Understanding Retirement Annuities: How Dramatic Changes

Affecting TIAA-CREF Members can increase retirement income 20-100+%

by Harold Wong PhD Note: This article is the second of a series to be published in The Advocate (published by the AZ chapter of the American Association of University Professors). The series will focus on how to increase AZ faculty/staff assets before retirement and how to increase income after retirement. Key research findings by faculty across America will be reported.

In Arizona, all faculty and staff, whether Kindergarten - 12th grade, community college, or the three universities (U. of A, ASU, or NAU), must belong to the AZ State Retirement System (ASRS). This is a defined benefit plan where the employee has little investment input. His retirement benefits are determined by a formula: (number of years of credited service) x (2%) x (average monthly compensation before retirement). In 1974, the Legislature established an Optional Retirement System (ORP) for faculty & administrative staff of the three universities. This is a defined contribution retirement program (where the employee's future benefits do depend on his investment decisions and amount contributed. Of the four companies authorized by the AZ legislature, 85% have selected Teachers Insurance and Annuity Association - College Retirement Equities Fund (TIAA-CREF).

This article will focus on those who have chosen TIAA-CREF although the conclusions would hold for those in the other 3 companies or those who have money in any other Tax-Sheltered Annuity.

Whether you chose the ASRS or the ORP, understand that:

1. This is an irrevocable choice.

2. You are still allowed to contribute extra money to a Section 403(b) Tax-Sheltered Annuity. This contribution is deducted from your salary as a pre-tax contribution to fund extra retirement benefits but is not matched by the employer.

3. Legal and policy restrictions effectively force you to take your retirement benefits as an annuity (stream of income from date of retirement) instead of a lump-sum pile of cash. Example: If you withdrew your employee contributions from the ASRS at retirement, you would forfeit the state's matching funds. This provision is so punitive that no one would choose this option.

The concept of a retirement annuity is simply stated. An insurance company takes your retirement contributions and in return contracts to give you a formula-derived amount of money (usually paid monthly) from the date of retirement until the day you die. The insurance company actuaries estimate the life expectancy of your group (college faculty & staff) and how much they expect to earn on your money when they invest it. After deducting expenses, the insurance company pays out the rest to the policy holders. There are several key issues to consider with annuities:

1. What kind of annuity do you want, fixed or variable?

TIAA invests primarily in long-term (30 years is typical) bonds and mortgages and the goal is to pay a relatively stable fixed rate of interest. Hence the name fixed annuity. But the 1970s and early 1980s showed how inflation could devastate those on a fixed retirement income. CREF was created by TIAA to start an annuity program that was based on stocks that might grow at least with the rate of inflation and beat the return from fixed-income financial instruments. Hence the name variable annuity.

2. How long do you expect to live?

Purchasing an annuity is essentially an irreversible decision. If you die one month after retiring and you have chosen the typical lifetime with no refund (payments for your life only) annuity, your spouse and kids get no further income. They could be destitute even if your combined employer and employee contributions to your retirement fund totaled $ 1 million.

Purchasing an annuity is the opposite of purchasing life insurance. If you die after paying one month premium of your life insurance policy, your beneficiaries (typically spouse and kids) would receive a large lump sum. The insurance company hopes you live a long time and pay many premiums. That's why the life insurance company typically insists that you submit to a medical exam and provide your medical records. With an annuity, since the insurance company is paying you, it hopes that you do not live as long as the actuarial tables indicate.

If the life insurance company wants you to have a medical exam when you want life insurance, you should have one before you decide to buy an annuity. Your medical condition and family longevity would greatly influence your decision. However, most of the tax-sheltered annuity insurance companies do not allow you a choice of life insurance instead of annuities with your retirement contributions.

3. Do you want a guaranteed period of payment?

For example, a Life Annuity-Ten Years Certain pays the employee or his beneficiary the same monthly payments for 120 months. If the employee died after 1 month, his beneficiary would receive the remaining 119 payments. However, the trade- off is a lower monthly payment than the Life Annuity-No Refund option. And, if you or your beneficiary live longer than 120 months, it's tough that your retirement income stops.

4. Do you want your annuity to cover the life of more than one person?

The Retirement Equity Act of 1984 forces a married couple to take a joint & survivor option (after employee dies, payment continues to surviving spouse, although typically at a much lower level) rather than single life annuity, unless the spouse signs a document indicating understanding of the implications.1 As professor Willard F. Enteman wrote in his book (Retirement 101: How TIAA-CREF Members Should Deal with the Dramatic Changes in their Pensions), "It may seem that a spouse would always be foolish to sign such a document, but that does not necessarily follow. In some cases, it may be advantageous for the annuitant to take the single-life annuity rather than a two-life annuity and use the difference to fund a term life insurance policy owned by the spouse on the life of the annuitant. If the annuitant spouse dies first, the annuitant simply stops paying the premiums on the life insurance and saves that expense. If the annuitant dies first, the annuity will stop, but the surviving spouse will then have the money from the life insurance policy... Nevertheless, it does underline, once again, the importance of planning ahead for retirement. If a couple chooses the single annuity and term life insurance, the prospective annuitant should look into life insurance early in order to be sure illness does not cause uninsurability or a stepped-up premium".2

The Revolution in Retirement Planning

Until fairly recently, there was no way to fully reconcile the dilemmas discussed within the previous four key annuity issues. But IRS Revenue Rulings 90-24 and 66-143 allow a solution to these dilemmas.

