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Money Matters




May 07, 2018
Monday PM

(SitNews) Ketchikan, Alaska - Recently, I have been asked by quite a few people to explain annuities.

Having been in the business of financial planning and investments for over 34 years now, I am familiar with patterns and cycles that are almost predictable. One of these patterns is that some people get so rattled by the ups and downs of the market that they start looking for investments that offer relief from the volatility by promising guarantees. Seeking a guarantee is understandable, of course, but is it a good idea? Well, in order to answer that question, let’s take a closer look at annuities.

jpg Money Matters by Mary Lynn Dahl

Mary Lynn Dahl

Annuities are insurance products. They mimic other investments for a very specific reason, which is that they were invented to compete with other investments, mutual funds in particular. In the beginning, insurance companies sold insurance to offer protection from losses resulting from death, fire, accident, etc. However, at some point, insurance companies noticed that people were putting money into mutual funds and the insurance companies wanted a piece of that market. In order to get a foothold in the mutual fund marketplace, they invented annuities. This allowed the insurance companies to compete for the investment dollars going to mutual funds. The result is that annuities have become a very profitable source of revenue for many insurance companies.

Annuities are basically insurance policies that include a contract for a savings or investment account in addition to the death benefit. There are basically 3 kinds of annuities: fixed, variable and indexed. I will explain each one separately.

Fixed annuities simply pay an interest rate, like a CD, for a specific period of time. They usually pay a higher rate of interest during the accumulation period (such as 10 years) and a lower rate of return when they are “annuitized” (paid out as income). The interest rate is usually guaranteed, sometimes for a year at a time, sometimes for longer. Fixed annuities are often used to fill in gaps in income for people who retire early and want income prior to becoming eligible for Social Security or a pension.

Variable annuities are policies that offer mutual funds in what are called “sub accounts” which are invested in the stock and bond markets. They do not guarantee a rate of return on the investments used, but many do guarantee the principal .The idea with variable annuities is that you can participate in the stock and bond market, without as much of the risks of the stock and bond markets, plus have the potential to earn higher returns than if you simply get a fixed interest rate on your money.

An indexed annuity is one that pays a rate of return that is tied to an index (a benchmark) in the market, such as the S&P500 Index. The return does not actually match the index; it is calculated as a percentage of the index and is limited by a “cap” that is the maximum that the insurance company is willing to pay. For example, if the index earned 15% in one year, the annuity policy may promise to pay 50% of that return up to a cap of 6%. So, 50% of 15% is 7.5% but since the cap is 6%, the annuity would earn 6% that year.

In volatile markets, these characteristics may look attractive to investors, but they come with a very complicated set of rules, restrictions, conditions, fees and costs that most investors simply do not understand.
With these facts in mind, what are the pros and cons of annuities? Should you consider buying one? Are they a good investment for you to purchase? Maybe, maybe not. The bottom line is that you should not sign a contract that you have not read and fully understood, nor should you invest in anything that you cannot explain and do not understand. You should ask questions until you do understand and can, in fact, explain what you are buying.

So, what are the details that are so important to actually understand? Read on.

Let’s start with the benefits of annuities. They are easy to buy. The insurance company does all the work. You just write a check and hope for the best. At some point you begin to withdraw your money with whatever it has earned and again, the insurance company does all the work. They defer taxes until you withdraw in many cases, so you don’t pay a lot of taxes while you accumulate or hold the annuity, and that’s nice. You either get a guaranteed rate of return or the potential for market returns on your investment, without much risk. And, you get a guaranteed death benefit in the event that you die before you begin to take withdrawals. All of that is what attracts most people to annuities.

However, there is a cost for all of this and it is pretty hefty. Costs are a major downside and should be fully understood by the investor considering purchase of an annuity.

The first big expense you will pay is a sales commission to the agent who sells you the annuity. This can pretty high, typically over 5% of the value of the annuity at purchase, according to a report by the US Securities & Exchange Commission (SEC).

