Wednesday, August 13, 2008

Annuities: investments generally worth avoiding

An annuity is something of a cross between an insurance policy and an investment.  They are complicated, expensive, and generally probably not something that most people need.

An annuity is an investment vehicle.  You purchase an annuity bit by bit over time or in one lump sum.  The money inside the annuity will be invested for you until you "annuitize" your policy.  Once annuitized, you no longer own the money inside the account.  Instead you hand the money over to the insurance company who runs your policy.  In exchange, they agree to make a regular, fixed payment to you for the rest of your life.  It is almost like life insurance in reverse.

When I was a financial advisor I sold exactly zero annuities.  While having a fixed stream of income from an annuity can be very attractive, in practice I found that my clients were always better off investing on their own without an annuity.

The fee structure for these vehicles is enormously complex.  Even after attending seminars for financial advisors about specific annuity products, I recall not entirely understanding all of the different fees that an investor in that annuity needed to pay.  The one thing that was incredibly clear to me was that advisors who sold annuities made a great deal of money.

Because of the high fees and complexity of annuities, I quickly realized that they were not right for my clients.  This does not mean that annuities are always a bad choice or that anyone who tries to sell you one is a crook.  However it does mean that you should very carefully consider an annuity purchase.  Once you have purchased an annuity, it is usually very difficult - and very expensive - to move your money out of it.  Most annuities have "surrender fees" that you have to pay if you wish to transfer your money within the first 7 - 10 years that you own the annuity.  There might also be some very serious tax implications if you transfer money out of an annuity.

If an advisor recommends that you purchase an annuity, make sure that you know what you are getting into.  Ask him why he is recommending the annuity.  Ask him to explain all of the fees involved and ask him to show you the projected results of purchasing the annuity vs. investing the same amount of money in mutual fund.  You should also ask how many of his clients own annuities.  They are very specialized products, and in my opinion, they are generally not the best investments for most people.  If an advisor tells you that he recommends annuities to all or most of his clients, unless he has a very specialized market, I would be concerned.

5 comments:

Anonymous said...

After that post on annuities I am sure you really never understood fixed annuities. I want to be civil, so don't take this the wrong way. The typical fixed index annuity with 8% annual cap outpaced the FTSE 100, DOW, S&P 500 and the NASDAQ from Jan 1, 2000 to Dec. 31, 2007. DALBAR says that the average equity investor over last 20 years got a 3.8% return only 30% of a 12+% market. Now that is expensive. Don't advisers get their cut off the top. Don't adviser fees decrease the gains of the winners and increase the losses of the losers? Isn't it true that fund performance comes ands goes, but cost go on forever. Not one person that I know has ever lost any money in a fixed index annuity. They are always at a high point never waiting for the market to come back. Those are some thoughts from a crafty peasant.

RDS said...

Crafty Peasant,

Thanks for your comment - I appreciate your post and your perspective.

Annuities can be good investments for some people and because of certain insurance benefits investors in annuities (of all kinds) are less likely to lose money than investors in other types of securities. However, because of their high fees and the tax treatment when you withdraw your money I believe that most investors are better served with other investments.

The average annuity charges its owner (on an annual basis) 1.15% for mortality and expenses (the insurance charge) plus an average .82% management fee for the investments. This average annual fee of nearly 2% (before you have added any riders) is nearly 10 times the cost of owning a low cost index fund (total annual fees are generally around .2%.) Additionally, because an investment in an equity indexed annuity only tracks an index (and does not actually hold shares of those underlying securities) the investor does not benefit from dividends.

I am not familiar with the DALBAR statistic that the average equity investor only earned 3.8% per year over the last 20 years. However, my suspicion is that this number is the result of a huge number of investors who try to time the market, buy and sell at inopportune times, and let fees and missed opportunities eat up their returns. An annuity will prevent you from making those mistakes - and to some people that might be a big advantage.

Annuities can be good investments for some people. However, the complex nature of the investment and the high fees makes me very cautious about buying or recommending them.

For more information, take a look at this Fool article: http://www.fool.com/retirement/annuities/annuities02.htm


RDS

Anonymous said...

I would like to say it hard to lump all annuities together for a discussion. You are mainly speaking of variable annuities when you speak of fees. Fixed annuities don't carry management fees or investment fees.

In the response to what you said about the taxed treatment of annuities is not favorable. First Fixed index annuity, FIA, are taxed deferred. You choose when you pay the tax. Also IRS code 1035 allows an owner to make a tax free exchange to another annuity. If an annuity is annuitized over a number of years or life the exclusion ratio which is a combination of principal and interest spreads the tax over the pay out period.

If you cash out before age 591/2 it is ordinary income tax and 10% penalty. After this election capital gains may no longer be an advantage afforded mutual funds. The real argument is if the average mutual fund has 100% turn over of its portfolio each year then it is not tax efficient and the capatial gains are all short term and taxed as ordinary income. But if you were taxed at long term capital gains and volatility of the market caused you to loose 15% like 2008. What have you gained. People I talk to would rather trade capital gains and volatillity for the stable FIA.

One of the advantages of the FIA is that it does not own the index. It does not put principal at risk, so if the market goes down there is no loss. They use index options to control the market not principal to control the market. If the market goes up the gain is locked in and if it goes down zero is the hero.

I agree with you on the low cost index funds, but thats only part of the story advisers who are commissioned, fee based or fee only have a cost that starts at about 1.5%. It gets even worse if you spend a dollar on the fools secret information. Sorry about that comment, but they say "we are the good guys" buy our secret letter to be ahead of the curve. Just bite the good guy bait on the end of the hook, I want to make an evil profit off you.

RDS thank you for your blog an open forum. Your the MAN! Crafty Peasant

RDS said...

Crafty Peasant,

One of the primary goals of my blog is to present information about personal finance in a way that someone without any real knowledge of finance and investment can understand. In order to do this I do, as you point out, "lump things together" and paint with a pretty wide brush.

Glad to see that you agree with me about the Fool. I think that their site offers some great information. However, it seems to me that the free information on their site (you can do it yourself, avoid high fees, most money managers can't beat the averages, etc) directly contradicts the idea of paying for stock recommendations from them or anyone else.

RDS

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