Do I Need an Annuity in Railroad Retirement?

There is a expression in the financial services industry when it comes to annuities. Annuities are "sold" and never "bought". You hear the pitchman all the time on the weekend radio or at "free" dinner seminars guaranteeing returns to investors with no risk. The world is coming to a end only annuities can save you...Before we render complete and final judgement of these complex financial instruments let's look at some pros and cons of annuities.

What is an Annuity?

An annuity is a contract between you and an insurance company. You pay for the annuity through a lump sum or payments over time. The insurance company will then invest your money. The most common way to invest is through mutual funds which are managed by the insurance company.

From these earnings, the insurance company will make regular payments to you, again in the form of a lump sum or payments over time. Well that seems very straightforward but now the tricky part. There are multiple types of annuities and the exact payment structure of each will vary based on the terms that you agree to with the insurance company.

Types of Annuities

There are three main types of annuities – fixed, variable and indexed. A fixed annuity guarantees a minimum rate of interest on your money, as well as a fixed number of payments from the insurance company. On the other hand, a variable annuity allows you to invest your money in different securities, such as mutual funds. The payments you receive will depend on how well your investments perform.

While an indexed annuity is technically a version of a fixed annuity, it more combines the benefits of both fixed and variable products. The returns you earn from an indexed annuity aren’t based on investment decisions you make. Instead, your money will follow the performance of a stock market index like the S&P 500. However, the insurance company limits your return by placing a "cap" on the return. For example, if the index returned 10% but the annuity had a cap of 3%, you receive only a maximum 3% rate of return. Many indexed annuities put a cap on the return. In addition, an often overlooked point is that for the purposes of the insurance company calculation, an index return excludes dividends, so your return from an indexed annuity will also exclude dividend income. This is important because history indicates that dividends have been a strong component of equity returns over the course of time. Since 1930, dividends have made up approximately 40% of the S&P 500's average annual total return.

The Pros of Annuities

#1: You Can Receive Regular Payments

The most basic feature (and biggest pro) of an annuity is that you receive regular payments from an insurance company. These payments provide supplemental income during your retirement, and can help if you’re afraid that you haven’t saved enough to cover your regular expenses. Keep in mind that the value and number of your annuity payments will vary depending on the type of annuity you have and the terms of your contract.

#2: Your Contributions Grow Tax-Deferred

The money that you contribute to an annuity is tax-deferred. That means you can contribute money before you pay taxes. In fact, you won’t owe taxes on the money until you start receiving payments. During the time between when you contribute funds and when you withdraw them, it’s possible that your money could grow significantly. This type of growth is similar to how 401(k) contributions grow.

#3: Fixed Annuities Offer Guaranteed Returns

The insurance company will invest any money that you put into an annuity. There’s always a certain level of risk involved when you invest money. However, any contract you sign for a fixed annuity should include certain guarantees to prevent you from losing money. Fixed annuities guarantee that you make a certain percentage of your principal investment. That percentage is usually quite low, but it does mean that you’ll earn more than the amount of your original investment.

Pro #4: Variable Annuities Offer a Death Benefit

Variable annuities carry risk because they have the potential for you to actually lose money. But they also provide an extra perk: a death benefit. A death benefit is a payment that the insurance company will make to a beneficiary if you die. For a basic variable annuity, the death benefit is usually equal to the amount that you contributed to the annuity. If you get an annuity contract worth $100,000, then the death benefit payout will likely be $100,000. It does not matter how your annuity’s investments perform.

The Cons of Annuities

 #1: High Fees

Annuities can get very expensive. Any time you consider an annuity contract, you need to understand all the fees that come with it to be sure that you pick the best annuity for your personal goals and situation. Variable annuities have administrative fees, as well as mortality and expense fees. Insurance companies charge these, which often run about 1.25% of your account’s value, to cover the costs and risks of insuring your money.

Surrender charges are common for both variable and fixed annuities. A surrender charge applies when you make more withdrawals than you’re allotted. Your insurance company could limit withdrawals particularly during the early years of your contract. Surrender fees are often high and can also apply for an extended period of time.

Many annuities are sold by brokers who collect fat commissions for doing so, with some commissions as high as 10%! If you don't see a commission fee broken out for you, that doesn't mean it's not there. It may simply be baked into the annuity's operating costs, for which you're charged.

#2: Annuity Growth Might Not Match Stock Market Growth

The stock market will make gains in a good year. That could mean more money for your investments. At the same time, your investments will not grow by the same amount that the stock market grew. One reason for that difference in growth is annuity fees.

Many annuities charge annual fees. This is mostly a feature of variable annuities, and is one of the knocks against them. It's not unheard of to be paying between 2% and 3% per year. For context, managed mutual funds will often charge around 1% to 1.5% per year, while ETFs (exchange-traded funds) will often charge 0.50% or less.

#3: Getting Out of an Annuity May Be Impossible

This is a major concern relating to immediate annuities. Once you contribute the money to fund an immediate annuity, you cannot get it back or even pass it on to a beneficiary. It may be possible for you to move your money into another annuity plan, but doing so could also leave you subject to fees.

On top of the fact that you can’t get your money back, your benefits will disappear when you die. You cannot pass that money to a beneficiary, even if you have a lot of funds left when you die.

#4: They May Only be as Good as the Insurance Companies that Sell them

While annuities are often sold with the promise of guaranteed income, the insurance company may not be able to make your payments if they experience financial difficulty or go under. If you have a fixed or indexed annuity, you could lose your entire investment. If you have a variable annuity, you’ll likely get to keep your underlying investment, but you could lose any returns or optional benefits (i.e., income, withdrawal, death benefits) the annuity provides.

Bottom Line for Railroaders

Congratulations!!! You already own the best annuity out there. You have been funding it your whole railroad career. The Tier 2 part of your Railroad Retirement is a annuity, but instead of having a contract with a insurance company you have a contract with the Railroad Retirement Board (RRB). By having a annuity with the RRB, you actually have a contract with the US Government which is far better risk then any insurance company can offer.

The returns on Tier 2 annuity are substantially better then any return you could receive from a insurance company. The Tier 2 benefit will provide you with a supplemental income in retirement thereby giving you the flexibility to invest and grow your additional retirement resources, i.e. 401k, IRA, etc. Let's look at a example of a Annuity purchase. You are 65 and plan to purchase a Immediate Single Life with Cash Refund Annuity with a $100,000 premium with the expectation of receiving a monthly check of $550. While that might seem attractive remember the insurance company is paying you back with your premium payment(s) and you lose it all if you pass away early. A better alternative for you is to invest and grow that money in a portfolio of ETFs and mutual funds that meet your risk profile. The insurance company is after all investing in same asset classes that you would be investing so why pay the expense fees. Not to mention if something unfortunate does happen to you then you can pass those invested assets to your beneficiaries.

Understanding how all the different parts of your retirement funding streams work together is a key part of maximizing your railroad retirement income. If you would like assistance in understanding how to maximize your railroad retirement income as you approach or are in retirement, then please schedule a Free 30 Minute Consultation. 

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Photo by Ray Lewis

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. Highball Advisors encourages you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Highball Advisors, and all rights are reserved.