When is an annuity a good retirement strategy? SPIA advice (Forbes.com)

For Some Retirees, This Annuity Makes Sense
Mel Lindauer, 07.30.10, 12:00 PM ET

We've talked about a number of different types of annuities in our previous columns. We discussed nonqualified deferred variable annuities in the first and second columns in this series on annuities. We covered qualified deferred variable annuities in our third column, and in our fourth column we talked about fixed deferred annuities.

Based on these previous columns, you might be getting the feeling that Bogleheads are against all types of annuities, but you'd be wrong. We're against high-cost annuities that trap investors into substandard investments for long periods of time using often-hidden surrender periods and the associated high surrender fees. We're also against annuities that are sold by unscrupulous salespersons who sometimes "hoodwink" (often older) investors into investing with them by providing false or misleading information about the annuity products they're selling.

However, despite all the negatives and cautions we've mentioned in our previous columns, we do feel that annuities can be appropriate in certain situations. In earlier columns we listed some situations where a low-cost variable annuity may make sense in both non-qualified and qualified situations.

In this column, we'll talk about another type of annuity which could play a role in some retirees' overall investment planning, and that's a single premium immediate annuity or SPIA.

A single premium immediate annuity offers an income stream that will last as long as the annuitant (or joint annuitant, if that option is selected) lives or for a predetermined period, depending on the option selected at the time of purchase. The fixed immediate annuities include nominal, graded and inflation-adjusted payment options. There is also a variable option in which the payout is determined by the returns on the investments chosen by the investor.

In exchange for these payments, the annuitant surrenders a specific amount of money to the insurance company. These payments can be based on a single or joint life. Normally this purchase is irrevocable, and the money used to make the SPIA purchase is not available to one's heirs, even if the annuitant dies shortly after purchasing the annuity, unless a predetermined payment period was selected. However, selecting one of the available term-certain payment options will result in lower payments.

An SPIA is probably one of the easiest annuity products to understand. You give the insurance company a specific sum of money in exchange for an income stream that you can't outlive. The SPIA can offer peace of mind in bridging income shortages. For example, if a retired couple needs $4,000 per month to cover their living expenses, and Social Security and pensions provide $3,000 per month, they could purchase an SPIA that would pay out the needed $1,000 per month for as long as either one of them lived. However, they would need to keep in mind that most annuity payments aren't indexed for inflation, so over the long term, the spending power of that $1,000 would decrease.


Should the couple choose to purchase one of the few inflation-indexed SPIAs available, they'd have to either pay a higher premium or receive a lower initial payment. And since inflation-indexed annuities are only offered by a few insurance companies, there's not a lot of competition to help make those rates attractive for the annuitant. Finally, it's important to remember that the return of your principal is included in the promised payment stream.

An SPIA can also provide a "bridge" that could allow an investor to delay taking Social Security until later in life. Doing so could mean larger Social Security payments to both the recipient and his/her spouse. Boglehead Ron explained his use of an SPIA this way: "In our case, we used it as ‘SS gap insurance' since I retired at 59 but will not claim SS till age 70 (primarily for the benefit of my wife)."


Using a period-certain SPIA as a bridge to Social Security may be a valid strategy for some folks like Ron. However, for many relatively young retirees, the period-certain option is probably not the best choice. Remember, the insurance company has to plan to pay for the rest of your longer-expected life, so that means you'll receive lower payments. In addition, because of the longer expected payout period, you magnify default and inflation risks since the insurance company has to remain solvent for a very long period of time and inflation will almost surely erode the yield over those longer periods. As an alternative to taking the inflation-indexed option, consider purchasing TIPs at the Treasury auctions and holding them to maturity, since TIPS both preserve capital and protect against inflation.

