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What You Need to Know About Annuities

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.

[Annuity] guarantees are not what they are promoted to be

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.

Be smart

"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".

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Anonymous   |     |   Comment #1
In reality you have two choices, give all of your money to the insurance company for a fixed stream of income, which is very small by the annuity standards from the past or keep them there for a very small return.
If you die the heirs do not get stepped up reassessments of the money and almost 50% will go to uncle Sam in taxes.
It is a very bad time to own an annuity today, the return on SPIA(s) are less then 2% but they play the trick on you by counting the return of the principle as income received and then you pay tax at a regular tax rate, depending on your other income even the part of the principal exempted until your longevity expires.
Anonymous   |     |   Comment #3
SPIA to be qualified for Medicaid or Medi-Cal payments for nursing home spouse with the other spouse living in the family house who is the recipient of the annuity payments is also an option.
Anonymous   |     |   Comment #5
You clearly have no idea what you are talking about. SPIA annuities are treated for tax purposes, very differently than other annuities. The IRS changes the order of tax to be First In/ Blend Out or "tax exclusion ratio" treatment. When properly architected, we are getting tax-equivalent rates of north of 4% without any fee-drag.  
Anonymous   |     |   Comment #6
#5, the tax exclusion ratio treatment expires between 80-85 years old person, depending when you bought the SPIA, after that, all income is taxable and if you die before longevity expires, the money belongs to the insurance company.
Anonymous   |     |   Comment #16
No, it doesn't; well, sort of. The money does technically belong to the insurer, until actuarially, they will pay out every cent of it to someone. Half of the life annuitants will die short and the other half will die beyond their mortality dates. This is why it is insurers who issue annuities; they are genuinely an insurance product.

Rob Drury 
Executive Director, 
Association of Christian Financial Advisors
Anonymous   |     |   Comment #19
There SPIAs do not require life contingent options, they also allow period certain options. In this case, the the exclusion ratio last the entire period of the income annuity  and even if the annuitant owner dies prior to all payments being paid, the entire sum of payments is paid out. We ladder these like bonds. However, we use DIAs for laddering more than we use SPIAs.
Anonymous   |     |   Comment #20
Do you use SPIAs for Medicaid qualification for stay at home spouse and thus the Medicaid will fund the non-stay at home spouse at the nursing home?
Anonymous   |     |   Comment #9
SPIA for Medicaid/Medi-Cal are purchased by the joint owners, i.e. each has complete ownership in same...especially in a community property state.  The income only is taxed and given that a person needs it only when the other spouse is going into the nursing home, i.e. very late in life, and the annuity is over the IRS specified life expectancy for the stay at home spouse...the amount of tax is minimal b/c the income, i.e. component of the monthly payment is very low in this day and age and any reminder, if any, goes to reimburse the state for the payment for other spouse's nursing home care 
Anonymous   |     |   Comment #2
Allow me to suggest the following:

Now ask yourself why a 30 page contract is required. The primary beneficiaries of annuities are the brokers who market them. A $200,000 annuity can pay $12,000 in commission to the broker. People simply refuse to perform simple math. Give me $200,000 and I can "pay" you $12,000 per year (6%) for 16.66 years without earning a dime on the money. I will earn interest and I will most definitely restrict or completely deny you access to any or all of the original 200 grand during and/or after life. OK, I guess I'd need a thirty page contract too.
Anonymous   |     |   Comment #11
I ran some quick numbers. Invest $200,000 in stock market. Pay yourself 6% per year or $12,000 with no inflation adjustment. Earn an average of 5% per year on the market balance. At the ten year mark the account would = $177,000; 20 year = $138,000; 30 year = $75,000. Market volatility can be a problem and when you start investing affects results (beginning of bull/bear market, etc.). Earn an average of 3% and your money/payout with this scenario will last 25 years.

I like flexibility and can manage money but many will be sorely tempted by the hustler's language employed in selling annuities. Purchasing an annuity is a bet you'll live longer than the insurance company bets you will. On average guess who wins the bet? 
Anonymous   |     |   Comment #15
On average, it's a draw. The annuity payout is based on life expectancy. Assuming perfect actuary, and you can be sure it's incredibly close, roughly one half of the insured population will die before life expectancy, and half after; averaging precisely at life expectancy. Sorry, no one wins the bet; it's perfectly mathematical and perfectly fair.
In the article, Reno Frazzita states that if an annuity is annuitized for life, and the annuitant dies, the insurer keeps "any remaining money left over." What Frazzita overlooks, and this is critical in understanding annuities, is that there is no money left over. This is an insurance product; the payout is actuarial. Every penny that one individual loses by dying too soon goes to someone else who outlived his money. Just as in any insurance product, risk is spread evenly over the insured population. A person who dies shy of his expected mortality date doesn't lose money any more than the person who loses money on his homeowners policy because his house didn't burn down. A "life only" payment is just that; an insured guaranty that one's money will not run out before one's death.
Rob Drury 
Executive Director, 
Association of Christian Financial Advisors
Anonymous   |     |   Comment #17
Listen to what you just said. It's of no comfort to me that my hard-earned money "goes to someone else" if I die prematurely. The simple fact is many annuities are sold to unsophisticated folks with large retirement payouts, inheritances and/or spousal death benefits. Commissions (love of money) drive annuity sales, not love of neighbor. Furthermore, no insurance company is in for a "draw". Commissions, operating expenses and profits are all paid for by premiums. Those folks who died prematurely, leaving large sums on the table, simply paid for an excutive suite, new automobile and/or as you say, a portion of someone's payout.

