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Q My CPA has advised me to convert the invesments in my profit sharing plan into annuities. He assures me the high costs this year will be offset by big tax advantages in retirement, but I can't follow his math.A You would come out ahead with an annuity only under less-than-ideal circumstances, and if that's the case, there generally are better options. Plus, you should never use annuities in a tax-preferred environment like a profit sharing plan.Under an annuity contract, you pay an insurance company money, and the company agrees to make incremental payments back to you. Payments to the company can be in one lump sum (like a nest egg) or over a period of time. Payments back to you can be fixed or tied to the market or an index. Payments can be for a specific time period, for your lifetime, or the later of your or your spouse's death (last to die).
The insurance company offers benefits and expects to receive a profit for this product. However, if these "benefits" are of no benefit to you, you are paying for something you don't need.
1. One benefit of an annuity is the opportunity for tax-deferred growth. You already have tax-deferred growth through your profit sharing plan, so you're not gaining anything there. Furthermore, good tax-managed investments are managed differently than the tax-insensitive equivalent. Tax-managed investments assume you are in a taxable account, and that could change the trading parameters in ways that can be disadvantageous in a tax-preferred account. That's why you don't want annuities (or tax-free bonds or tax-managed mutual funds) in your profit sharing plan. I would seriously question your CPA's advice on this basis alone.
2. Another benefit of an annuity is managing risk in retirement. If you don't know how to invest and you are afraid of stepping into quicksand with the wrong investment, the regular payments of annuities can be comforting. However, if you have had a reliable professional managing your investments, your retirement should already be secure.
3. Another benefit of an annuity is discipline. This is a little different than managing market risk. If you're afraid you can't stick to a budget and will spend more than you should in retirement, then the forced discipline of annuity payments may be welcome. If you purchase an annuity with multiple payments over time, this also structures saving for you. However, if you have good saving and spending discipline, or if your advisor does it for you, you have this covered.
The insurance company, as an institutional investor, can earn more on your money than it is paying you. Annuity returns are notoriously weak, but of course the insurance company is providing the benefits so it deserves some consideration. But generally speaking, if the insurance company can make more on your money, that means that you also can make more on your money outside an annuity.
The insurance company also pays a sales commission, in this case to your CPA. This kind of money can color objectivity, and even a subtle nudge is too much.
The insurance company is not a financial advisor. It doesn't know how much you need to live on. It simply makes a mathematical calculation based on what you pay in. There is nothing in an annuity contract that guarantees its payments will be enough for a comfortable retirement. You still have to figure out what kind of life you want in retirement, what that will cost, anad much you have to save to get there.
Most significantly, when you jump into something with guaranteed lower return, you lose future compounding that continues through retirement. The difference between 7 percent and 9 percent return on a $500,000 portfolio over 20 years, even if you never save another penny, is huge: 7 percent — $1,935,000; 9 percent — $2,802,000; difference — $867,000.
This is a pure mathematical calculation that does not take costs and fees into account. Still, if you continue on with the math into retirement using a 4.5 percent annual draw, that $867,000 that you didn't earn translates to $39,000 less per year over a 30-year retirement. That's what you lose when you give up just 2 percent in earnings on $500,000. If you increase the differential or increase the principal, the loss increases as well.
So really, if you don't need the structure of annuities to discipline your finances, you could only come out ahead financially if your current investments were worse, which is hardly a validation of annuities.
Gene Dongieux is the author of If You Have It Made, Don't Risk It: A Physician's and Dentist's Guide to Investing. As chief investment officer for Mercer Advisors, he manages over $3 billion in client assets. Dongieux has been quoted in "The Wall Street Journal" and "Investment Advisor" magazine. Contact him at [email protected].