In another recent Bogleheads.org forum post, author and forum leader Taylor Larimore listed a number of valid reasons why he and his wife, Pat, purchased an SPIA. He stated that "The primary reason we bought our lifetime annuities was so that we could give our heirs their inheritance while we're living. The annuities assure us (and them) that we will not run out of money no matter how long we live." Taylor then went on to list a number of other reasons that he and Pat considered important in their decision to annuitize a portion of their savings:

"Our annuities give us a guaranteed income of approximately 10% of premium (using interest and principal). This is more than we could get from any other safe investment.
"Our annuities immediately reduced our estate for tax purposes and offered protection from lawsuits.
"It was very comforting to have a steady income and protection of principal during the recent bear market.
"Our annuity income is only partially taxable.
"It will be much easier for survivors to not worry about this part of our portfolio." Here are some situations where an SPIA may make sense:

For someone who is in good health and has a family history of longevity.
For folks who are afraid of running out of money before running out of breath.
For investors who don't know how to properly manage their assets or who don't care to do so.
For an investor who is concerned about a surviving spouse who has no knowledge of, or interest in, investing.
For people who have no heirs or who have no desire to leave the funds used to purchase the annuity as part of their estate.

There is no one rule that covers every situation or every investor. However, if one or more of the above situations apply to you, then there's a good possibility that an SPIA may be appropriate for you

What is an Accredited Investor ? (Morningstar)

New Law Changes Wealth Definition


by Tim Galbraith | 07-23-10


President Obama just signed into law a sweeping set of financial reforms contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act. One significant change is the modification of the definition of an "accredited investor."

Accredited investors are a minority in the United States, as the description imposes high-net-worth thresholds. There are many details in the definition, but broadly speaking, the historical accredited investor standard meant investors had to earn $200,000 during the previous two years with the likelihood of earning the same during the forthcoming year. Alternatively, investors not meeting this income test could qualify for accredited investor status by having at least $1 million of net worth, which included all investments and, critically, one's home.

Accredited Growth
These income and asset rules were put into place in 1982. In that year, the SEC estimated that only 1.87% of U.S. households would pass either of those financial tests. With the march of time, inflation and asset appreciation increased incomes, home prices, and the value of other investments. Take for example incomes: Government statistics show that in 1982 the top 5% of households earned just more than $60,000 and by 2008 the income level was $180,000--an increase of 200%. Average home prices rose 237% in the same period, and in some metropolitan areas the appreciation was much more.

The SEC estimated that the percentage of accredited investors increased by 350% from 1982 to approximately 8.47% of households in 2003. In 2010 the percentage was likely higher despite the recent housing and 2008 equity market correction. Like many things that do not adjust for inflation, the old definitions got easier to meet and more investors, even though they may not have felt rich, were now members of the top investment club.

An individual who meets the definition of an accredited investor has access to a group of investment products unavailable to the retail masses, namely private partnerships that can invest in private equity, real estate, commodities, and hedge fund strategies. It is common sense that legislation put in place net-worth tests to limit access to these types of strategies, which typically have poor transparency, intermittent pricing, and episodic liquidity. However, more sophisticated investors who understand the greater risks could potentially benefit from greater return from these investments.

But as net worth increased over time, many investors found themselves technically eligible to be accredited investors, though their own investment proficiency was less than a perfect match for these complicated products. It is easy to imagine a pensioner or school teacher, not able to meet the $200,000 income threshold, but who owns a home in an affluent area, where the housing bubble lifted their net worth more than $1 million. Are they really an accredited investor, able to judge complex trading strategies, partnership tax treatment, or esoteric securities such as a collateralized debt obligation?

Wealth Redefined
The new legislation immediately removes the value of a home when calculating the $1 million net worth limit. Newly minted accredited investors must have true investments in excess of $1 million. The $200,000 income threshold remains unchanged. Additionally, after four years the SEC has the ability to increase the $1 million bar to account for inflation, eliminating the problem of having a fixed net worth hurdle that gets easier to jump with the passage of time. Existing investors who no longer meet the newer accredited standards may not be forced to redeem, but no new money will be permitted to be added unless the investor qualifies.

The most immediate impact of this legislation will be felt on those operating investment products that are limited to accredited investors, namely private partnerships, including hedge funds. The tighter standards will shrink the number of prospects, forcing these partnerships to target larger qualified and institutional clients. Additionally, there will be more scrutiny on partnerships to ensure their accredited investors really meet the new standards. Ultimately, an investment partnership is responsible for ensuring compliance with all securities laws, particularly Regulation D of Rule 501 in the Securities Act of 1933, commonly known as "Reg D." This is where the definition of accredited investor is detailed and the rules of private fund investor solicitation are laid out.