Annuity contracts are so varied (and most often very confusing) the average person has no chance of understanding them, especially the buried restrictions.  
Anonymous   |     |   Comment #27
It's no comfort? It would be if you understood my comments in their context., You have, on average, precisely a 50% chance of either giving some of your "hard-earned money" to someone else or collecting someone else's. Of course, all of my comments assume a "life only" payout. You can most certainly guaranty yourself and/or your heirs 100% of your principle and earnings by selecting a different payout option. This, as all guarantees, does cost an actuarially appropriate additional premium in the form of an extremely modest reduction in periodic payments. Bottom line: One chooses to purchase an annuity for increased earnings, the guaranty of never outliving one's assets, or both. If one's net ROI is higher, the first objective is fulfilled (which is not hard given typically higher interest payouts for fixed products, higher safe potential of variable and indexed products, and tax deferral). The latter objective is why annuities exist; having value beyond measure.

Your comments about commissions are irrelevant. Marketing is a reality. Why would a carrier pay any higher commission than is necessary to market the product? Besides, payouts are illustrated net of commissions and fees. Your return is your return, and is typically higher than any other options with comparable safety.

Rob Drury
Anonymous   |     |   Comment #4
My husband collected on his defined benefit pension annuity for 17 years before he passed and I have collected on it for the years after his death. His pension and his  annuity is and was self funded and managed by an elected board of workers with guidance from a chosen and voted on fund manager and lawyer. There are a lot of injuries in construction and we chose an annuity for us after his permanent injury and it was a good choice for us.
There were several choices to choose from on the kind of annuity payout we wanted. The annuity enabled us to not use our savings and IRA money early in his disability and to let them continue to grow. To have the steady income each month from both pension and SS disability actually is like living on a monthly paycheck. Because I have no personal needs I now  live and do on SS everything I would like to do and have and don't even use his pension, my pension or the RMD's from the IRA's. 
Anonymous   |     |   Comment #7
What you need to know about annuities is to stay away from them......They are NOT backed or insured against anything other than the company that issues it.......And don't tell me they can't fail just look at AIG and Lehman Brothers........Forget it. Besides.... they don't even have a rate of return much bigger than long term CD's.
Anonymous   |     |   Comment #10
No, annuities taken out today do not have a very good rate of return.  In years gone by they did have.  And as #4 pointed out, annuities can be beneficial.  There are many types of annuities and many things to consider before committing to an annuity.  They are not all the same and one size does not fit all. Just like any other investment, it is best to not put all your "eggs in one basket".  Everything is a gamble.
Anonymous   |     |   Comment #14
Absolutely incorrect! First of all, they ARE backed by the guarantee funds of the states in which they are chartered (which, by the way, are more solvent in most states than the FDIC). More importantly, as I point out in my comments in the article, insurers are required to hold 100% in reserves, so there is ZERO risk of insolvency. AIG annuity holders were never at risk of loss, even if the company had gone under.
Rob Drury 
Executive Director, 
Association of Christian Financial Advisors
emdtech   |     |   Comment #18
Comment #14 - Your reply is mostly correct except in the case where smaller insurance companies defaulted like in the 1980's. In several cases, the insurance company is liquidated and you end of with a percentage of the final assets which can range from cents on the dollar to almost whole. The company you state was a "too big to fail" close to default case with AIG. Many stakeholders would experience substantial losses if they did. That is why the Fed's stepped in. Insurance companies do carry a risk if you invest in their products. If you choose a high quality company based on long term ratings from Fitch, AM Best & S&P, you may be able to minimize your risk exposure. One needs to choose wisely.
Anonymous   |     |   Comment #24
From what I understand  and have read on the official guarantee fund websites is that it is illegal to promote annuity guarantee funds because it is an unfunded program.  If there is a larger scale financial meltdown, a hope that insurance companies who are supposed to fund this program will have the resources to do so seems to be a bit of a stretch.  At least the government can tax and print money.  (I don't sell product so I have do dog in the fight.)
CTM   |     |   Comment #25
#24 - You are correct.  All 50 state insurance guarantee associations have similar language.  Mr. Drury should know this, as he is licensed in the state of Texas. The entire passage from their website is reproduced below.  The emphasis is theirs, not mine.

The Texas Guaranty Association law prohibits using the existence of Texas Guaranty Association coverage as a reason to buy insurance. The Texas Guaranty Association should not be considered a substitute for the prudent selection of a well-managed and financially stable insurance company.
Agents are prohibited by the Texas Guaranty Association law from using coverage or the existence of the Guaranty Association as an inducement to sell insurance.
Anonymous   |     |   Comment #28
Mr Drury does know that; however, Mr Drury is counseling on, not selling, annuities. Mr Drury's job is heading an organization whose primary function is consumer advocacy. 

In my opinion, there is no difference between considering FDIC protection of bank accounts and guaranty funds for insurance products. It is relevant in the decision to obtain an annuity and should be part of the discussion. Fortunately, in my current position, discussing it is as legal as it is appropriate. 

Rob Drury

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