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Money Matters




February 17, 2017
Friday PM

jpg Money Matters by Mary Lynn Dahl

Mary Lynn Dahl

(SitNews) Ketchikan, Alaska - A financial planner that I know recently mentioned to me that she had a new client who asked her to explain annuities. The planner had not recommended an annuity but the investor was interested and wondered why not, because he had seen a commercial on TV which he said claimed that you could not lose money and your return could only go up, not down, with a certain kind of annuity. The investor was attracted to that idea, of course. Who wouldn’t want an investment that could not lose money and which guaranteed a return that would only go up and never down? It sounded too god to be true, which should be a warning flag. Too often, it is not.

What is an annuity? An annuity is not simply an investment like a mutual fund or stock. It is an insurance product that combines insurance with investments. In simple terms, it uses an insurance contract to provide the insurance portion and a mutual fund or similar investment to provide the investment portion. When someone invests in an annuity, part of the money buys insurance and part goes into an investment, and there are problems with this as an investment strategy. One of the main problems is high fees.

According to Fisher Investments, annuities are so loaded with fees that this firm advertises on national TV against owning them. Our own research bears this out as being true in most cases. Typical fees charged by annuities are fees for mortality expense (in case the insured dies), fees for administration, fees for managing the investment portion, fees for “riders” that can be added to the contract for special benefits and a penalty fee for cancelling the contract before a certain date, usually 5-10 years from the date of purchase. According to research done by Fisher Investments, these fees can add up to 3.95% and is the primary reason why so many annuities do not perform as well as traditional, non-insurance investments such as stocks, bonds, exchange traded funds and mutual funds.

Another negative is that annuity salespeople are paid a commission for selling each annuity to investors, often as much as 5% - 8% up front. This creates a conflict of interest for the salesperson who offers the annuity as an investment. The combination of this conflict of interest and the high fees is why so many financial planners do not recommend them to their clients.

Another reason why financial planners often do not recommend annuities to clients is that they are complicated and difficult for the average person to understand. The contracts are filled with technical jargon, endless pages of insurance language, a myriad of choices, odd terminology not familiar to average investors and very little transparency about any of the details. Nevertheless, people do buy them. Why?

Usually it is because of several key selling points utilized by the annuity salesperson. Often, the main selling point uses the word “guaranteed”. Many annuities provide a guarantee of a minimum return, regardless of market returns or interest rates. Unfortunately, that minimum return, paid out for very long periods of time, usually turns out to be far less than the average return of the underlying markets available outside of the annuity contract. So, how does an annuity actually work?

There are 3 kinds of annuity contracts. One is a “fixed rate” annuity. It pays an interest rate that is permanently fixed for a specific period of time and may or may not also include a traditional insurance policy death benefit.

Another kind of annuity is called a “variable” annuity. It allows the owner to invest in the stock and bond markets, usually via mutual funds or similar pooled investment choices. It includes an insurance policy death benefit and all kinds of riders for specific benefits, multiple investment choices and various conditions on the investment returns, such as “caps” and “floors”. Caps are maximum returns allowed and floors are minimum returns promised, regardless of the actual returns of the underlying investments in the contract.

A third type of annuity is called an “indexed” annuity. It is even more complicated and is based on an investment return that is pegged to the return of a stock or bond market benchmark, such as the S&P 500 index. Many state and federal regulators have issued warnings about indexed annuities on their web sites, saying that they are not suitable for average investors and carry too much risk, in spite of the annuities ads that emphasize a guaranteed return or guaranteed stream of income to the investor at a later date.

The reason so many government regulators warn against these annuities as investments is that the cost to get the promised benefits is too high. The fees, early withdrawal penalties, sales commissions and benefit restrictions are excessive when compared to the actual benefits received by the investor. In most cases, there are better ways to get the benefits being sought by an investor, such as a stable and predictable stream of income at retirement. There are also better ways to invest with less risk than through an annuity, especially a variable annuity, which utilizes the exact same stock and bond markets to produce a return that any investor can utilize herself without buying and annuity.

All investments have risk. Managing and reducing risk can be done without paying the high fees of most annuities. It requires a sound investment plan that is customized to the investor and should be carefully crafted to reflect the various details of that investor’s personal situation in life at that time.

For investors who seek a stable stream of income at retirement, the biggest risk they face is inflation. A distinct disadvantage of most annuities is that the income they promise is almost always a fixed amount paid monthly or quarterly and therefore cannot keep up with inflation. It is not flexible and cannot be changed once it starts. It uses up the principal, leaving nothing for heirs. It cannot be used for lump sum withdrawals. In some cases, it is based on a single life and ends at the death of the insured, regardless of how much income has been paid out. In almost all cases, the income paid out is based on a low rate of return that is not competitive.

The bottom line is that you not only pay a lot for benefits that may not be worth the expense, you also give up a lot to get that guarantee. In my opinion, it is not a fair exchange of costs and benefits.

Annuities do have tax consequences that should be noted. The earnings are tax-deferred until withdrawn, like an IRA or 401-K, but the contributions are not tax deductible from your taxable income. Annuity profits are not eligible for capital gains when realized, so they are taxed as ordinary income rates, which are usually higher than capital gains rates for most tax payers. In addition, at death, your heirs do not get a step up in basis on the value of the annuity, so if they cash it in they will pay far more in taxes than if they had inherited those funds outside of an annuity. All of these tax consequences are important, but they are often never discussed when the annuity is proposed by the salesperson.

Before you buy that annuity that looks so attractive, read the entire contract….every single page. If you don’t understand it, ask questions or get an opinion from an unbiased professional. Find out what fees will be charged, what penalties exist for early withdrawal, how much the sales commission is, what restrictions there are on getting benefits, how long the contract lasts, what makes the investments portion grow in value, what riders it offers and what they mean, what tax consequences it will produce on your estate and heirs, what limits there are on investment returns, what happens when the policy matures and what interest rate is used when the income starts being paid. If you don’t like the answers you get, this annuity is not for you. If you do like them, maybe it is.

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©2017 Mary Lynne Dahl, CFP® is a Certified Financial Planner ™ and partner in Otter Creek Partners, a fee-only registered investment advisor firm in Ketchikan, Alaska. These articles are generic in nature, are accepted general guidelines for investment or financial planning and are for educational purposes only.

Mary Lynne Dahl©2017

Mary Lynn Dahl can be reached at


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