Registered Investment Advisor specializing in Model Portfolios

SMar 24, 2010

You Can’t Be Your Own Insurance Company

Scott Burns

Q. You have suggested that putting some funds in a competitive-yield annuity could be beneficial. I asked an annuity salesman how the funds were invested, thinking I might be able to make similar investments. He had no answer but said that, because of state regulation, annuities were safer. Can I create my own annuity or do they achieve higher rates and safety because they are pooling funds and using life spans as a sort of insurance pool. —A.C., by email

A. Insurance companies are intermediaries, just as banks are. They take your “deposits” and invest them in a broad variety of investments. They are direct investors so their returns tend to be higher than the returns you and I would get as retail investors in bonds or mortgages.

The portfolios of insurance companies tend to be heavily committed to fixed income investments such as real estate mortgages and corporate bonds. They have limited exposure to the stock market. They are also regulated and every state has a fund that acts as a backup in the event your insurance company fails.

Insurance companies also have the enormous advantage of being able to bet on a pool of lives. Yours may turn out to be longer than expected and require years of additional payments (you hope!) but it will be offset by another life that is shorter than expected. While they are taking the risk of your longevity, the reality is that their pool of lives will likely live to the expectancy of the age group.

These are benefits that you cannot create in your spare time at home. The big issue in life annuities is whether they are priced to provide your “money’s worth.” In addition to having selling and administrative costs, the insurance company wants to make money with your money. If its life annuity monthly payment is too small, many people feel they could do better by taking the risk of investing. The entire purpose of a life-annuity, however, is to AVOID the risk of running out of money.

In the world gone-by, the one where workers had career jobs with one company and could expect a lifetime pension, your pension was a life annuity. So you didn’t need to consider buying one. For the millions of younger workers who will not receive a pension, however, some form of guaranteed life-time income can be a very useful tool.

Q. My wife and I find ourselves, happily, with a negative tax liability for our 2009 federal income taxes. We live on our Social security and pension income, with withdrawals from investments for major expenses. I am 66 and she will be 65 this year. I am considering a withdrawal from a 401(k) account to bring our tax liability to zero for 2010. I would invest the money in an "after-tax" account. Is this a good idea? —D.Z., by email from Nashville, TN

A. That’s a great idea. You’re way ahead of lots of people. Let me explain why. First, most people don’t know their tax bracket. Lots of people think they pay taxes at much higher rates than they actually do. Most people haven’t figured out that a retired couple can have an income from Social Security, pension, and investments approaching $100,000 and pay federal taxes at a rate no higher than 15 percent.

If you can take money from a retirement account and not need to pay income taxes on it because of all your other deductions, etc. then you should take the money out and build a separate taxable account. This account can be invested in tax-efficient equities, such as a total stock market index fund. Most of the return will not be taxable and the taxable return will be taxed at low rates. More important, you will be able to use a large portion of this money with minimal need to pay taxes because it will be original principal. This will give you flexibility for meeting cash needs. You don’t have that flexibility if all your money is in a tax-deferred account because every dollar withdrawn is a taxable event.

Taking money out of a retirement account at a zero, 10 percent, or 15 percent tax rate today may allow you to avoid paying at a 25 percent tax rate on withdrawals in the future when Required Minimum Distribution rules increase your taxable income regardless of your cash needs.

Filed Under: Q&A (from print), Annuities