"It would be hard to exaggerate the impact of recent changes in retirement provisions for faculty members and other academic staff who have been covered by the Teachers Insurance Annuity Association and the College Retirement Equities fund (TIAA-CREF). Without much preparation or warning, our retirement world has been turned upside down. Earlier assumptions need to be reexamined and reevaluated; what was once a subject to which we reasonably devoted only passing attention has become one that requires significantly greater attention. Where there was little discretion previously, there is now a very large range of choices. What was once an area largely beyond our control and managed by other people for us has become, as of March, 1990, one in which we must take responsibility for a wide range of decisions which may affect our future substantially. One major change is known as transferability, which means that participants now have an opportunity to transfer their accumulated savings into investments which are not supervised by TIAA-CREF.3

How to Increase Retirement Annuity Income by 100% !

A number of faculty and colleges have been disappointed by both the investment results and long-time refusal to accept the suggestion of the Commission on College Retirement that funds be transferable from TIAA and CREF to approved third-party investment managers and approved third-party providers of annuities.4 They criticize TIAA-CREF as having a virtual monopoly on the Tax- Sheltered Annuity market.

IRS Revenue Ruling 90-24 adds the ability to do partial tax- free transfers with your Section 403(b) Tax-Sheltered Annuity retirement funds. You can now diversify your 403(b) funds simply by moving the desired portion, leaving the balance intact without disturbing ongoing contributions. Regulations force recalcitrant carriers (such as TIAA-CREF) to provide a direct rollover option. "As long as there is an eligible distribution from the 403(b) values, carriers must issue checks directly to a new investment option if the participant so directs".5

With this new transferability of your 403(b) funds, it is easier to solve the dilemma of picking a fixed versus variable annuity. The well-known Ibbotson study at the U. of Chicago calculates the annual rate of return (since 1926) of stocks to be 10.3% versus 5.0% for bonds.6 If one felt comfortable with the risk characteristics of stocks, your long-term expected rate of return would be double for a variable annuity (invested in stocks) than a fixed annuity (invested in bonds).

How to Increase Retirement Annuity Income by 20-30% !

Revenue Rulings 90-24 and 66-143 allow a solution to the dilemmas discussed in the last 3 key annuity issues (How long do you expect to live?; Do you want a guaranteed period of payment?; and Do you want your annuity to cover the life of more than one person?).

One can choose the maximum retirement system annuity option (whether one is in ASRS or the Optional Retirement System) and purchase life insurance on the employee. This gives 20% more income (using the ASRS numbers for a couple who retire at 65) than the joint and survivor-100% option.

Retirement 403(b) annuity income is 100% taxable and properly structured life insurance death proceeds are not taxable. If a couple was in the 30% tax bracket, they would enjoy 20% more gross income while the retired employee lived and the surviving spouse could enjoy 30% more after-tax income after the employee died.

Despite this obvious increase, certain couples or singles (if they wanted to provide for kids or other dependents) might not choose this solution because of temporary budget problems. But Revenue Ruling 66-143 allows you to purchase life insurance with either your previously contributed 403(b) funds or your future contributions. The amount used to pay life insurance premiums must be less than 50% of the employee's contributions in the case of whole life insurance, and less than 25% in the case of term life insurance.7

As discussed earlier, one's 403(b) retirement funds are effectively frozen and forced into a retirement annuity. By simply repositioning the funds within the 403(b) account, one typically increases retirement income 20-30% for the life of the retiree and his beneficiary. In fact, the law does not allow one to pay for the 403(b) life insurance by personal funds. You cannnot write a personal check, but you can reposition your 403(b) funds.

SUMMARY

This article has discussed how either the AZ State Retirement System or Optional Retirement System effectively force faculty & staff into retirement annuities. Four key issues of annuities and their dilemmas were discussed. Solutions to these dilemmas and the perceived unresponsiveness of TIAA-CREF are now possible because of fairly recent law changes. Retirement income can now be increased by 20 - 100% if one takes the time to plan ahead. Most faculty have spent 20+ years as students and worked 30-40+ years as professors or administrators, all at relatively low salaries. Please take the time to increase your modest retirement income.

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1. Harry E. Allan, "Recent Developments in Private Pensions", Management Review, January, 1987, p. 54-55.

2. Willard F. Enteman, Retirement 101: How TIAA-CREF Members Should Deal with the Dramatic Changes in Their Pensions,1992, U. of Wisconsin Press, p. 98. Dr. Enteman was a professor and administrator at a number of colleges.

3. " " "

4. The Commission on College Retirement, Pension and Retirement Policies in Colleges and Universities: An Analysis and Recommendations, Jossey-Bass Publishers, 1990, pp. 1-106.

5. Eleanor A. Lowder, "All Grown Up: Tax-Sheltered Annuities", Life Association News, November, 1994, p. 154.

6. Ibbotson study, cited in Dennis T. Blair and Andrea T. Sellars, "Retirement Planning: More than Investment Education", Journal of the American Society of CLU & ChFC, May, 1995, p. 69.

7. David E. Kenty and Jeffrey L. London, Tax Management: Tax- Deferred Annuities - Section 403(b), Portfolio 388-4th, 12/13/93, p. A-5.

Harold Wong received his PhD in economics at UC Berkeley where he conducted various research studies on economic success. He taught at the U. of Oregon, passed the national CPA exam, and was contributing editor to a legal publication. He has published many articles and appeared on over 300 TV and radios shows, discussing economic, tax, and financial issues. Through his consulting business, he has tested his research in the real world and helped hundreds of families and companies improve their finances. He's in Arizona researching various issues relating to Arizona educators' retirement plans and how to improve their economic well-being. He can be contacted at (602) 381-6655 in Phoenix for a schedule of lectures, articles, and personal consultations. He welcomes your questions and comments.