What the heck is an annuity part 2: fixed deferred

Posted By Paul

I came across another major annuity type called the "fixed deferred" or "fixed interest deferred" annuity that I wanted to talk about.

A fixed interest deferred annuity is kind of like a savings account, so I'm going to assume we all know what a savings account is and describe the annuity in contrast to that.

1) Like a savings account a fixed annuity gives you a known return on your money. In fact with fixed annuities you generally "lock in" an interest rate for some amount of time (like 5 years) and then after that interval has expired you "lock in" a rate again. One example is that Vanguard has a fixed annuity where if you open today you get a rate of 2.65% for the next 5 years. Note that this isn't a bad rate, in fact it's better than most CD's you can find right now.

BEWARE: I read about places where you get some awesome rate for the first year and then after that it resets to something lame, only now they have your money and you have to go through all kinds of hassle to move it.

2) Unlike a savings account, any interest you get is tax deferred. You don't pay taxes on it until you take it out.

3) Unlike a savings account, you can't just deposit and withdraw money whenever you feel like it. They vary, but it seems like most places have rules about how and when you can withdraw your money. The one through Vanguard for example says you can take out 10% of your savings in a year without penalty (but be careful, as with all tax deferred vehicles there can be tax consequences for getting your money out early). From my research it also seems that in most cases to add money you have to open a whole new annuity.

The above points generally capture what this type of annuity is. It's sort of like a 401k (you get the tax deferred part) and kind of like a savings account or CD (guaranteed interest).

So what are the pros and cons? Here is what I was able to come up with:
Pros: You get all the perks of a savings account PLUS tax deferral.
Cons: This is money you shouldn't plan on touching until the terms of the annuity are met. If you needed to "break open the piggy bank" early then tax and penalties could eat in to your money fast.

Overall, I think that this sort of annuity isn't a bad thing to consider if you've already given all you can to your 401k AND Roth IRA and still have money to sock away. When considering this sort of annuity BE SURE TO READ THE FINE PRINT and make sure you know what you're getting. Key questions to ask are:

1) What is my rate and how long does it lock in?
2) Is this rate an introductory rate?
3) How can I withdraw my money and what kind of withdrawal limits/penalties are there?
4) Is there any way to deposit additional money?

One interesting point is that when you compare this to my previous post:

What the heck is an annuity? Part 1

You'll see that this type of annuity is VERY different from the type I describe in my earlier post. As I mentioned before (and will mention again) that's one thing I REALLY don't like about annuities, it's such a broad term.

Once again I'll close with a quote from Warren Buffett about business investing, but it applies just as well to investment vehicles:

"Never invest in a business you cannot understand. "

The 100 Rule For Investment Allocation

Posted By Paul

Have you ever heard of the '100 Rule' for asset allocation? The idea is that you subtract your age from 100 and the result is the percentage of your investments that should be in stocks (as opposed to less aggressive bond funds or the like).

Well I'd heard of it and recently decided to see if I was adhering well to that rule. Well imagine my surprise when I saw that my Vanguard fund (designed to automatically transition to more conservative funds as time goes by) wasn't even close.

A little research took me this article:

Money Savvy Rules of Thumb

Which specifically mentions the '100 Rule' (rule number 3) and says that this formula is too conservative considering the current longer lifespans of people. They suggest using a '120 Rule' which is right in line with my Vanguard fund, but unfortunately not as catchy.

What the heck is an annuity? Part 1 - Single Premium Fixed Immediate Lifetime

Posted By Paul

As I try to become better at understanding the financial world, one word that pops up every now and then is 'annuity'.

I realized recently that I really don't have any idea what one is. I have this vague sense that I'm not interested in them, but that's not really based on anything rational, so I thought I'd do some research and share what I've found.

Here's what I've learned:

First of all, annuity is a REALLY broad term. To define it in terms that apply to all of the different flavors you end up with something like:

An annuity is an agreement (generally with an insurance company) to pay out money for a period of time.

Pretty general huh? Well it is, and that's probably why annuities get such a bad reputation, there are so many different flavors of annuity (not to mention many providers) that it's really easy to end up with a bad one.

So I'm going to start off with what I consider to be the simplest type of annuity: the single premium fixed immediate lifetime annuity.

Quite a long name, but the terms make sense if you take them individually:

Singe Premium - means there is one premium (essentially you buy it with a lump sum)
Fixed - means the payments don't vary
Immediate - means that the payments start immediately
Lifetime - means the payments continue for as long as you are alive

This type of annuity is essentially a policy that you buy with an insurance company that says that the insurance company will pay you a certain amount of money for the rest of your life.

