA. The following guide compares CGAs with single-premium annuities.

The payout for a CFA is a lot less than for an SPIA.
Table 7.3
provides an example assuming a $100,000 investment.

The payouts from charitable gift annuities are deliberately set to be low and noncompetitive. The American Council on Gift Annuities (ACGA) is a qualified nonprofit organization. It was established in 1927 to stem rate competition between providers, so there is no point in shopping around. All providers offer identical rates. A 1995 lawsuit challenging this as price-fixing was resolved when Congress exempted CGAs from antitrust law.

The low payout rates on CGAs provide a safety margin for the charity. Since about half of the premium is expected to become a gift to the charity, the charity is receiving twice as much as is needed to make payments to annuitants.

Most states have little regulation of charitable gift annuities because they are not considered insurance and are not regulated as such. They require the annuity contract to contain disclosure language such as “a charitable gift annuity is not insurance under the laws of this state, is not subject to regulation by the State’s insurance division, and is not protected by any State guaranty fund.” Only 15 states (Alabama, Arkansas, California, Florida, Hawaii, Maryland, Montana, New Hampshire, New Jersey, New York, North Carolina, North Dakota, Oregon, Washington, and Wisconsin) require charitable gift annuities to maintain a segregated reserve fund. Five states (Delaware, Michigan, Ohio, Rhode Island, and Wyoming) and the District of Columbia have no laws addressing charitable gift annuities at all.

It is worth mentioning that, as with all investments marketed to seniors, it is unfortunately necessary to be alert to the possibility of fraud in the CGA marketplace. This is not a problem with CGAs in particular, but investment scams take many forms, and phony CGAs are among them. The Mid-America Foundation pretended to offer CGAs and took in more than $54 million before the Ponzi scheme was uncovered in 2001. A Ponzi scheme pays a high income to investors with the only funding for that income coming from new investors, not actual returns on investments. Eventually the pyramid collapses.

The CGAs are important donation vehicles, and you are really giving the charity worthwhile help when you buy one. The ACGA says that the payout rates are “computed to produce an average ‘residuum’ or gift to the organization at the expiration of the agreement of approximately 50 percent of the amount originally donated under the agreement.” That is, if you pay $100,000 for a charitable gift annuity, from the charity’s point of view, it is about the same as an outright donation of $50,000.

The ACGA states that taxpayers who itemize deductions can claim a charitable deduction for a portion of the original gift. The present value of those payments is determined by using IRS tables (see
www.IRS.gov
). There is also software that provides accurate tax calculations. All charities that offer gift annuities can provide these calculations to individuals who are exploring whether a gift annuity is appropriate for them, and many of those charities have calculators on their web sites that allow potential donors to enter basic information and see how their income tax situations might be affected by a charitable gift annuity agreement.

With regard to the income payments, if the gift annuity is funded with cash, part of the payments will be taxed as ordinary income and part will be tax-free. The charity that issues the annuity will send a Form 1099-R to the annuitant. This form will specify how the payments should be reported for income tax purposes. The ACGA website at
www.acga-web.org
provides additional information.

An illustration generated by an online calculator suggests that for a couple age 65, a gift of $100,000 would qualify for a charitable deduction of $20,866.78 when the gift was made, and that $2,221.96 of each year’s $5,400.00 payments would be taxable. For an 80-year-old couple, $40,625.08 is shown as deductible, and $1,924.81 of each year’s $6,600.00 payments as taxable.

If you have been accumulating money in an investment account and decide to annuitize, you would contract with an insurance company to start paying you income. When you make the choice to annuitize, you also decide how the payments should be structured.

Mortality credits are the additional return derived from pooling assets and giving up residual estate value. They increase with age and at an exponential rate.
Figure 7.4
illustrates this phenomenon. At around age 75, the mortality credits appear to be sufficient to overcome the various costs of annuitization. The mortality credits are always positive, so theoretically (so long as you don’t care about leaving an estate), for a given investment return, you should always be better off with an annuity than without one, but in reality you must first exceed the difficult-to-determine, embedded costs of the annuity before you see any net benefits.