"No one conducts financial audits or demands absolute proof of net worth," says Rory Cohen, partner at the law firm Venable LLP. "But clients typically attest to their net worth through subscription documents, on which broker-dealers and funds rely. Ultimately, the investment partnership is responsible for its ability to assert compliance with the Reg D safe harbor. Partnerships ought to show some reasonable level of diligence in confirming that an investor meets the eligibility requirements."

For funds that target accredited investors, the responsibility to meet the new standards falls to the fund and its general partner. Adds Cohen, "Funds should have a pre-existing substantive relationship with each investor, through which they could gain sufficient information about an investor's occupation and financial circumstances to better assess whether they are accredited. When in doubt, it would be prudent to ask for a tax return."

What are the penalties for failing to meet the Reg D requirements? "Failure to adhere to the private placement requirements could lead to fines and potentially far more punitive measures," says Cohen. The ultimate sanction would be closing a fund and liquidation. The high fees charged to investors by hedge funds means many funds are wealth-creation machines for their fund managers. For a fund manager charging a 2% management fee and a 20% performance fee, closing a partnership is the equivalent of taking the Golden Goose to a barbeque.

For retail investors, it can be argued that the new higher standards to become an accredited investor provide additional protection. Investors can be better matched to investment products that suit their level of understanding and sophistication. For clients and financial advisors, once again, suitability reigns supreme.

One other possible outcome from the new definition could be an increase in the number of mutual funds and exchange-traded funds that attempt to mimic the same strategies as these private partnerships. If you run a private partnership, the new definition means there are fewer prospects; asset raising is more difficult and more costly.

One option is to scrap your partnership and open a mutual fund, where there is no net-worth threshold for investors. The numbers of these alternative mutual funds are growing, and include such hedge fund styles as long-short and market-neutral. Morningstar's last count was 153 funds, with more in the pipeline. For retail investors, the benefits include daily liquidity and pricing, a 1099 tax form instead of a K-1, and no minimum net-worth requirements.

We are encouraged by these changes as they provide additional investor protections. Time will tell if this legislation will be the catalyst for new financial product innovation, nudging private money managers to open mass-appeal products. We are hopeful and very watchful as innovation brings new but not always enduring products. The lasting lesson is something we've known all along, that client suitability is timeless, and knowing your client (and their limits) is a protection that legislation can never universally provide.

Data Sources:
Census.gov (housing data) http://www.census.gov/const/uspricemon.pdf
Census.gov (top 5% income) CPS data
U.S. Congress conference report for HR4173
Federal Register / Vol. 72, No. 2 / Thursday, January 4, 2007 / Proposed Rules (SEC) stats on numbers of accredited investors

Tim Galbraith is head of alternative investment strategies for Morningstar Associates, LLC.

Best age to buy long term care insurance (Morningstar)

When Is the Right Time to Purchase Long-Term Care Insurance?
By Christine Benz | 07-20-10


Question: My husband and I are in our early 50s with no kids. We'd like to purchase long-term care insurance but wrestle with the right time to do so. I know it's cheaper to buy a policy when you're younger, but my hope is not to need this coverage for another 30 years, if at all. Any guidance?

Answer: With nursing home care averaging $200 a day in 2008, according to MetLife (and skilled home health care or nursing care at higher-end facilities or in high-cost geographies costing a lot more than that), you're wise to contemplate a purchase of long-term care insurance. But you've hit on one of the crucial questions: When is the time to buy it?


Much like the questions surrounding when to begin collecting Social Security benefits, timing a long-term care insurance purchase is more art than science and involves guessing about your own health and future.


Insurance professionals often push long-term care coverage at an early age--no surprise there. The benefit to you is that the premiums are certainly lower than if you waited, and being younger reduces the likelihood that you would have already encountered a serious health problem that could jack up your premiums or disqualify you for coverage. (You'll typically be required to take a physical to obtain coverage.) A Consumer Reports study found that 23% of people who applied for long-term care coverage while in their 60s were denied it, while 45% of those in their 70s didn't pass the physical. So clearly, waiting too long to purchase a long-term care policy can backfire. And if you have a serious medical condition that runs in your family, that's an extra incentive to consider purchasing long-term care insurance pre-emptively, while you're in good health.


