The following is the fifth of a series of weekly articles in which Sheryl will provide overviews of investment options that offer alternatives to bank accounts. Last week's article covered U.S. Treasury securities. As with any investment that's not an insured deposit account, there are risks. Some may feel that these risks are worth it for the chance of higher yields. The focus of these articles will be on conservative investments that may appeal to some savers who want a chance of higher yields and minimal risk.
If you want to get a heated debate going, just bring up the subject of annuities.
"Financial advisors either love or hate annuities. I don’t fall into one category completely," says James Roberts, a certified financial planner and president with RT Wealth. "I am a firm believer that no single financial product is either good or bad for all people. Some products may only be effective for a very small percentage of Americans. On the other hand, some products may be very effective for a large percentage of people, but just not you. Annuities fall into this category," says Roberts.
What is it about annuities that stirs passion? In case you’re somebody who’s asking "annu what?" An annuity is an insurance product that can be designed to pay out income over a specified period of time. Typically, you make a lump sum payment or a series of payments to the seller, often to an insurance company. In return, that company agrees to make payments to you for a period of time, explains Roger Cowen, founder of Cowen Tax Advisory Group.
How do annuities work?
Insurance companies take the premium you pay up front, and then, after a set period of time, begin paying you the money agreed upon in the contract. "It’s similar to a company’s pension plan, but the difference is that you, not an employer, whose contribution makes those lifelong, valuable payments possible," says Cowen.
Know too, that there are many types of annuities.
Immediate annuities provide the highest income payout of all the annuity types. However, they are the least sold because of their disadvantages, says Reno Frazzita, president of Secure My Funds, a financial and retirement planning services firm. "In general, an immediate annuity is an irreversible transaction. The policyholder cannot change his or her mind and opt for a better opportunity down the road. The policyholder loses access to the principal and in many cases, any remaining money left over reverts to the insurance company when the annuitant dies," Frazzita says.
Fixed annuities are somewhat similar to a CD, except you are buying from an insurance company, instead of a bank. The insurance company pays a fixed rate of interest until maturity, and then the policyholder can move the money elsewhere, or continue on with the policy. Although annuities are not FDIC insured, one of the advantages of fixed annuities is the safety of principal they provide, points out Frazzita. The interest is also tax-deferred until withdrawn from the policy, and in general, fixed annuities pay higher interest than most CDs. One downside is that in order to trigger the lifetime income benefit, most policies require that you annuitize the policy, which entails the same disadvantages of an immediate annuity.
Variable annuities offer options. The policyholder has the choice of several different mutual-fund type accounts (called sub-accounts) with which to invest the principal. This type of annuity, believes Frazzita has the highest potential for growth, But, the principal is subject to the risk of loss from a downturn in the financial markets. These policies often have some kind of income rider, which allows the policyholder to trigger a guaranteed lifetime income payment without having to annuitize the policy.
Fixed index annuities pay interest each year that is linked to the performance of a stock market index, instead of a fixed rate. This allows for a higher potential growth if the stock market does well. However, because they are on a fixed income chassis, the principal is protected from loss in the event of a downturn in the stock market. These annuities also offer some type of income rider that allows for lifetime income payments with annuitization of the policy. "With FIAs, you will not lose your principal, as it is guaranteed by the issuing insurance company and by a state insurance guaranty fund," says Jim Poolman, executive director of the Indexed Annuity Leadership Council.
What’s to love about annuities?
"The advantages which are most commonly marketed relating to annuities is upside potential with downside protection. Who wouldn’t want that? If your account can presumably participate in market gains and at the same time find shelter from market losses, how could this not be a great fit for everyone?" says Roberts.
Rob Drury, executive director of the Association of Christian Financial Advisors, in fact contends, "There is no safer vehicle than a fixed annuity." Why? "Insurance companies are required to maintain reserves far greater than those of banks and credit unions and state guaranty funds provide higher protection than the FDIC."
Then there’s the fear factor. "Retirees biggest fear is running out of money. Annuities can help solve that risk and retirees feel much more comfortable about their future," says Andrew Carrillo, president of Barnett Capital Advisors.
What’s to hate?
"I have been in the investment business for 30 years. I have found that variable annuities (with exceptions such as Vanguard) are a bad deal for most, if not all investors – at least the ones sold by brokers. Their guarantees are not what they are promoted to be," says Paul Ruedi, CEO of Ruedi Wealth.
Like any financial instrument, annuities carry risk. With fixed indexed annuities, there is a risk that your investment may not keep pace with inflation if the markets don’t perform well, and your yearly earnings may be capped at a certain limit. With a fixed indexed annuity, if the market declines you don’t earn any interest that year, but you don’t lose any money either, says Cowen.
Know too, that your money is locked into the issuing company for the duration of the contract, and you may have to pay a large surrender charge if you need to get your money back before the contract matures. "If you need immediate income, you may want to consider other investment products," says Cowen. Not only can surrender fees be hefty, but also initial and ongoing fees.
Not every annuity allows for a beneficiary to inherit or receive distributions. "Be sure your annuity is structured to pass money onto your beneficiaries, if this is what you want," says Cowen.
Of much importance, the annuity policy is backed only by the solvency of the issuing company. "Make sure you’re investing with a company with an outstanding reputation," he adds.
Understand that annuity contracts are not securities or even investments. "Basically it is a cash flow and arbitrage strategy/scheme that the insurance companies use on unsophisticated investors," says James Winkelmann, a registered fiduciary with Blue Ocean Portfolios.
"I see more awareness of annuities, but investors often don’t understand the details and the level of complexity involved in finding the right one to fit their needs," says Josh Alpert, CEO of Wealth Trac Financial Group.
Do your homework. Says Curtis Cloke, CEO of Thrive Income Distribution System, LLC, "Always consider the goal of what you’re trying to accomplish before selecting an annuity. Read carefully the fee structure. Understand the tax implications on the distribution from the annuity. There is more than one way that distributions may be taxed. Annuities can be very good and annuities can be very bad. Always seek a financial professional who provides a full range of planning services, not only annuity products."
Editor's Note: For more viewpoints on annuities, please refer to the CBS MoneyWatch article, "Why So Critical on Annuities?", Clark Howard's article "Index annuities are poison for your pocketbook" and the DA article, "Options for the Elderly to Live with Today's Ultra Low Interest Rates".