Last month, I discussed variable annuities. First brought into existence by TIAA-CREF in the 1950s, they later gained popularity in the ’80s as a tax strategy. The “tax-deferred annuity” was a very popular tax shelter … when capital gains were taxed at the ordinary income tax rate.

As mentioned previously, insurance companies loved them because they could charge fees and not be responsible for the money (it was in the market). Wall Street loved them because they had captive clients (surrender charges and fees). Brokers loved them because they carried high commissions and, in some cases, were classified as assets under management and fees were charged on top.

Really, the only people they were not good for were those who they were supposed to benefit: the client.

Unfortunately, these products have continued to be marketed heavily by Wall Street and the insurance industry, for all the reasons indicated. They are still massively profitable for the industry – and still not efficient for the client. Even worse, they are marketed as “safe money,” which they are most certainly not.

However, there are annuities that do serve the client well. Unfortunately, these products have been mixed in with VAs in the public’s perception, and even though they can be effective planning tools, they are often maligned due to their similarity to VAs. Hopefully, we can dispel some of those myths here.

In addition to the variable annuity, in which the customer bears all of the risk and pays high fees, there are two other broad categories of annuities: The first is the immediate annuity (usually in the fixed category), and the second is the fixed deferred annuity.

We will discuss these in this column, and next month we’ll round out this discussion with a combination, or “hybrid,” of all three.

The immediate annuity is typically the one people think about when they hear the word “annuity.” When you think immediate annuity, think “pension.” In this arrangement, you give the insurance company your money, and the insurance company then guarantees a payout for a defined period of time.

This is a pure actuarial, or mortality play. You are betting that you are going to outlive your money and will benefit from the extended payments over the course of your lifetime, and the insurance company really doesn’t care, as it is dealing with many thousands of people.

The most difficult challenge when designing a retirement plan is the fact that, barring dread disease or other circumstances, very few people know with any accuracy how long they are going to live. This creates a dilemma we call “Long Life vs. Good Life.”

In other words, are you going to plan for a long life – thereby spending less in the short run in case you live a long time – or are you going to spend more now on lifestyle and put your future self in jeopardy? Eighty percent of people who try to do this planning themselves get it wrong. About 40 percent err on the long life side, and 40 percent on the good life. Only about 20 percent get it right.

The insurance company, however, gets it right 100 percent of the time. It doesn’t actually know how long you will live, but it does know with pinpoint accuracy the life expectancy of the group of lives it is covering. Therefore, it can provide you a guarantee of lifetime income, while at the same time providing you the ability to maximize your lifestyle.

The upside to this type of annuity for the client is significant: long-term security without sacrificing quality of life. The downside to these annuities is that in order to reap these benefits, you have to give up control of your money. A good friend of mine calls this committing “annuicide.”

Our parents, who were raised with the widespread proliferation of defined-benefits plans, didn’t mind, as their focus in retirement was on income. We, the baby boomer generation, have a completely different orientation. As products of the defined-contribution era, we have been oriented toward rate of return and the stash of money. It is very difficult for us to give up control of that stash.

Giving up control has other implications, as well. If you choose a life annuity, for example, the money will expire with you. You can mitigate this by purchasing a joint and survivor policy or a period certain, but these have drawbacks, as well.

For example, if a joint and survivor policy, what happens if the spouse predeceases the primary annuitant? He or she is stuck paying for a benefit they will never get for the rest of their lives. It’s the same with a life with period certain. Sooner or later, the period certain will expire, but the cost of the benefit will last as long as the annuity does.

There are no perfect solutions to any problem. But there are appropriate ones. And when you are dealing with retirement planning, a key issue is always going to be life expectancy. It makes sense to use a solution that is built for that. Next month, we will look at the new breed of “hybrid annuities” that can solve many of these problems.

“Free Money Guy” Stephen Kelley can be heard, along with his co-host, Mark Perkins, on the Free Money Radio Hour at 9 a.m. every Tuesday and Wednesday morning on 1590 AM WSMN in Nashua, and Sundays at noon on 980 WCAP in Lowell. In addition, Steve is heard weekly on the nationally syndicated “America Tonight” with Kate Delaney and is author of the book “Safe Harbors That Can Reduce Taxes, Remove Risk and Protect Your Retirement.” His financial planning practice, Safety First Financial Planners, is located at 33 Main St. in Nashua. He can be reached at 881-8811.

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