But as alluded to in the question above, the average age for entering a nursing home is roughly 80. So, if you buy a policy now, you could be paying premiums for 25 years or more before you actually use the coverage. The question is, what's the opportunity cost of sending that money to an insurer rather than holding on to those premiums for another decade and purchasing a policy then?


Let's look at some numbers. The average annual premium for long-term care insurance for someone in their 50s was roughly $2,000 in 2008, according to LIMRA International, versus an average annual premium of $2,250 for a person age 60 to 64. (Those statistics encompass a broad range of purchasers and policy types.) If a person who's 52 now held off on buying a policy until he was 62 and invested that $2,000 per year instead, he'd have amassed $24,000 by age 62, assuming a 4% return on his money. Thus, purchasing now versus holding off carries a sizable opportunity cost.


But while it may seem like waiting is a no-brainer, it's worth noting that my example bakes in some assumptions. The big one is that the individual would still qualify for coverage--a big if--10 years later. And long-term care premiums, like almost everything else, are likely to inflate over time. So by the time he got around to buying the insurance at age 62, it's very likely that his premiums would be much higher than $2,250 a year. (The two policy premium averages cited above--$2,000 for a 52-year-old and $2,250 for a 62-year-old--are as of the same date.)


As you weigh the pros and cons of purchasing now versus waiting until later, ask your insurance provider to price coverage for someone at your current age as well as for someone who's five or 10 years older; that will help you determine how much you're saving by starting earlier. For most people, initiating long-term care coverage in their early 60s strikes the right balance.

To Investors Under 40 (Washington Post)

Wanna eat when you retire? If you are under 40, listen up


To retire comfortably, under-40 workers need to seriously bulk up savings
By Jonathan Kern
Special to The Washington Post
Sunday, July 18, 2010; G01



If your junior-high soundtrack was more Bangles or Britney than Beatles, I am going to try to scare some sense into you with three words about life in retirement, based on personal experience: The paychecks stop.
I retired last year after 30 years as a broadcast journalist. Unlike most baby boomers who have retired, I do not receive a pension. This surprises and appalls my fellow early retirees, who are either enjoying income from a spouse who's still working or receiving checks from old employers.

If you're, say, under 40 -- and especially if you're under 30 -- you probably have worked only at firms or agencies that offered 401(k)s or their nonprofit cousin, the 403(b). That means that when you finally do retire 25 or 35 years from now, you will be responsible for providing for your own income. No pension for you!

Much has been written telling you how to prepare for that day -- namely, to save every cent you can.

A recent study shows that most people ignore that advice. In the wake of the recession, the Employment Benefit and Research Institute found that, among other things, fewer workers are saving for retirement, a quarter of those surveyed have nearly no savings (i.e., less than $1,000), most workers don't know how much they'll need to retire and more than half say their total savings is less than $25,000.

Clearly, all those thoughtful lectures about the need to prepare are falling on deaf ears.

So I'll say it again: The paychecks stop. Every day, every week and every month of your retirement, you'll use up some of the money you accumulated while you were working.

Specifically, imagine that every week you have to pay for food with cash from savings. And it's the same with your electricity, cable, phone, gas, credit card and other recurring bills. Because your health care is no longer subsidized by your employer, you write a big check each month to an insurance company as well. If you earn a few bucks on the side, even the taxes have to come out of your savings; no one else withholds federal and state tax from every paycheck.

Sure, if you work until you can collect Social Security, you'll get some money from the government, but it's a fair bet that your No. 1 source for retirement is going to be you. If you are not saving assiduously now, you are going to be much, much poorer in retirement. Restaurants, cable TV, BlackBerry service, travel abroad -- even things like beer, fast food and haircuts -- all will be fond memories of youth.

Retirement does not have to be this way.

