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December 5, 2011

These Annuity Pitfalls can be Bruising

Two risks to consider when deciding if an annuity is right for you.

Thick with intricacy well beyond stocks, bonds, and mutual funds, annuities are some of the more vexing financial instruments around. Their guarantees can attract investors from two extremes – those who avoid Wall Street and choose annuities as a safe alternative to CDs, and those reeling from stock market upheaval who want a certain retreat from risk.

Annuities can meet an important need for some investors; and with so many options available, the right product is within reach. But before signing near the X, investors are wise to look beyond a smiling salesman or glossy brochure and consider that annuities may be more sold than bought – and it’s easy to invest in them for the wrong reasons.  We’ll explain a couple of them. 

First, some basics:  An annuity is an investment contract with an insurance company that produces returns in one of two ways. A fixed annuity earns interest like a CD that’s paid and backed by the insurance company, while a variable annuity captures the performance of underlying mutual funds.

One benefit of annuities is tax-deferral. A $250,000 annuity earning 4% per year net of expenses would grow to $305,249 at the end of five years. The $55,249 in growth would have no tax consequences until withdrawn at ordinary income tax rates. Investors like tax-deferral.

Investors also like the guarantees unique to insurance products, especially in times of market turmoil. One guarantee is a death benefit that pays the higher of the account’s market value or original investment value to the heirs of a variable annuity owner. Another works likewise, paying an income stream based on the higher amount during an owner’s life. You can add a number of these riders on a basic annuity contract. Insurance features come at a cost, however, and can add 1% to 3% per year on top of mutual fund expenses.

So what two pitfalls should you consider?

1) Safety

You might think an annuity guarantee gives you the safety of FDIC-insured bank deposits. After all, it’s a guarantee. But what happens if the company you trusted goes belly up? FDIC insurance won’t help you here.

The past decade is a daisy-cutter landscape with the corpses of corporations that were once household names, from accounting to energy to automotive to financial. We’ve learned never to say “never.”

Insurance companies are among those companies hit hard in the 2008 financial crisis, leaving some more distressed than others and bringing guarantees into question. The result? If Company A’s bond debt is investment grade but Company B’s is junk, so are their annuity guarantees. In some cases, there also may be a cautionary gap between an insurance company’s corporate bond rating and its A.M Best industry rating. In any case, you should think twice about the quality of insurance guarantees when the industry’s bond debt is dipping below investment grade.

Your backstops against default are asset protections provided by your state’s insurance guarantee association plus the insurance company’s own insurance policies. But no one wants to see these put to the test. With annuities, “safety” is a relative term.

2) Tax-deferral

Let’s think about the two general ways an annuity can provide returns from a tax standpoint and see if you agree with this astounding conclusion:

A fixed annuity may offer a better value than a variable annuity with stock funds.

How can this be? Stay with me a sec. In a brokerage account, bond interest is taxed each year as ordinary income, with rates as high as 35%. A fixed annuity paying similar interest defers the tax until withdrawal, but also is taxed at the same ordinary income tax rate.

Stocks, however, are ideally held long-term until profits are taxed at lower long-term capital gain rates, currently 15%. Owning growth stocks outright actually provides tax deferral until sold AND a lower tax rate. But owning stocks in an annuity means the growth will be taxed at withdrawal as ordinary income.

So, the variable annuity might cost you 20% more in taxes in addition to higher fees. That’s not such a good deal. There may be other reasons to own a variable annuity with growth investments, but tax deferral alone is not one of them.

The upshot? An annuity’s chief benefit is tax-deferral on conservative income for taxable assets. Virtually every other facet of owning an annuity from safety to fees to growth to flexibility is available elsewhere, usually in better measure. That said, contract guarantees and the ability to annuitize have their place – for those with such needs who consider the trade-offs and count the costs.

Hopefully, these examples show why it’s important to put on your thinking cap before you take out your pen. When designed properly for the right situations, annuities offer effective solutions to financial problems. We know every financial decision involves trade-offs – but annuity pros and cons may not be easy to identify. You should take your time and get good advice.

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