The Truth About Annuities

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I get the impression that most financial planning articles about annuities pull their punches, hesitating to criticize the industry upon whose advertising they depend and the large portion of advisors whose livelihood depends on commissions from their sale.

It was therefore with interest that I read Alanna Ritchie’s article “The Truth About Annuities” in Financial Advisor Magazine.

In some type of nod toward fairness, the author listed three pros and three cons. We don’t think these are pros. Here are their three so-called pros:

Pros Of Annuities

Three of the primary benefits of annuities are lifetime income, tax benefits and principal protection.

  • Lifetime income, which is a guarantee with certain annuities, provides annuitants with payments that continue as long they are alive. The payments are often higher than Social Security and pensions, as there are not contribution limits.
  • Annuities include multiple tax benefits. The main tax advantage is the ability to make contributions and not pay any taxes until you make withdrawals. Basically, the money has time to grow without penalties. You can also roll over funds from qualified IRAs or 401(k)s without tax penalties.
  • Principal protection is a feature of fixed and equity-indexed annuities; it guarantees that the value of the annuity will not fall below the amount of money initially invested. While other investment options carry risks, this offers a nice guarantee.

Let’s unpack each of these “pros of annuities”:

Lifetime Income

  • Which is usually not indexed for inflation. If they pay you a $30,000 a year annuity, in 20 years at 5% inflation it will only have the buying power of $11,307.
  • Is usually just giving you your own money back for the first 16 years. If a $30,000 annuity costs $500,000 they make it sound like you are somehow getting a 6% return. In fact you have lost 100% of your principal. And for the first 16 years they are just handing you your own money back. In 17 years you should easily double your money. So they can do this indefinitely and still make a profit.
  • If you live forever, your infinite annualized return might approach 3%. It won’t even keep up with inflation because the payment to you will ultimately become trivial.

Tax Benefits

  • The main tax advantage is probably more of a disadvantage. Most of the time you would like to put money into a Roth when you are young. When you are older and at the height of your earnings there is an advantage in putting money tax deferred, but normally maximizing your 401(k) is sufficient.
  • Money in a 401(k), Roth or Traditional IRA also grows tax deferred or tax free. And these investment vehicles give you the ability to choose your own low cost investments.

Principal Protection

  • As mentioned earlier, you lose 100% of your principal the minute you annuitize it.
  • Principal Protection is easy when an investment is locked up. Simply buy a zero coupon bond maturing in ten years. That guarantees that in ten years you will still have your principal. The remainder of your money can be safely invested in the markets, used to purchase upside options or other “participating in the upside of the market” ventures. The difference is that if you do this yourself you won’t gouge yourself with the high fees and expenses that annuities often have.

Usually, none of the “advantages” of annuities provide the best means to achieving your goals.

I did, however, agree with all three cons:

Cons Of Annuities

Three hindrances to consider when considering annuities include limited return, inflexible commitment and fees.

  • Limited return is often the downside of annuities that come with principal protection. Eliminating the risk limits the return. Stocks, bonds and mutual fund investments fluctuate, allowing a greater potential for growth than some annuities.
  • The inflexible commitment that is a part of annuities may deter some consumers. Once the contract is signed and the money is invested, the consumer has limited access to the money. If an emergency or major expense arises, consumers would need to sell their annuity payments to a third party in order to access their money.
  • The fees that accompany annuities are the biggest deterrent for many. Written into each contract are fees for added features and early withdrawals. For some annuities, the return may not be worth the amount paid in fees.

We would not recommend putting any of your money into annuities. There is nearly always an investment option which gives you a better chance of meeting your financial goals.

Photo by Erik K Veland used here under Flickr Creative Commons.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.