I glimpsed my own future more than 20 years ago, when my wife and I worked for the federal government. In 1987, it introduced the Thrift Savings Plan -- basically a 401(k) for government employees. When we left government service, we withdrew our contributions and invested the money ourselves. My next employer offered no pension, only a 403(b).

In other words, although we are both baby boomers -- born in 1946 and 1953, respectively -- we are living the Gen X or Gen Y retirement.

Over the past year, I have learned a few things about how to retire successfully without a pension.

First, take a moment to think about how much money you will need each year after you stop working. Start by itemizing your usual expenses. Estimate your rent or your mortgage and property tax. Make reasonable assumptions about what you spend on food, utilities, essential travel, clothing, car repairs and so on. I assumed that my single biggest expense would be health insurance and budgeted more than $10,000 a year.

Whatever figure you come up with -- let's say, $50,000 -- consider it a minimum. Divide it by 26 to come up with your biweekly retirement income -- about $1,925. Your figure will probably be much less than the usual 80 percent of your current income that most financial advisers say you'll need. We're talking about getting by; any extra will only make life better.

So without a pension, how much do you need to get $50,000 (before inflation) each year? Simply put: a bundle. If you plan to retire at 65 and hope to have at least 30 years in retirement, you'll probably need something like $1.5 million in today's dollars. Even a little inflation could push that to $3 million if you're two or three decades from retirement. For the moment, let's leave inflation out of the calculation.

In other words, if you have saved just $25,000 -- and remember, that describes about half of all workers -- you are less than 2 percent of the way toward your goal. Your future definitely doesn't include cable.

Here's more bad news: Just saving a lot isn't going to be enough. Let's say you're 30 years from retiring, you earn $100,000 now and you guess that your income will go up by about 3 percent a year. Even if you earmark 10 percent of every paycheck for your retirement and your employer adds another 5 percent, you'll have set aside only about $713,000 by the time you stop working. That's half of what you'll need for that $50,000 annual income.

To live comfortably in retirement, whatever you save has to grow -- and its growth has to beat inflation by at least a percent or two. Here's where time is your ally. Take the example above, where you're earning $100,000 a year: That first $10,000 you set aside in 2010 will have become more than $30,000 in 2040 if it grows by 4 percent each year. If it grows by 6 percent, you'll have more than $50,000. And whatever your employer put in will have tripled or quintupled as well.

The bottom line is that the only way to ensure that decades from now you will have enough money to live on is to invest wisely.

So it's imperative to educate yourself. You should understand what a bond is, how to select a mutual fund, how inflation affects your investments and so on. Even if you turn to a financial planner, you'll need to evaluate the advice and make your own decisions about where to put your money. Bernie Madoff's clients wouldn't have been so easy to scam if they'd understood that it's simply impossible to get 12 percent returns, year after year, in vastly different economic climates.

That's a key point: Economic conditions change, and you will need to take advantage of those changes. If the next 30 years are even remotely like the past 30, inflation will swing from low to high and back. There will be stock market booms and crashes. As an investor, I've endured the crash of 1987, the bursting of the tech bubble in 2000 and the terrible bear market of 2008-09. I've also seen 13 percent annual inflation, which gave us 16 percent mortgages but also money markets with yields of 15 to 20 percent.

So do a little research about when it's smart to buy bonds -- and whether they should be Treasuries, corporate bonds or municipals -- and when it's better to invest in stocks, bank certificates of deposit or commodities. Learn how to recognize when investments overseas are strong. Over 20 or 30 years, you'll want to diversify and rebalance your investments so that the inevitable market tsunamis create relatively small waves in your portfolio. You're surrounded by this information. Read books about how the markets work, go to Web sites with primers on stocks and bonds or just watch business channels on TV.

Finally, even when times are tough -- especially when times are tough -- don't ignore that quarterly 401(k) statement. That's when you can see whether all your planning is working -- cushioning the blow of a bad stock, bond or real estate market -- or whether you need to explore different investments.

Think of all these do's and don'ts as a warning from your (not-so-distant) future. You can't just cross your fingers and hope that things turn out, or that someone else will take care of it. Start thinking about retirement now. Your life -- or at least your future standard of living -- depends on it.