A hypothetical example, if I were an insurance company, I might say that if you pay me $50,000 today then I will pay you $100 a month for the rest of your life.

I found a very simple web annuity quote calculator and asked it the question:

If I were age 40 (the calculator had 40 as the minimum age) and wanted an annuity that paid me $200 a month until I died, what would it cost me?

The answer? About $41k. So the question then is, is it worth it? If I just took my $41k and stuck it under the mattress and took out $200 a month, how long would that last? The quick math says I would run out of money in about 17 years. So from that calculation it seems like a pretty good deal since I plan on living longer than 17 years.

But of course if you didn't buy the annuity you probably wouldn't just put the money in your mattress, so how best to compare that?

That gets difficult, but luckily I found a savings calculator that you can use to see how long savings will last assuming a certain APR and monthly withdrawal.

If you're curious the savings calculator is here.

Using this calculator, if I start with $41k and take out $200 a month then the amount it will last depends on the APR, but for a few values comes to:

24 years at 3% interest
28.8 years at 4% interest
38.6 years at 5% interest

Interesting. At this point you start to see the trade off between having the annuity and keeping the money for yourself. Here are some of the pros and cons of the annuity:

Pros:
1) Takes some of the uncertainty out of retirement savings, with this sort of annuity you know exactly how much you'll having coming in for the rest of your life.
2) Low risk, assuming the insurance company stays solvent, you'll get your money.

Cons:
1) It's possible that you could meet or beat the returns by just managing the money yourself.
2) If you die an early and untimely death, no money is paid to beneficiaries the money is just gone (note that there ARE annuities that include a death benefit but they cost more).
3) Your lump sum is gone, so if something happens where you wanted that lump sum back, you're out of luck.

Overall, this type of annuity doesn't seem like a terrible thing from an investment standpoint, but remember, this is just ONE type of annuity, there are so many types of annuities out there that you REALLY need to be careful to make sure you're getting what you're expecting.

I'll close this (and probably all my annuity related posts) with a quote from Warren Buffett (he uses it to refer to investing it in a particular business, but I think it applies just as well to any investment vehicle):

"Never invest in a business you cannot understand. "

Article: Teaching Kids About Money

Posted By Paul

As a new parent I'm thinking a lot about how best to deal with money and my child. I'm planning on going with an allowance system when they are old enough. I remember that when I was a kid that all of my neighborhood friends had the system where if they wanted to do something they had to ask their parents (e.g. "Can I have money to go to the movies?"). I enjoyed having my own money so that I didn't have to track down my parents and ask for money for each little thing I wanted to do.

I also remember that with my friends that if they were given $5 to go to the movies (which of course back then was ample) they would make an effort to spend every nickel, since every bit they didn't spend just had to go back to their parents. They would pay for the movie, and also get a soda and candy (and maybe a video game or two). I would just pay for the movie and skip the expensive snacks so that I could keep my velcro wallet a little fuller.

I liked the fact that this article encourages the parents to let the child aware of the family finances and also highly discourages the parents from bailing out their child when they want something but have already spent their allowance.

Click on the link below to read the article. Are there any other great ideas for ways to teach children money lessons?

The Four Terrible Money Mistakes We Make With Our Kids

Article: Back To School Shopping On A Budget

Posted By Paul

I was reading an article in the newspaper talking about how many children and teens are developing frugal shopping habits because their parents are encouraging them to stretch their back to school budgets.

There were kids talking about how they were avoiding clothes that had the brand name right on them and were focusing more on trying to get as much for their dollar as possible by checking out the clearance rack and so on.

It was exciting to hear about children developing good spending habits early, and I noticed that the common thread among the children in the article was that they were given a spending limit by their parents and therefore were motivated to stretch their dollars as far as they could.

As a new parent I think a lot about how I might instill good values (including good spending habits) in my child. When I was in my tween and teen years I was never told: "You can only spend $100 on back to school clothes this year." I was told something like: "Let's go to the store, we need to go and get you some shoes and a winter coat."

Of course I remember that I really disliked clothes shopping (still do) so if my folks had told me something like "You have $100 to spend on back to school clothes." I probably would have just asked to wear my ratty jeans one more year so I could spend the money on comic books.

However, many teens are more concerned about clothes than I was, so I think it's a great system to provide your child with a spending limit so they can start to understand the benefits of making their dollar go farther.

Here is the article in full:
Frugality is cool in back-to-school shopping