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Understanding Annuities

Let's Come to Peace With This Misunderstood Retirement Vehicle


Annuities are misunderstood. It is not easy to know what to think of them. Part of the problem is that annuities have a history of being expensive and confusing, and salespeople have made big commissions pushing the wrong investments on people. That seems to be changing, and in some cases there are apparently good annuities to be found today.

I got a lesson in modern annuities in the book, A Good Financial Advisor Will Tell You..., by advisors Robert J. Luna and Jeremy A. Kisner. The two put research and thoughtful argument behind their annuities recommendation, and with good reason. There was a time when respectable financial advisors did not mention annuities, because the word alone conjured up such negative associations.

The authors think this prejudice is misguided. The book cites two independent studies commissioned in 2010 by Allianz Life Insurance Company. In surveys of more than 3200 people, more than half of the respondents had a negative reaction to the word annuity. A quarter of respondents formed these opinions about annuities more than 20 years ago. And yet, 76 percent of annuity owners were happy with their investments. Annuities ranked second only to gold and precious minerals in investor satisfaction among those surveyed, higher than mutual funds, CDs, etc.

So the verdict is that not all annuities are what they used to be, but they are still complicated. Not all investors should rule out annuities as part of a retirement plan. In fact, a good annuity could be a great idea. But you need to be careful to understand how an annuity works before you sign.

So, What Is an Annuity?

An annuity is an income stream that is paid out over time. Here we are talking about annuity investments, which are insurance contracts that pay out at a future date. You invest in the annuity today and at some point you are entitled to start receiving income payments from the annuity—either monthly, quarterly or annually for life, or for a set number of years, or as a lump sum. How it works depends on your particular annuity.

Types of Annuities

You can categorize annuities in different ways. The first distinction is fixed, variable or indexed.

A fixed annuity offers a set or guaranteed payout amount over time. You pay a premium for this security but you may also give up the upside potential of your investment.

A variable annuity offers securities market exposure. Money in a variable annuity grows as it might if invested in the securities and the rate of return that you get will depend on the market's performance. Investing in a variable annuity is a lot like investing in mutual funds that own stocks, bonds, money markets or some combination of each.

An indexed annuity is something in between. The underlying investment performs like an index fund or funds. But indexed annuities may also have a guaranteed minimum regardless of the index performance.

The next way to categorize an annuity is according to when you start getting the income. A deferred annuity pays you after a set period of time, typically after retirement. An immediate annuity starts to pay out income, well, immediately. Some deferred annuities can be turned into immediate annuities after a given period of time.

Like 401(k)s or individual retirement accounts, money inside an annuity grows tax deferred until the distribution of the payments. Tax-deferred investments compound and grow more quickly than taxable investments, which makes all of these retirement accounts great vehicles for investing.

If you receive payments for a guaranteed period of time, you could also get a death benefit paid to your beneficiaries should you pass away. If you are getting lifetime payments, a death benefit is less likely, but you can purchase riders that allow your heirs to continue to receive payouts for a certain number of years after your death. And there are joint survivor options for spouses who want to continue to receive payouts after the other's death. But for any guarantee, you can expect to pay a bit more in fees.

Advantages of Annuities

One big advantage of annuities is the amount you can invest in one each year. Unlike 401(k)s and IRAs, which have annual contribution maximums, there are no limits to the amount that can be invested in an annuity. If you are 15 years or fewer away from retirement and want to put away some serious cash, an annuity could be a solution. On the other hand, if you are not maxing out the contribution limits in your 401(k) and IRA, higher limits are not necessarily a problem.

Luna and Kisner suggest in their book that the guaranteed benefits offered with some annuity riders make investors behave better. You are more likely to change your investing strategy in a panic if you know you are getting x-percent per year throughout your retirement.

And that's one of the major advantages, as far as I can tell: knowing you can get x-percent per year for a certain period of years is a plan. You can also have a 401(k) or collect Social Security, but this is an additional income stream and you know it's coming. Security is a good feeling.

Disadvantages of Annuities

There can be a lot of disadvantages to annuities. Most of them have to do with cost. If you buy an annuity through a commission-based broker, you will likely pay a steep commission for the annuity. When you invest with a variable annuity, the fees that you pay each year are higher—you could pay up to 3 percent compared to around 1.5 percent for a regular mutual fund. Plus, with all annuities, you pay extra for guarantees, which come with riders that you can add to your plan.

The other issue is liquidity. Many annuities have lock-up periods during which you can't take your money out without paying a penalty fee, known as a surrender charge. This is different than the early withdrawal fee you pay for taking money from a retirement plan before you reach age 59 1/2. Annuities are subject to the same early withdrawal fees. Since you want to invest in an annuity for the long term, a lock-up period may not be a big deal to you. But if you decide you don't like the investment, it will cost you to get out. This is why you should choose your annuity with care. And it's not easy to choose with care because the contracts themselves are confusing.

Another disadvantage is you trade your upside potential for less downside risk. This may be a fine choice for you, but if the market starts to soar tomorrow you may not want all of your money locked up at a 7 percent rate.

Also, many of us purchase annuity options within a 401(k) plan. Annuities and 401(k)s have the same tax benefits, so there is no real advantage to owning one inside of the other.

So, Are Annuities a Good Investment?

It seems there are annuities that are good investments, and there may be one that's right for you. If you are considering an annuity, your best bet is to work with a trusted financial professional. Look for so-called direct sold annuities—which are annuities sold without a broker, and therefore have no commissions. You can find these at Vanguard, Fidelity, T. Rowe Price and Schwab. Read through as much of the prospectus as you can, understand every fee, and ask a lot of questions until you know the investment inside and out. This is a long-term investment, so you will be living with it for awhile.

The content on this site is provided for information and discussion purposes only. It is not intended to be professional financial advice and should not be the sole basis for your investment or tax planning decisions. Under no circumstances does this information represent a recommendation to buy or sell securities.

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