What Powerball can teach us about annuities

by @PaulFiarkoski

Dream with me for a minute. Imagine that you woke up this morning and realized that the quick pick numbers on the Powerball ticket you bought at the convenient store the other day matched all six balls in last night’s drawing.

Lump sum or annuity?
Among the many important decisions you’ll have to make is weather you want a lump sum or series of payments over twenty years. If you were to choose the series of payments, you’re opting for what we call in the financial planning world an annuity.

Powerball ticket
Suppose you win the Powerball lottery. You’ll need to decide whether you want the jackpot as a lump sum or series of payments – or an annuity.

Now you know what an annuity is in it’s simplest form. Unfortunately, the insurance industry has added so many bells and whistles to annuity products that they’re far from simple.

When I used to teach my financial consultant trainees about annuities, I always found it helped them understand the concept better if we put them into categories. Most annuity products can be categorized as either a fixed annuity or variable annuity and again as immediate or deferred.

Fixed or variable
A fixed annuity means that it accrues interest at a minimum guaranteed rate. The interest paid is generated by underlying investments in bonds or other securities that pay interest and the eventual return of principal. Since annuities are also insurance products, fixed annuities are typically guaranteed to pay a minimum rate plus additional earnings (or dividends) on top of the guaranteed amount.

On the other hand, a variable annuity offers no guaranteed rate. Instead, the return generated by a variable annuity depends on the performance of underlying investments – usually publicly traded stocks and other non-interest bearing securities. Variable annuities can even lose principal in the event of a drop in the stock market.

Immediate or deferred
Most annuities can also be classified as either immediate or deferred, a reference to when the payments (to you) begin. As the name implies, an immediate annuity will begin payments right away. That could be in a month, a quarter or even a year from the contract date, depending on when you request your first payment. Deferred annuities often don’t begin to pay out for several years. During that time, you can typically increase the size of the annuity principal by contributing more premiums to it.

To summarize, you could have a fixed annuity that’s immediate or deferred. Likewise, a variable annuity can be either immediate or deferred.

The connection to Powerball
Okay, so how does this lesson about annuities tie in with Powerball? Remember, if you ever win the Powerball lottery one of the most important decisions you’ll have to make is whether you want to receive your winnings as a lump sum or annuity – a series of payments.

You don’t need me to tell you that your chances of getting hit by lightning in this life are better than matching all six Powerball numbers. However, anyone can purchase an annuity contract. If you have a sizable lump sum from insurance proceeds, the sale of property or a business or what have you, you can convert that money into a series of payments with an immediate annuity. In many cases you can even roll all, or a portion of, your retirement account into an annuity. (Be sure to educate yourself on potential tax consequences if you consider this move.)

Suppose you don’t have a large sum of money. You can purchase a deferred annuity with a smaller sum of money and add to it over the years to build up your own annuity “jackpot.”

6 financial resolutions you can live with

by @PaulFiarkoski

Here we are in a new year again. If you are a resolution maker and want to do a better job at managing your finances, consider one or more of the resolutions below.

1. Make a budget (or spending plan)
Budget – it’s a scary word, I know. Almost as bad as the word “diet.” If you don’t like the word budget, try calling it a spending plan. Whatever you call it, without putting more thought into what you spend, you are more likely to spend money recklessly.

Keep it simple. You don’t need any fancy software or apps; a simple spreadsheet is what I use. Plot out what income you expect to receive on a monthly basis and how much you expect to spend.

I have found that predicting expenses is a lot easier if you download transaction history from your bank or credit union for recent months or the same month a year ago. Although it takes a little more work, I like to plot out every day of the month so I can project how my account balance will likely change from day to day. This is a good way to help prevent unnecessary transfer and overdraft fees.

2. Spend less
Sounds painful, but this is actually the one of the easiest things to do. A simple way to find ways to save is to look at your bank statements. What always stands out to me are purchases like coffee or fast food places. You don’t need to give them up completely, but you can cut back on the number of times you go there or on what you buy. Try this: small-size rather than super-size. Or bring your lunch to work one more day per week. Taking these little steps can add up to big savings.

poll results top financial new year's resolutions
Top financial resolutions people make according to creditcards.com.

3. Pay down debt
This one is a real challenge and offers perhaps the greatest feeling of satisfaction. My wife and I paid off three loans that had been weighing us down in 2012 and we aim to get rid of our last two in 2013. Take if from me, there is no better feeling than calling to ask for the payoff amount for a loan then telling the service rep, “Thank you – now help me make my final payment and close this account for good.”

Opinions differ among experts as to which debts should be paid down first. We’ve been following the debt snowball method made famous by Dave Ramsey. You pay off your smallest loan first by getting aggressive with extra payments. As soon as that debt is gone, add the minimum payment that you would have been paying on that loan to the payment you’re required to make on your next biggest loan until it’s paid off. Repeat that sequence until your debts are paid off.

With interest rates as low as they are currently, now is also a good time to see if you can renegotiate lower rates with your lenders. Be careful about consolidating debt. By bundling all your debt into one large loan, it’s possible to become overwhelmed and feel like you’re getting nowhere.

4. Save more
Don’t confuse this with spending less. What I mean by saving more is actually putting money away for you to use later on. The best way to get and stay motivated on this goal is to think of it as paying yourself. Ideally, you should be the one you pay first always. Anyone just starting out in the working world should make this a high priority. However, it can be really tough to do if you haven’t gotten serious about spending less or paying off some debt.

5. Get in touch with your investments
When friends or family members ask me for advice with their investments, I’m always amazed to find out how little they know about what they currently have. How much do you have? Where is your money invested? What sort of return are you getting? If you can’t answer those basic questions, getting answers should be a high priority.

Once you have a better idea of what you have and how it’s invested, do some digging to find out if it’s appropriate for your goals. Learn about investing in stocks, bonds and mutual funds and get intentional about how your money is invested. You can only work so many hours per week to earn money for yourself. If you’re investing wisely, your portfolio can become like a silent partner for you – earning money for you even on your day off. Trust me, if you ever plan to retire you cannot grow your investment portfolio too large.

Don’t have investments? Make it a goal. It’s easier than ever to invest your money and have it go to work for you. The most convenient way to get started investing is with your retirement plan at work. If you don’t have access to one, look into setting up an IRA (individual retirement account) or mutual fund account.

6. Educate yourself
Learning more about what you currently have is an important step, but don’t stop there. Learn about the stock market and what impact the decisions made by the numbskulls in Washington have on the market. Find a few blogs or websites to follow, starting with mine. I learned a lot about financial matters in college and my formal training but the real valuable lessons I learned by reaching, watching and doing. Expanding your knowledge about finances is a responsibility you owe to yourself.

Some resources to get you started: