Annuities are not a solution for all financial concerns.  They are products that may offer greater confidence for those worried about outliving their retirement assets.  But that confidence comes at a cost.

 

Let’s start by examining variable annuities.  A variable annuity is a financial contract that creates a long term, tax-deferred investment vehicle.  The vehicle contains an investment component and an insurance component.  They are sold only by prospectus.  Be aware that the guarantee is made by the insurance company and their ability to make good on that promise.  While many states have a public/private fund to back up insurance company guarantees in the event they become bankrupt there are typically limits as to what they will cover.  That’s why it is a good idea to choose an insurance company with a strong financial rating.    

These annuities have an underlying investment portfolio held in a tax deferred wrapper.  The returns of those investment portfolios can fluctuate such that the value of the investor’s unit could be lower than their initial investment when redeemed.

Tax deferral benefits typically require that you do not take any money out of the annuity until you are 59 ½ years old.  If you do so you may have to pay a 10% penalty on any money withdrawn.  When you do take income from the annuity it is taxed at ordinary income rates.   

Variable annuities typically have expenses, known as Mortality and Expense or M&E, along with management costs of the underlying funds that, when combined, can range between 2 to 3 percent annually.  Additionally, many insurance companies allow investors to choose “riders” or optional features that carry their own expense. 

Most variable annuities have a death benefit.  This benefit varies by product and by whether or not additional riders have been purchased.  An investor should be wary of any annuity that does not offer at a minimum a death benefit of the amount invested minus any withdrawals.  Some products will allow an investor to purchase a rider that can offer greater death benefits.  These riders do have an additional cost associated with them. 

Variable annuities may be appropriate for investors who are seeking some guaranteed income, but still want to be able to participate in the growth that potentially comes from securities investments.  Most variable annuities will allow investors to choose from several different investment options.  The value of the portfolio will fluctuate and the amount of income paid out is typically a percentage of the current portfolio value.

One of the biggest considerations when deciding on a variable annuity are the costs associated with the investment.  As I described earlier, there are many expenses associated with both fixed and variable annuities.  Variable annuities also charge the expense ratios of the underlying investments.  All of these expenses can reduce the portfolio’s performance.  The reduced performance can potentially offset the tax deferral benefits of the annuity.  Therefore, variable annuities should be considered as a long term investment. 

Fixed annuities might be considered more straightforward than variables.  The insurer agrees to pay an interest rate that is typically fixed for a certain period and thereafter will vary according to market rates.  The rates that a fixed annuity may offer are typically better than prevailing rates for CDs held to maturity and money market accounts.  The principal also grows tax-deferred as long as it is left in the annuity.  However the principal is not FDIC insured as many bank CDs are.

The major drawback of both fixed and variable annuities are the surrender charges that essentially lock up your principal for a set period of time.  This period can vary, but usually runs between 5 to 10 years.  If you withdraw your money before this period expires you will pay a penalty to the insurance company.  It’s why I recommend that a client never put the majority of their investable assets into one of these products.

Another criticism of annuities is that the income that is distributed is taxed at ordinary income tax rates.  If you instead chose to buy a mutual fund and held it for over a year your taxation would be at long term capital gains rates.  This is another reason that annuities may be most beneficial when held for the long term.

Possibly the biggest attraction to annuities are the flexibility of the distribution options.  Some investors choose to receive their payout in a lump sum after years of contributing and enjoying tax-deferred growth of the assets, some choose a systematic payout that will stretch the payments over a specified time frame.  Others choose the lifetime income option which will pay out income even if the account balance reaches zero.  The last option is the most expensive, but can provide greater confidence to those who worry about running out of money during their lifetime.

As with any investment there are pros and cons to annuities.  Make sure you understand the appropriateness of annuities for your portfolio.   

 

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