Annuities - Good, Bad, or Otherwise?

For many folks, questions about annuities are a large part of your financial concerns. So, I thought I’d take the opportunity this month to address some of the basics of annuities, as well as the ways annuities are used and abused.

First the basics: Annuities are generally a product of insurance companies. There are two components to the contract – a rate of return, either fixed or variable; and a payout, which may be deferred to the future or immediate.

To define these terms a little better:
· Fixed rate: this kind of annuity invests in very conservative assets. The rate of return is guaranteed, and usually slightly higher than current CD or money market rates.
· Variable rate: this type of annuity has multiple “sub-accounts” (like mutual funds) to choose from, allowing for fluctuating returns. The point is that with these investments, presumably you will have a greater likelihood of positive results. Oftentimes, the opposite may occur.
· Deferred: In a deferred annuity, the payout begins at some point in the future, usually retirement.
· Immediate: With this type of annuity, a lump-sum of money is deposited, and the payout begins immediately. The payout then continues for a certain period of time, or for the life of the annuitant.

All annuities share certain common characteristics, including tax deferral on the funds until withdrawal, surrender charges if the contract isn’t held for a certain period of time, penalties from the IRS if the money is withdrawn prior to age 59 ½, and a death benefit if the annuitant dies prior to the payout. Oh, yes, and one other common item: expenses and charges – of as much as 4% or more – are charged to the account annually.

It is due to the high expenses associated with annuities that they are a favorite of insurance salesmen. After all, high expense equals high commission!

One place that an annuity might make sense is for the individual who has maxed out all of their other tax-deferral options, such as 401(k) and deferred compensation plans, as well as a Roth IRA. Even so, you need to look closely at the expenses and examine the true return you can expect, as well as your need for an insurance component in your portfolio, before diving into an annuity.

Another good circumstance for a fixed annuity is to provide a steady conservative component of your portfolio. These should be compared to bond funds for yield to see if there is a benefit, of course.

The good news is that there have recently been some alternatives developed in the annuity arena by low-cost providers like T. Rowe Price and Vanguard. These companies’ offerings should be considered if you’re thinking about an annuity.