Protect your retirement from future stupidity
Reprinted courtesy of MarketWatch.com
Published: Feb. 26, 2014
To read the original article click here
Future stupidity? If you’re smart enough to be reading this article, you probably “know” it’s meant for somebody else. Me too.
Lew Mandell, a retired business professor, at first dismissed the idea that seniors were likely to lose some of their good sense. After studying this issue, he discovered that for many people, financial wisdom peaks when they are in their 50s and then drops off quickly. The result: Many seniors are more likely to make bad decisions even though they are trying to be smart.
One of Lew’s (he and I have become friends since he retired to Bainbridge Island, where my wife and I live most of the year) 22 books is titled: “What to do when I get stupid.” The title came from a question he was asked about buying an annuity — an idea that Lew at first thought was dumb because so many annuities are expensive, complex and often risky.
When he heard the question “What happens when I get stupid?” Lew put his 44-year academic career to work, drawing on his experience as a finance professor at several universities including the University of Washington and the State University of New York at Buffalo.
After some study, Mandel concluded that a fixed-life annuity — very different from the variable annuities that are often expensive and risky — might be a good way for seniors to put their finances “on automatic” and avoid some costly mistakes.
Of course most of us think this will never happen to us. “But the research shows that as you get older, not only do you become less competent to understand complex things — you also become more convinced of your ability in this area,” Lew said.
One mistake a lot of seniors make, for example, is making major decisions based on emotional advertising, without consulting family members or a financial adviser.
The biggest risk many seniors face is outliving their resources. By guaranteeing an income that never runs out, a fixed-life annuity addresses that risk.
The downside of this arrangement is that such an annuity, once issued, can’t be cashed in. The purchase decision, in other words, is final and irrevocable. But Lew says that’s really the strongest point of a fixed annuity: “That’s money you can never be cheated out of.”
Without an annuity, you take the risk that you could live so long that your money runs out. You also take the risk that the investments you make could turn out to be very unproductive for the rest of your life.
When you buy an annuity, an insurance company assumes those risks. In return, you give up the potential opportunity to make more money by investing yourself. And of course you can’t leave that money to your family or other heirs.
As you can see, this is an important trade-off, and it isn’t suitable for everyone. But sometimes it works out to be just fine.
Recently I met with a couple in their 70s, who were still working because they didn’t think they had enough money to retire. They had saved $400,000 but needed twice that much to comfortably meet their needs using bond funds. Millions of Americans are facing similar challenges.
I told them that if they were willing to surrender to the downsides of an immediate life annuity, they could buy one with the money they had and retire right away.
They understood this wouldn’t let them leave an inheritance to their kids. But it would let them retire without working another five years. They accepted the trade-off and bought the annuity.
If you’re shopping for an annuity, it pays to do your homework thoroughly, because your purchase will shape your financial future. A handful of variables help determine how much monthly income you’ll get. These include:
- How much profit the insurance company will make
- How much money the agent or salesperson will make
- The insurance company’s assumptions about the life expectancy of its customers and
- The company’s assumptions about the interest rates it can make on its investments.
As I helped the couple in their 70s shop for an annuity recently, I was told by Vanguard (see below) that their monthly payout could range from $2,550 to $2,480 depending only on which of four top insurance companies they chose. This is a detail that many investors will fail to discover when they are relying on a commissioned salesperson.
Perhaps the most important variable is the size of the sales commission. This is at least somewhat under your control if you shop carefully.
When you buy an immediate life annuity from an insurance salesperson, he or she will likely get a commission of 3.5% to 5%. The most common figure is 4%.
Here’s why you should care about that: Every additional percentage point in the commission costs you about 1% of your monthly payout. No salesperson is likely to tell you of this relationship, but every salesperson is keenly aware of it.
For example, consider a policy that pays $2,500 a month based on a 5% commission. The same policy with a commission of only 4% would pay about $2,525. At 3%, the payout would be about $2,550 and so forth, growing to $2,600 with a 1% commission. For a savvy shopper who lives 20 years after buying the annuity, that extra $100 a month would add up to $24,000.
Where should you shop?
I suggest you start at Vanguard, which offers annuities from some highly rated insurance companies with a commission of only 2%.
Another source worth checking is annuity.com. This will give you access to insurance companies that aren’t available at Vanguard, and their easy online comparison tool might find a better deal for you.
This comparison shopping can be tricky, and I’ve recorded a podcast called: How to buy an immediate life annuity.
Most consumers will never acquire the expertise to effectively sort out all the choices. And this leads me to the best source I know for buying annuities: Low Load Insurance Services Inc., where the commission is only 1%.
This source is available only to clients of fee-only financial advisers who work as fiduciaries. Aside from the lower cost, this gives you a conflict-free expert working to make sure you get the best deal for your needs. I know lots of advisers who work with low-load insurance, and not one of them charges any additional fee for this work.
For anyone who’s already using an adviser, this is a no-brainer. And for some people this source of low-cost annuities might tip the scales and make hiring an adviser worthwhile.
As a matter of fact, that is probably the very best protection against the risk of future stupidity.
Richard Buck contributed to this article.
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