In order to become a great investor you have to understand how all investments work more or less – even the crappy ones like annuities.
I apologize for being so opinionated. Let’s first look at how these stink-balls work. Then you can decide yourself.
What Is An Annuity?
An annuity is a deposit with an insurance company. We’ll discuss the safety of annuities shortly but for now, please understand that they are not FDIC insured like bank deposits are.
The insurance company credits your account with interest or earnings. As long as you keep money in the contract, you defer paying tax on those earnings. The minute you take money out of the investment you’ll pay income tax (at income rates as opposed to capital gains rates) on each dollar of profit you withdraw. Simple enough. Now let’s look at the safety issue.
Are Annuities Safe?
Annuity investments are backed by the insurance company that sells you the investment. If they go belly up you still may be OK but you could also lose it all. It depends.
First, you must find out if the insurance company holds your money in their general or separate account. If they hold it in the general account and they go bankrupt, get in line. You become a general creditor of the company. Depending on what state you live in, your account could have some guarantees set up by the guarantee fund of your state. But let’s face it. A guarantee today isn’t the same as it was several years ago. Sorry…that’s just the way it is. But there is some good news.
If your money is held in a separate account, your assets are protected from the claims of the other insurance company’s creditors. This is a much better position to be in.
So the most important action step for you is to find out which account your money is held in and how the state guarantee fund works if there is one. And do this before you buy the annuity please.
Now, if you have “annuitized” your annuity — selected a stream of payments for some period of time — the same holds true except you don’t have the guarantee fund backing you up. Just wanted that you it from me first.
The bottom line is that there are risks to annuities just as there are with any investment. None-the-less, you can still protect yourself. Here’s how:
1. If you have an annuity, make sure the company is as safe as possible. Call the company and ask for a ratings report in writing or go to their website to learn more. If need be, move your money to a safer company and one that will keep your money in a separate account.
2. If you have already annuitized your annuity, you don’t have to do anything because you can’t. Once you’ve made the decision to annuitize, you can’t do anything about it so it makes no sense to worry.
3. If you don’t have any annuities — don’t buy any.
I’ve never liked annuities because I’ve rarely seen them work for clients. Of course this isn’t always the case… it’s just my experience. In very unique circumstances, they could be a smart investment but in most cases I wouldn’t count on it.
What I’ve described above is true for most types of annuities. Now lets dig a little deeper into the minutia.
Fixed annuities earn a flat interest rate. That rate could be honored for years or it could change every year. It depends on the contract. Variable annuities (described below) invest in mutual funds. You can’t know how much you are going to earn up front. There is a third type of annuity, known as indexed annuities. These are really a form of fixed annuities. But your account values rise as market indexes go up – like the S&P 500.
Your account is credited with a portion of the increase of the index. So, for example, if your indexed annuity is tied 60% to the S&P 500 Index and that index rises 10% for the year, your account will be credited with a 6% increase. Capiche?
Now, the reason that people scoop up these annuities is that they have downside protection. So if the S&P 500 declines this year by 10%, your account value won’t decrease a dime in most cases. That’s why people are willing to only accept a percentage of the increase – because they are protected against the downsides depending on your contract.
Sounds sweet…right? Well, it’s not so simple. In fact, indexed annuities stink to high heaven. Here’s why:
Once you buy an indexed annuity, you usually say goodbye to your capital for a very long time. That’s because, in many cases, you’ll pay astronomical penalties if you want your principal back before an extended time frame. In one case described by Investment News, an 82-year-old woman was bamboozled into investing $1,000,000 into indexed annuities. It cost her $150,000 a few years later to get out of them.
The crediting calculations can be very complex – something the slick salespeople rarely disclose fully. So you’ll rarely get all the interest you think you might have coming. My experience is that in generally rising markets, you’ll give up a great deal of the return due to these complex index calculations. And in a declining market, you’ll probably make out with close to nothing. True you won’t lose, but you may have done better in fixed alternatives in those cases.
Kent Smetters, a professor at the Wharton School and former official at the Treasury agrees. He says, “They’re [index annuities] terrible ideas for older people even though they’re peddled to them.”
3. High Commissions
I get offers all the time to sell this junk. Companies are happy to pay me 12% or more to peddle it. If they’re so willing to pay me so much, where do you think that commission comes from? You better believe it’s coming right out of your return. That’s why those returns are so stinky.
Sales of these indexed annuities are through the roof because people just love the idea of downside protection and upside potential, but it very well could be all smoke and mirrors.
4. Other Problems
I generally like insurance companies (when they stick to selling good life insurance like term). But they stick it to you when you buy indexed annuities from them. The insurance companies take your money and buy stocks, bonds and derivatives, but they don’t credit your account with the dividends these investments make. That’s like paying full price for a car but only getting to use the front two wheels.
Remember, index annuities are very long term investments. That being the case, you can buy a good portfolio of stocks and bonds through ETFs and funds and keep all the return. Over a very long time frame, the risk could even out and you could potentially be far ahead.
According to William Reichenstein, professor of investments at Baylor University (per the Investment News article), indexed annuities perform worse than laddered CDs. And the laddered CDs provide more protection, much better insurance, less risk and more liquidity.
Remember, with the Mount Everest-sized commissions they pay the people who sell these things, insurance companies have to make up that money over time. That’s why they pay investors so little and keep the money locked up for many, many years.
A variable annuity is a deposit with an insurance company like a regular annuity. The big difference is that you decide how to invest the money and you have many choices (including growth mutual funds).
Each company has a set menu of funds to choose from – and you can only invest in the funds the company offers. Some funds pay interest, others try to provide growth and still others own stocks that pay dividends and will hopefully grow.
