What is an annuity?

In the broadest sense, annuities are any stream of payments. Your daughter’s allowance qualifies.

But, in practice most of us use the term to describe an insurance company product. Someone turns over money to an insurance company, and sometime later the company gives it back. What makes the insurance company’s product different from your promise to pay your daughter each week is their ability to make certain guarantees as to lifetime payments. As we shall see, those guarantees may not be as ironclad as many people believe.

Another significant difference between your promise to your daughter and an insurance company product is a perceived tax advantage that the insurance company contract provides. In real life, that tax advantage has been grossly oversold, and may not deliver any benefit at all. In fact, an annuity may cost you more in taxes than several widely available, lower cost, and higher quality alternative investments.

Immediate v. deferred annuities

If the stream of payments back from the insurance company start right away then we have an immediate annuity. For example, you fork over $100,000 and the next month the insurance company starts sending you $500 a month for the rest of your life.

If the payments are delayed until sometime in the future, we have a deferred annuity. For instance, you send the insurance company $5000 every year, and the sum accumulates until you either withdraw the proceeds or begin a life annuity.

Fixed v. variable annuities

If the payments coming back from the insurance company are based on an assumed interest rate that the insurance company is earning, then we have a fixed annuity. On the other hand, if the payments are based on the performance of an underlying investment pool, we have a variable annuity.

You shouldn’t make too much of the analogy, but fixed annuities look somewhat like a CD, while variable annuities look somewhat like mutual funds. (More about the mechanics later.)

Costs

The first thing you need to know about annuities is that from the insurance company’s point of view, annuities are low risk, and very high profit. The next thing you should consider is that annuities pay some of the highest commissions in the securities business. So, you shouldn’t be surprised that there are large armies of fired up salesmen flogging annuities to any hapless investor that they might come across.

Of course, the flip side of high-cost, high-commission products is that investors receive one sided sales presentations and net somewhat less than they should on their capital.

The actual mechanics of how investors are fleeced differs between fixed and variable contracts. In the case of fixed annuities, the insurance company simply pays out somewhat less (say two to three percent) than they make on a bond portfolio. From their perspective, the annuity business is a fat cost plus operation with almost no risk. Fixed annuities are not securities subject to SEC, NASD disclosure requirements. So, figuring out where all the funds are going is a challenge. Rather than a prospectus outlining costs, the investor is presented with projections and annuity tables. Few investors have the tools available to connect the dots or make fair comparisons.

Variable annuities contain a bewildering assortment of costs layered on top of one another. Each fund has an expense level, often higher than an equivalent mutual fund might be. Next, there are Mortality and Expense (M&E) charges that typically run about 1.4% per year. Finally, each fund usually levies an account charge of $10 to $25 a year. The total charges can easily exceed 3% per year. These costs compare very unfavorably with average mutual fund expenses of 1.3% per year. Of course, some index funds have expenses as low as 0.2% per year.

Variable annuities are securities and subject to SEC and NASD regulation, but I have never seen a prospectus for one that clearly explains the full extent and implication of these costs.

Costs are a dead drag on performance. There is a direct relationship between high costs and low performance. You would have to have a compelling reason to bear such costs, and in the case of annuities it’s just not there.

Surrender Charges

Almost all annuities are sold with “back end loads” or contingent deferred sales charges to cover the high commissions that are paid out to the sales force. Depending on the contract these surrender charges can be as high as 10% and/or last for 10 years. These surrender charges are fully disclosed in the contracts, but surely not emphasized. While it’s not legal to call the policies “no-load” you will hear things like “no front end load”, and “all your money goes to work first day”.

There is nothing good about surrender charges. They reduce your options and lock you in.

Next: Where’s the beef? Annuities claim two big advantages: tax savings and an income that you can never outlive. Do these claims hold up? Or is it just marketing hype?

Frank Armstrong, CFP, is the author of Investment Strategies for the 21st Century, published here, President of Managed Account Services, Inc., a fee-only Registered Investment Advisor, and Chief Investment Strategist of DirectAdvice.com.

Note: The featured writer is solely responsible for the content of this article. The opinions expressed herein are not necessarily those of MFI or BES, Inc.

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