Annuities: Security Blanket or Insurance Scam?
These days, it seems like we can’t turn on the television or open a magazine without seeing an ad for some type of annuity. The options can be bewildering: immediate and deferred; fixed, variable, and equity-indexed. Within these categories are even more options, many available only for a steep price. Some insurance companies have come under fire recently for their aggressive marketing of annuities to consumers who may not fully understand these complicated products.
An immediate annuity is an arrangement with an insurance company whereby you hand over money now—either in the form of a lump sum or a series of payments—in exchange for a more or less guaranteed stream of income that begins immediately. Purchasers of a deferred annuity begin receiving payments at a predetermined date in the future. Regardless of the type of annuity you buy, your investment grows tax deferred. Depending on the source of the money used to purchase an annuity product, however, your income payments can be partially tax-free or taxed as ordinary income.
Many investors think annuities are a bad deal. The most common complaint is high costs. The average annuity carries a 1.40 percent charge, and when you add account maintenance fees to the sales commissions and the expense ratios on a variable annuity’s underlying mutual funds, the overall expense ratio can soar over 3 percent. Another legitimate gripe is liquidity: It can be expensive to retrieve your principal once you have signed an annuity agreement.
There are three basic types of annuities on the market today. The traditional product is the fixed annuity, which provides a guaranteed stream of fixed-dollar payments to the annuity holder. Purchasers of fixed annuities are trading growth for security. A note of caution: Inflation will slowly erode the buying power of the guaranteed payments. Consumers should always beware of the term “guaranteed.” In the case of annuities, the guaranteed income is subject to the credit risk of the insurance company and its ability to pay out its liabilities. Today more than ever, with large financial institutions failing or under great strain, it is worth taking an extra-long look at your provider. Choosing an independent company such as Fidelity Investments may make the most sense.
A variable annuity allows the purchaser to address the problem of inflation by investing the money in a range of stocks, bonds and money market accounts. Equity index annuities are relatively new products that, as their name suggests, tie the account value to the performance of a stock index. The account value from both variable annuities and equity index annuities can rise and fall with the broader securities markets; many companies address the problem of downside risk in these nontraditional annuity products by guaranteeing a minimum return.
Annuities make sense for many investors, particularly retirees, who want to remove some risk from their portfolios. Annuities also make sense for investors who have maximized contributions to their 401(k)s and IRAs and want to make further tax-deferred investments. Due to the severe penalties typically associated with withdrawing principal, you should probably not purchase an annuity unless you plan to keep it for at least 15 years.
As with all investments, be sure you thoroughly understand the terms of your agreement before you hand over any of your hard-earned money. If you know and trust an insurance expert, it’s best to consult him or her; insurance companies have not signed on to “simple English” regarding their policies and agreements.
