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Annuities: The Good, the Bad, and the Ugly

Written by Dan Solin on June 29, 2010 in Retirement  |   4 comments

There’s a lot of misinformation about annuities. That’s not surprising, since the term “annuity” is applied to a variety of dissimilar investments. These investments are also quite complex, which seems to suit the insurance industry. Complexity makes it more difficult for investors to separate good…

Annuities information-pros and consThere’s a lot of misinformation about annuities. That’s not surprising, since the term “annuity” is applied to a variety of dissimilar investments. These investments are also quite complex, which seems to suit the insurance industry. Complexity makes it more difficult for investors to separate good annuity investments from the bad.

I divide annuities into three categories: the good, the bad, and the ugly.

The Good: Immediate Annuities

If you ask retirees what they fear most, most will say it’s running out of money. That’s where immediate annuities come in.

With an immediate annuity, you give an insurer a lump sum. It gives you a monthly, quarterly, or yearly payment for the rest of your life, for the rest of your life and your spouse’s life, or for a specified length of time (such as your life plus a stated number of years).

You can also purchase a fixed or an inflation-indexed immediate annuity. Of course, you pay for the inflation protection, which means that your payments go down. Your payments are as much as 30 percent lower for an inflation-indexed annuity than for a fixed annuity.

Studies have shown that buying an immediate annuity can significantly reduce the possibility that you’ll run out of money before you die.

A prudent approach to immediate annuities is to compute your monthly expenses, deduct income from all sources, and purchase an immediate annuity to cover the difference.

The industry leaders in low-cost immediate annuities are Vanguard and TIAA-CREF.

The Bad: Deferred Variable Annuities

With deferred variable annuities, you pay the insurance company a lump sum. Your money is invested based upon your selection of the investment options provided by the insurance company. The invested funds grow tax-deferred until you start taking distributions. You cannot access your funds without a tax penalty before the age of 591/2.

Deferred variable annuities are high-commission products sold with great enthusiasm by insurance agents and brokers. They are rarely suitable investments.

The expenses are high, averaging over 2 percent a year.

Their main selling feature is the fact that gains are tax-deferred. However, you are trading capital gains tax rates for ordinary income tax rates at the time of withdrawal. Today, that’s a huge difference in the tax rates and no one knows what those tax rates will be in the future, so you’re betting on an unknown.

When someone is trying to sell you a deferred variable annuity, you’ll hear them carry on about the “death benefit,” which is guaranteed to equal the total of the amount contributed (less withdrawals). However, this is rarely a real benefit, since over the long term it is highly unlikely the amount contributed plus appreciation will be less than the death benefit.

The Ugly: Equity-Indexed Annuities

One of my least favorite investments is the equity-indexed annuity. The pitch is enticing: there is a floor that protects you from loss, but you benefit when a designated index (like the S&P 500) increases in value.

It sounds too good to be true: limited risk, unlimited reward.

You need to understand the fine print.

Here’s why an equity-indexed annuity is such an ugly investment:

  • There are major penalties for early cancellation.
  • Depending on the wording of the guarantee, you can lose money.
  • It can take years before the minimum guarantee breaks even.
  • You don’t get the full increase in value of the designated index.
  • There are obscenely high hidden costs to fund the outrageous commissions for these products.

Equity-indexed annuities are made to be sold and not purchased. Avoid them.

Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read and The Smartest 401(k) Book You’ll Ever Read. His latest book is The Smartest Retirement Book You’ll Ever Read.

Follow Dan Solin on Twitter.

Read More:

Five Simple Rules For Protecting Your Retirement Savings

Running Out Of Retirement Money? Make Your Money Outlive You

Creating Your Own Best Retirement Plan

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4 comments

  1. Lump Sum Annuity says:

    Lump Sum Annuity

    Nice Article, i wants to include some more to this…….

    Some of these plans are also growth investment plans with assured Lump Sum Annuity in addition to some health coverage plans, etc. Some investment plans include payment of Lump Sum Annuity to the spouse or any other nominee either at the same rate or at a revised rate.

    Well working after retirements is an another option if one really wants to earn money or to increase savings.but it also has some pros and cons.working after retirements totally depends upon individual choice or his/her financial status/position.

  2. Jennifer A. Freeman says:

    Thanks for your comment. There are pros and cons to most investment and retirement decisions, and your options should be carefully weighed for your personal situation.
    Thanks for reading and check back for more retirement advice from Dan Solin.

    Jennifer
    Editor for the Equifax Personal Finance Blog

  3. dalton says:

    Dan: you really should take the time to educate yourself on a particular product, in this case the Fixed Indexed Annuity, before you formulate an opinion. Your opinion on this product (strategy) is so misinformed it’s laughable; coming from a professional NYT’s best selling author on personal finance it’s pathetic.

  4. Thomas says:

    Most VA investors are using the money either to accumulate until needed, or to provide an income as needed. VA’s do exactly that – they provide a personal pension. The guaranteed income payments provide that security and peace of mind knowing you cannot outlive your income. If you are living off your investment assets, when they drop 33% like the Dow did last year, your choice is to either lower your spending by 33%, or face running out of money. With the VA and a guaranteed income benefit, you won’t run out of money. How much is left at the end may change, but running out of money before running out of life is the biggest issue to many retired individuals.
    - Thomas from http://www.lifeant.com/blog/


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