Looking Inside Annuity Contracts

Are Annuity Contracts Bad for Investors?

What is an Annuity?

The popular press paints them as one of the greatest scams of the century. Yet, the growth in popularity and inflows has increased over the last ten years. When an investor uses the annuity contract correctly, he can avail himself of services and safety unavailable elsewhere.

Annuity contracts provide an agreement between you and a large institution, like an insurance company. In some cases, the company may promise you a lifetime of cash flow that you cannot outlive, subject to the insurance company’s solvency, of course. Additionally, other guarantees might provide you with life insurance and protection for your spouse. In some cases, the contract might afford you protection in the event of a nursing home stay and replace the need for a long term care policy.

Fixed Annuities Offer Guarantees

Fixed Annuities guarantee you a fixed rate of interest over a fixed period.
Annuity rates vary with macroeconomic factors and the best annuity rates may change quickly. Fixed contracts provide in the constancy of income stream. The risk lies in the threat of inflationary erosion of your spending power.

Equity Index Annuities Limit Losses and Gains

Equity Index Annuities provide an asymmetrical return agreement.
Based on the SP500 Index, you get paid either an interest rate near the current “risk free rate” level or you get paid an interest rate equal to the rise in the SP Index over a fixed period. However, if the index rises above a certain “ceiling”, you may not participate in further increase. Liquidity issues may decrease the effective return on your money, as some companies require an extended payout period in order for you to receive the full benefit possible with the contract.

Variable Annuities May be Least Understood and Most Complex

These agreements call for expertise on the part of the advisor in order to make the agreement an effective instrument for retirement planning, it’s most frequent use.

Variable Annuity Pros and Cons:

Liquidity may decrease to 10% per year during the “surrender period.” Penalties may apply on withdrawals greater than ten percent in any one year. Most retirees plan to withdraw 5% or less, so except for a severe emergency, this may not create an issue for a particular investor.

Commissions for these products are said to be high, however the insurance company pays the representative from its own funds, not yours. Management, mortality and expense fees range from 2.25 to as much as 4%, depending on the level of guarantees superimposed over the basic annuity vehicle.

Retirees May Defer Taxes

Investors don’t pay taxes on appreciation until the money is withdrawn and, at that time, may be in a different tax bracket than during their accumulation phase. However, the IRS treats the withdrawals as ordinary income, not as capital gains or dividend income.

The return on a variable annuity contract depends entirely on how your advisor constructs your annuity. Inordinate volatility may produce wild swings in value and available income. Too little return risks performance which does not preserve spending power over the next few decades. Your advisor must properly allocate the sub-accounts to reflect a Prudent asset allocation among equity benchmarks; he may not be qualified to do this. On the other hand, some annuity companies provide your advisor with analytical services that might cost over $100,000 per year if performed by a private party or smaller business.

In order to get the best variable annuity contract, you need to have a thorough analysis of the contract details, expenses, fees and services. Of the more than 1,400 annuity contracts available right now, we have found only a handful that provide enough service to make the costs low enough to compete with a fee-based arrangement.

Charitable Gift Annuities may make sense for investors who want to leave some of their estate to a charity or cause. Essentially, such contracts allow for an estate planning function to manage the value of your portfolio and the distribution plan. Many aspects of the annuity contract take care of certain estate planning functions, saving you the headache and expense of attorney’s fees as well as providing convenience for your benefactors.