Why does everyone want to sell you a variable annuity?
Sales people make huge commissions when they do. I know… I used to sell them. (When I started my career selling investments in a bank, my manager told me to sell more annuities. I didn’t like selling these contraptions so I asked him why he wanted me to do so. He told me that it would help increase my income. It had nothing to do with taking care of the clients. Shortly after that conversation, I quit.)
Commissions range from 6% to 10%. That means if you invest $100,000, the person who sold you the annuity pockets at least $6,000. Guess who pays that $6,000? That’s right… you do. And the commission conversation leads us to……
Why Variable Annuities Stink
Fees and penalties. The funds inside the annuity have annual costs (usually about 1.5%) and the insurance company has annual administrative costs (usually another 1.5%). There can be a host of additional costs too, but let’s just say that variable annuities charge you at least double what an expensive mutual fund would. Keep in mind that you pay those charges every year.
Of course, if you are lucky enough to make a profit and withdraw it, make sure you do so after you reach age 59 1/2. If you withdraw profits before reaching that age, you’ll get whacked by the IRS with a 10% penalty. No matter when you take the money out, you’ll pay income tax on your profits.
On top of Uncle Sam’s penalties, you have to worry about the insurance company’s too. They usually penalize you if you don’t hold on to the investment for a fixed number of years. This varies with the contract you sign. I’ve seen some companies charge as much as a 20% penalty if you close the account within 15 years. YIKERS!!!!!
Also, keep in mind that mutual fund growth outside of an annuity can be taxed at the lower capital gains rates. Within the variable annuity those same gains are taxed at higher rates because they considered income when you withdraw the money. WHAHHHHH…..
And consider your beneficiaries. If you own mutual funds and die, your beneficiaries may avoid paying any taxes on gains. Under current law, they do this through what is known as a “step-up” in basis. But if you own those same funds in variable annuities, they can’t take advantage of the “step-up” provision. Bummer.
Is there anything good about a variable annuity?
Folks are sometimes attracted to these investments because of the guarantees that are offered. Often, insurance companies tell investors they guarantee their investment and that the investor can never take out less than they invested. The only problem with these guarantees is that the investor usually has to die in order to get that guarantee. Oh… and by the way… if your contract offers this guarantee you usually have to pay an additional 1.35% every year on top of the fees we’ve already discussed.
There are other fancy-pants bells and whistles. The insurance industry is always coming up with new ways to sell you something. But if there was ever an example of “putting lipstick on a pig,” this is it. That’s why I can’t see many reasons for anyone to ever buy a variable annuity.
What you should do if you already own one of these lemons:
1. Determine costs to get out
The best option might be to get out of variable annuities completely but you have to do your homework and understand the numbers. Call the company and ask two questions:
- A – What penalty would the company impose if you closed the account?
- B – How much has the account grown? Ask this question to determine if you have any tax liability.
2. Should you stay or should you go?
This depends on your age, the gains, your tax liability and other aspects of your particular situation. But if you do decide it’s best to stay under the umbrella of a variable annuity, you may have the option of rolling it to a different company if your particular provider is too expensive.
Not all variable annuities are alike. Some companies have very low expenses and don’t lock your money up. If you go this route, you’ll have to come up with a strategy of getting the money out of the account without paying huge taxes down the road. I’ll write another post on this issue in the future.
Finally, if you are in the unfortunate situation that the company still imposes a huge charge to close the account, you have to do some calculations.
In this case, consider the cost of staying versus the cost of going. Here’s what I mean. If you stay, you pay ongoing fees as I mentioned above. Let’s say the company charges you 3.5% each year in total fees. Assume they also have a 2% penalty if you withdraw the money now. That means (in this case) the move pays for itself inside of a year. You win!
Of course, you should always talk to your tax and financial advisor before making decisions like this, but consider one very important warning. If your tax or financial advisor is the one who sold you this schlock… you might want to consider finding new counsel.
Should Anyone Ever Buy An Annuity?
I generally dislike annuities. Most of the people I have met who own one are sorry they do. But there are some cases where annuities work:
A. With immediate income annuities, the older you are and the higher prevailing interest rates are, the higher the payments will be. So if you are are in your late 70’s or above, rates are high, you need income now and don’t care about leaving a pot of cash behind for someone else, the immediate annuity has potential.
B. If you can’t stand the idea of ever losing a dime of principal, an index annuity might be a consideration. I would much prefer that you learn more about the trade-offs and make a more rational choice. But if you can’t eat or sleep because of the stock market, it might be OK to look into an index annuity.
C. If you are in a very high tax bracket now, are willing to tie up your money for more than 20 years, will absolutely tap into the annuity for income, yes, it’s something to consider. Having said this, most annuity owners die owning the annuity. This creates an income tax nightmare for the beneficiaries. So if you go this route make sure you really will tap into that income many years from now.
There might be other situations where annuities make sense but I am not aware of them. I can tell you that most people are sold annuities. Nobody ever calls me and tells me they want to buy one. They usually call and tell me how much they dislike owning annuities and call to ask me how to get out.
I started the post by telling you what I think about annuities; for most people, annuities are inappropriate. Consider how long you are going to invest and estimate the benefits and drawbacks carefully. If you do, you’ll see that you probably have better alternatives.
Annuities have a few redeeming qualities but not many. The rates are low, the tax treatment is disadvantages and liquidity is unacceptable. If you find yourself drawn to annuities it may be out of fear rather than out of logic. To overcome that problem, run your financial plan and make strategic long-term investment decisions that benefit you and your family rather than brokers and insurance companies.
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