Current Pension Topics
Annuities Have Their Limits

By JOEL L. FRANK

Over a three-day period, I took two calls from readers who recently bought annuities from their banks. The lure of annuities is that they offer higher interest rates than the banks.

Mr. Frank is a fee-only Retirement Financial Planner and a retired city high school Teacher of Accounting. He can be reached by telephone at (732) 536-9472, or via e-mail at rollover@optonline.net.

The problem is that in order to get the higher-interest rate, you agree not to withdraw your money for a certain period of time, i.e., seven years.

During this period, if you do withdraw (cash in) your account, you will have to pay a Cash Surrender Charge, another name for a sales commission. It works this way, assuming a $30,000 investment: If you cash in during the first year, you owe $2,100 (7 percent of $30,000). If you cash in during the second year, you owe $1,800 (6 percent of $30,000); and if you cash in during the third year, you owe $1,500 (5 percent of $30,000). As you see, the Cash Surrender Charge is lowered by each passing year and disappears at the start of year eight. It's stunning to learn just how many people allow themselves to be talked into this crap.

Having said that, I recommend the following alternative: Buy three Bank Certificates of Deposit (CDs) each for $10,000; the first for a term of one year, the second for a term of three years, and the third for a term of five years. This is called "laddering." Please recognize that in order to get these higher CD rates, you agree not to make any withdrawal from the CD during its term of one, three or five years. If you do, the interest rate reverts back to the day-of-deposit to day-of-withdrawal rate. This is, substantially, a much-better deal than buying a typical annuity as described above.

In my view, annuities should only be used if you have substantial liquid investments outside of pre-tax investment plans like IRA, 403(b), 457(b) and 401(k). With such a financial profile, one can appropriately reduce his/her income tax on investment income (bank interest and profits) by buying an annuity, where the interest and profits is tax-deferred for as long as it remains in the annuity account. If you believe you are in this financial bracket and are contemplating the purchase of an annuity, please do not sign the contract before speaking with me.

I come across many individuals who have substantial liquid investments (bank accounts, mutual funds, etc.) and believe, because of their tight budgets, that they cannot afford to participate in the Deferred Compensation 457(b) and 401(k) Plan (DCP) offered by the City of New York. But they can afford to contribute without cutting back on their lifestyles.

Assume one contributes the maximum of $15,500 to the DCP. This translates into about an $11,000 reduction in annual take-home-pay after factoring in Federal, state and city income tax. In order to sustain their life style, they need to replace the $11,000. Where does that $11,000 come from? That's right, from their savings and investment holdings.

Ideally, long-term investment holdings should be sheltered from taxation, not subject to taxation. There is no good reason to keep $100,000 in the bank as a way of life. So please don't tell me you can't afford the DCP plan while you have substantial savings and investments that are subject to annual taxation. Please contact me if you are in this category.