Suze Orman Gets It Wrong on Annuities and Taxes

Might a 50-year-old single woman with no children and plenty of retirement assets benefit from a stream of lifetime income at retirement? Is there a tax benefit to using a portion of her brokerage assets to buy an annuity, particularly if she is holding an allocation of bonds with yields that would otherwise be taxed annually (or in municipal bonds, as Orman recommends)?

Orman has a decent grasp of the fundamentals, but knowing when and if annuities make sense for consumers seems like a topic she should understand, especially since many of her listeners are women (who tend to live longer than men) and who obviously want to learn more about financial planning from an expert. She could benefit from reading what financial economists and financial planning experts have to say about annuities.

In a recent American College podcast with Jean Chatzky, former personal finance editor on NBC’s “Today” show and CEO of HerMoney.com, we had a candid discussion of the use of annuities by women. Chatzky recognizes that, for many of the 250,000 women who listen to her podcast each month, a simple stream of lifetime income through an annuity makes sense.

“Many of the women in my community are crystal clear: As they age, they want income that will allow them to sustain their lifestyles,” Chatzky notes. “I felt obligated to learn what financial tools would make that possible — which led me into the world of annuities.”

Annuities by the Numbers

Michelle’s question has two components: tax deferral until she retires and guaranteed income when she does retire. The simplest strategy uses a single annuity to accomplish both strategies, although the same approach works when turning a simple CD-like annuity into guaranteed income.

Let’s say that Michelle buys an income annuity that begins making payments in 15 years at the age of 65. The insurance company will estimate the growth on her $400,000 over 15 years based on the predicted return of the bond investments held within their general account portfolio. None of this growth is subject to income tax.

The firm will then estimate the amount of income that can be provided from the funds she will have accumulated by 65. An A++ rated insurer today is willing to provide Michelle with a lifetime income of $6,063 per month, or $72,756 starting at age 65 for life. Of this payment, only $4,396 is subject to income tax because a portion of each payment is considered a return of principal, a special benefit of annuitization.

The current yield on the Vanguard municipal bond ETF (VTEB) is 3.67%. If she was able to grow her savings at this yield for 15 years, she would have $686,841. Let’s assume that she’s paying a 25% average tax rate on this income in retirement. This means that her annuity is providing $59,568 of income after tax.

How long could she support an income of $59,568 with $686,841 of muni assets? About 15 years. Midway through her 80th year, the fund would be empty. According to mortality tables for annuity owners who are healthy women, this would mean that Michelle has about an 80% chance of outliving her savings by trying to match the net retirement income of an annuity.

The actual risk is even higher because the muni yield will rise and fall over time, increasing the range of ages at which Michelle will run out of money. She could run out at 75 or 85, but even at 85 she still has more than a 50% chance of outliving her muni savings.

Annuities can also be the right choice when funding spending from bonds in a qualified account, and she doesn’t need to make an irrevocable decision to secure an additional source of lifetime income.

Fixed annuities with a lifetime withdrawal benefit provide the same lifetime income guarantee and rates today from high-quality insurers are often competitive with deferred income annuities. Fixed annuities with a GLWB are also simple products that can help consumers overcome behavioral resistance to annuitization.

For example, another A+ rated insurer currently offers a fixed annuity that allows an 11.95% lifetime withdrawal benefit for a 55-year-old woman who begins income at 65.

Annuities can be particularly attractive when used as a bond substitute in a traditional individual retirement account since they provide far more income per dollar of savings than, say, a 4% withdrawal strategy, and qualified money is even less attractive as a legacy asset when beneficiaries are required to spend it down over 10 years.

How much more money could she spend? If she invested $400,000 in the fixed annuity at 55, she could withdraw $47,368 annually when she turns 65. If she had invested in bonds earning 4.2% (Blackrock projected 10-year aggregate bond return), she could withdraw $24,143 from her bonds if she followed the 4% rule.

Even if she increases spending with inflation, she would only begin spending more after 23 years at a 3% inflation rate. Creating a higher income from the bond portion of her savings also puts less pressure on the growth portion of her portfolio, giving her a more secure income without compromising equity upside.

Annuities and Tax Efficiency

How can a taxable deferred income annuity provide so much more income than municipal bonds? You guessed it — tax-deferred growth. The taxable bond portfolio held by the insurance company that is used to fund the annuity income will earn a higher yield than a muni bond portfolio.

Research suggests that the yield spread between munis and taxable bonds of equivalent risk equals the marginal tax rate of rich people. In other words, the insurer’s portfolio can earn a substantial yield spread by holding taxable bonds, allowing them to provide a more generous lifetime income to Michelle.

The second and most important advantage of annuities is the added spending that Michelle receives by transferring the risk of an unknown lifespan to an insurer. Since she doesn’t want to run out of savings in old age, she’ll spread the safe investments she plans to use to fund basic expenses to a reasonable age.

What is reasonable? If she needs a 90% probability of success, the money will need to last until age 100.

Spreading low-risk savings to an advanced age can help reduce the probability of running out but also reduces the amount she can spend each year.

Partnering to create income by allowing the insurance company to invest the bond assets and accept the longevity risk allows Michelle to spend as if she is going to live to the average longevity of a healthy female retiree — about age 89. Spreading savings to 89 instead of 100 allows her to spend about 30% more each year from the same amount of savings.

Orman’s misunderstanding of annuities becomes a problem when so many consumers rely on popular financial experts. She could benefit from reading what financial economists and financial planning experts have to say about when, and if, annuities make sense in retirement.

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Michael Finke, Ph.D., CFP, is a professor of wealth management and research fellow at the Retirement Income Institute.