Annuities Revisited-Part I

“Annuities Revisited- Part I”



From time to time, a client will ask me to look at a proposal related to the purchase of an annuity.  This is a product that is rarely sought out by investors but instead is bought after someone has “pitched” the product. Rarely do I recommend an annuity for a number of reasons:


  • Annuity products tend to have high internal and ongoing fees and expenses and many entail large up-front commissions as well.
  • Many of the annuities sold are variable annuities, which allow you to invest in a variety of both stock and bond mutual funds.  When you do this, you will ultimately convert what might very well have been long-term capital gains (taxed at a maximum federal rate of 15%) into ordinary income (taxed at a maximum federal rate of 35%).
  • Some annuities are sold in IRA accounts which means you have placed a sheltered investment (your IRA) inside another sheltered investment (the annuity) resulting in an unnecessary layer of fees.


Having said this, there are still hundreds of millions of dollars of annuities sold each year so they are impossible to ignore.  Insurance companies offer an array of enticing options with their annuity offerings so over the next two weeks I’ll discuss a few of the more popular options and offer some cautionary advice.


Fixed versus Variable Annuities.  As I have already mentioned, a variable annuity allows you to choose among a variety of mutual fund options which typically include money market funds, bond funds, stock funds and blended funds.  With a fixed annuity, you will receive a guaranteed interest rate for a period of time which may be one year or a number of years.  Beware: Many companies offer an initial ‘teaser’ interest rate.  This teaser is an attractive rate compared to current interest rates and is typically guaranteed for three to five years.  However, after the teaser rate ends, the new rate may not be competitive but you are unable to switch to a different, more competitive company because of stiff surrender charges.


Guaranteed Retirement Income Benefit.   Typically the insurance company guarantees that at the time you convert your annuity into a lifetime income (called annuitization), the income will be based on the higher of the account value at time of annuitization, net premiums accumulated at a pre-determined rate of return or the highest value on any contract anniversary.  The sales pitch says that no matter what happens to your returns, your retirement income will at least be based on premiums paid in plus a reasonable return (typically 6% per year).  Before this rider becomes effective, you typically must keep the policy in-force for a minimum of 10 years.  Beware: The insurance company may include language that alters the retirement income payments under this benefit.  In other words, how your payout is calculated under this benefit may result in lower lifetime payments than an actual account value of the same size.


Next week, I’ll continue this discussion on annuities.