With the Dow down and the market still experiencing volatility, some investment firms and insurance companies have become strong advocates of annuities as a guaranteed income source for retirement. While annuities can play a role in certain investor portfolios, in general, they are expensive and their benefits, limited.
Recent articles appearing in The New York Times and The Wall Street Journal echo the point that annuities—both fixed and variable—are being marketed to a vulnerable investor population, which might have an incomplete understanding of annuities’ complexity and risks.
Below is a brief primer:
• Annuities are products, sold by insurance companies that typically provide a stream of future income in return for an up-front cash outlay. An annuity can provide you with a flow of income that you cannot outlive, provided the insurance company remains solvent. A fixed annuity offers a fixed rate of income for certain periods, while variable annuities allow you to allocate your money among a variety of investments. Several payout options are usually available.
• Although fixed annuities promise a steady income stream for life, you are actually paying a hefty opportunity cost for the privilege. By locking up a sizable sum of your money until the day you die, you are restricting your ability to use those funds to participate in any future stock market rally or other attractive investment. Your fixed annuity will yield the same payment to you over the years which will erode your future purchasing power, thanks to inflation.
• If your primary objective is investment-related, an annuity is rarely a good alternative to investing directly. Variable annuities, which allow you to allocate your money among a variety of mutual fund investments, are marketed as investment vehicles. As with any investment choice, you should compare projected investment performance, factoring in the fees being charged. Another issue to consider is that at some point, either when you die, your spouse dies or a certain period lapses, your annuity payments cease (as long as your minimum guaranteed principal is returned). Thus, you may not get back your original investment, whereas, by investing directly, outside of an annuity, any remaining balance passes to your heirs.
• There are many fees and complex riders associated with annuities. Although the dollar amount of each fee may seem small, the cumulative effect can be substantial. Most annuity contracts assess a surrender charge against withdrawals from the contract for a period of years after the annuity is purchased. A typical surrender charge starts at 7% and declines each year until it disappears. There are also built-in insurance expenses, maintenance fees, charges for special riders, and fund operating expenses. Some variable annuities levy an overall administrative fee and several states impose a premium tax.
• Since an annuity is funded with after-tax dollars, you should first consider maximizing your pretax or tax-free retirement savings, such as 401(k)s, tax-deductible IRAs or a Roth IRA. And is it a good idea to put an annuity into your IRA? No. The IRA is already a tax-deferred vehicle, so why pay the extra costs of an annuity when its tax-deferral benefits would go to waste inside an IRA?
If you are thinking about an annuity, read the fine print carefully. Annuities can be complex with multiple riders (whose benefits are often difficult to obtain) and layers of fees. If you have a low tolerance for risk and you need a guaranteed steady stream of income, the benefits of an annuity might outweigh the additional costs for you. But buyer beware. Annuities should be compared carefully to more cost-effective alternatives. Corporate and municipal bonds as well as certain equities generally offer higher yields and carry less restrictions and fees than an annuity. Your financial advisor can provide counsel.
Robert J. DiQuollo, CFP®, CPA, is chief executive officer and senior financial advisor at Brinton Eaton (www.brintoneaton.com) a wealth advisory firm in Madison, N.J. He can be reached at [email protected].
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