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Interview: Ken Little

Create Income for Life with Annuities and Other Investments

Ken Little

Ken Little is the author of twelve books on investing and personal finance, including Teach Yourself Investing and The Idiot's Guide to Investing. He is the writer and editor of the Stocks web site on About.com, where he writes articles for beginning and intermediate investors. This is an edited transcript of an interview conducted on September 6, 2007.

"The average American family is carrying something like $8,000 in credit card debt. If a young family came to me and said "We've got $8,000 credit card debt, we want to invest in mutual funds," I'd say they were nuts. They should take every penny they earn and pay off that $8,000."

What is the best way to prepare for financial security in retirement?

Begin with a savings plan. Ideally that would start with your first job as a young person. We don't always do what our parents tell us is the best thing to do, but the first step is a savings plan and if you work for a company that has a savings plan like a 401(k), sign up and contribute as much as you can. If you work for a company that doesn't have a 401(k) plan or you are self-employed, get a savings plan started, an IRA, or a typical savings plan. The important thing is to get into the savings habit. Pay yourself first is the old cliché, but it is important and it is correct.

What specific steps should a young person take as they begin to save?

The first thing you are going to do is build up an emergency cash fund so that you have enough cash on hand to take care of an emergency that should come up. For instance, you lose your job, have a medical problem, etc. Three to six months of cash on hand to cover your living expenses. That money should be in a money market fund, a CD, bank account or something that you can get to. Then, you can start working on building an investment account. I would recommend people start off with a simple account such as a stock index fund that they can contribute to on a monthly basis. As they get more knowledgeable about investing in the stock market, there are plenty of resources on the Internet. Then they can start investing in individual stocks. If they feel they need a stockbroker, they can find those. But start off slow and do it on a regular contribution basis.

Assuming you have enough cash on hand to cover your emegencies and your everyday needs and you have some investible cash, you can open an account with a stock mutual fund. They will set you up so that your checking account can be debited every month for $25, $50 or $100 a month to go into that account, and that is one of the better ways for someone to invest in a mutual fund. You are buying shares in the mutual fund on a regular basis, so that when the fund is high, you are buying fewer shares, and when it is low, you are buying more shares. The concept is called dollar cost averaging, and it is one of the best ways for the average investor to get going.

Is investing in the market risky?

Investing always carries a certain amount of risk. People need to be aware of that. When you invest, say, in an index fund which matches one of the standard stock indexes like the S & P 500, you are betting that the market is going to do what it has historically done, which is – depending upon how you want to measure the results – 10-12% return over a long period of time. It has taken some bad falls in the past, but over a long period of time, the average says you are going to do okay.

What savings advice would you offer people when they use credit cards?

The average American family is carrying something like $8,000 in credit card debt. If a young family came to me and said "We've got $8,000 credit card debt, we want to invest in mutual funds," I'd say they were nuts. They should take every penny they earn and pay off that $8,000 credit card debt first, because there is no way you are going to earn 18% with any reliability in the stock market or any place else, and that is what you are paying on your credit card debt. Use your credit cards for what they were designed for – make a purchase and pay it off this month. If you don't, you are killing yourself with interest. If you are financing your pizza dinner on Friday night and you are putting it on your credit card and paying the minimum balance, that $25 pizza is going to end up costing you $40. If you have to take an odd job on the weekends to pay off your credit card debt, do it and pay it off.

How do annuities figure into the retirement strategy?

An annuity is a contract between you and a life insurance company where you give the life insurance company a sum of money and the life insurance company agrees at some point in time to turn that lump sum of money into an income stream that you design. Over the last 10-15 years they have just exploded on the financial services scene.

Who should consider an annuity?

If you have not maxed out your 401(k), do that first. If you have already done that or if you don't have access to that or another qualified retirement plan, you should ask yourself what your time frame is between now and retirement. If you are 65 years old, you don't want anything that is deferred, you want to have immediate access to your money. You don't want anything locked up for 5 or 10 years by high fees or high surrender charges. So you're going to be looking for a product that has low fees in a contract that won't tie you up so that you can't get your money immediately.

What types of annuities exist?

There are three types. First, there is a fixed annuity, which is probably the simplest and the most common form of annuity which you will find in a lot of retirement 401(k) and 403(b) programs. It is simply a contract that says the lump sum of money you gave the life insurance company will be converted into an income stream back to you for either the rest of your life or for a period of years that you designate. A fixed annuity is a good retirement tool for a lot of people who have maxed out their 401(k) or do not have access to a 401(k) because when you invest money into a fixed annuity (or any annuity), your funds grow tax-deferred. One of the big benefits, unlike an IRA or 401(k), is that there is no limit to the amount of money you can put in a fixed annuity.

The second type of annuity is called an equity indexed annuity. The value of your annuity is tied to one of the stock indexes like the S & P 500. So with a fixed annuity, the insurance company is going to say they will pay you a fixed rate of interest so you will know what the value of your annuity is. With the equity indexed annuity, the value of your annuity is tied to what the stock index does. It could go up, it could go down, you don't know. Until you get to that point where you are ready to terminate the annuity and convert it into an income stream, you don't really know the exact value of your annuity is.

The third annuity is a variable annuity, and they have exploded on the financial services scene in the last 20 years. This is essential a fixed annuity wrapped around a group of what the life insurance industry calls sub-accounts, which are really mutual funds. If you bought a variable annuity, you would invest a sum of money and then allocate parts of that money into the sub-accounts. There are other features you can add, such as the benefits that will allow you to convert some of your annuity if you go into a nursing home. But the thing that you have to remember is that every time you add a benefit or feature, it costs you money and that comes off your return. You just have to be very careful.

What fees are associated with buying annuities?

Annuity fees are defined, but you probably have to ask your financial professional about them. The fees are there and you need to know what they are. That is another distinguishing difference between life insurance companies. One company may have a fee structure that is significantly different from another company with the exact same product, and that can make a big difference in what you'll actually return out of an annuity, so you need to shop.

How is the owner of an annuity taxed when they withdraw?

When money is distributed out of an annuity, the earnings that you have accumulated in the annuity are taxed as ordinary income as opposed to money coming out of a mutual fund, which might be taxed as capital gains or dividends. This is a down side for some people because that ordinary income tax could be as much as 35%. As you get a monthly payment from your annuity, a portion of that payment is your principle and a portion is your earnings, and when you get your payment they will actually figure that out for you so that you will know how much is income and how much is your actual principal. If you are in a high income tax bracket, 35% on your earnings is a pretty big hit as opposed to 15% for capital gains distribution out of a mutual fund, so that is one of the things that people need to weigh when they think about an annuity.

What's the best place to buy an annuity?

Annuities, especially fixed annuities, are considered conservative and safe investments. But they are not federally insured like a CD or a bank account, for instance. They are only as good as the insurance company that backs them up. I would recommend that people stay with companies that are top rated by one of the premiere rating companies in the insurance industry such as A. M. Best Company. Every insurance company of any quality has a website and their rating by A.M. Best, Moodys and Standard & Poor are always listed on their websites.

I'd also stick with names you've heard of, remembering too that if you have never heard of a company, they may still be okay. Not all insurance companies are household names and it doesn't mean they are not good. Probably the most important contact you have is with the sales person directly. There are lots of people out there who will sell you this product that are honest and will do a good job for you.

Your next book is Complete Idiot's Guide to Socially Responsible Investing. Can you give an example?

Colleges and universities have done a bang-up job, as have a number of charities, offering annuities that are tied to their endowment funds. This is a win/win situation in most cases and has become big business for colleges, churches, charities and the like.

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