Then, there are fees. The first one charged against the annuity is the mortality expense, which pays for the death benefit included in the policy. According to Fisher Investments’ analysis of typical annuity fees, the mortality charge is typically as much as 1.00% - 1.18%, followed by an administrative fee of from .15%-.19%. In addition, variable annuities charge for riders, which my own research shows as being from .65% - 1.00% for management of the underlying mutual funds in the policy, plus riders that guarantee the benefits most people select and which typically run from .50% to 1.10%, per rider. Variable annuities are generally sold with at least 2 riders of this kind, so this adds up. These are on top of the sales commission the investor pays at the start. Separate from the sales commission that you will pay, these fees typically range from about 3.25% to 4.00% of the value of the annuity. That is a pretty expensive way to avoid market volatility.

But that is not all; there are more fees in store. Annuities also have a fee called a “surrender charge”. This is charged to the policy if and when the owner takes a withdrawal prior to a set date in the future, usually about 7 years from the date of purchase on most annuities. An exception to this is when an investor purchases what is called an immediate annuity, which starts an income stream right after purchase, without surrender charges. Some annuities allow a small withdrawal annually with no fee or penalty but do charge an additional penalty or fee on any excess amount withdrawn if it exceeds that small allowable amount.

Finally, many annuities, especially indexed or variable annuities, have “floors” and “caps” that limit minimums and maximums that the insurance company is obligated to pay to an investor. These limits can have the effect of a fee by reducing the potential returns on investment that the policy will pay.

Another downside to annuities is that they are inflexible. Once you begin to take withdrawals, as retirement income for example, the amount you will receive will not change; it is fixed and permanent.

This lack of flexibility can become a real problem down the road when you really need to have a little more income just to keep up with inflation. Over time, the amount of your annuity payment may not be enough, but because it has been annuitized, you are stuck and cannot change it. I really don’t like income streams that are inflexible because I know from experience that good financial planning requires a gradual increase in income for retired people trying to keep up with inflation. Living on a fixed income is not a good financial plan for anyone, and an annuity locks you into exactly that kind of problem.

So, if the convenience and guarantee of an annuity is worth the cost and the problem of an inflexible stream of income in retirement does not concern you, an annuity may be right for you. If not, you are better off investing outside of an annuity. How would you go about doing that if you decide that an annuity is not for you? How would you get the tax advantages of deferral of income taxes that annuities offer? How would you get a reliable stream of income in retirement? How would you get a guaranteed death benefit for your heirs if this is needed? How can you achieve these goals without using an annuity?

Let’s look at these goals one at a time, starting with tax benefits.

TAX BENEFITS: The answer is that an IRA or ROTH can provide tax benefits if you want them. An IRA gives you a deduction and defers taxes on all earnings on the investments until you begin withdrawals, while a ROTH does not give you a deduction but when you begin withdrawals they are tax free. Either of these is better than an annuity which only offers tax deferral on the earnings, not a deduction and not tax free income. The same advantages as IRAs and ROTHs are available if you invest in a 401-K or similar employer plan, as well, so it is not hard for most people to get tax advantages without using an annuity.

What about the problem of investing a large lump sum? You cannot put a large amount in an IRA or ROTH, so if you want tax advantages, your only option is an annuity, correct? No. You can invest in a portfolio of funds that do not pay dividends but grow in value instead. Since they do not produce dividends, there is minimal taxable income to report on your return during the years of accumulation. At some point, when you begin an income stream, you will want to sell shares, on which you will pay long term capital gains taxes (on the increase in value of the shares), but long term capital gains are at a lower rate than ordinary income taxes, which is how annuity income will be taxed. This is a good strategy to use in lieu of using an annuity.

A RELIABLE, STABLE STREAM OF INCOME: This can be achieved, and is routinely achieved every day by individuals, pension funds, endowment funds and ordinary accounts designed to produce reliable income, by using an asset allocation strategy that is broadly diversified, conservatively invested and well managed to reduce risk and maximize returns. It is a science and an art but is not an impossible task to design, build, manage and monitor a portfolio that can produce a stable stream of income. It is not rocket science, but it does require a sound strategy, a disciplined, long term financial plan and sometimes the help of a professional to stay the course and avoid common investment mistakes.

What about the returns on investments in an annuity compared to a non-annuity portfolio designed as described above? According to studies done by Fisher Investments, a well-respected portfolio management firm, the historical average return of the S&P500 index from 1926 to 2013 was an average of 11.6%, compared to 6.0% for US Treasury bonds of 7-10 years and 3.5% for the average return of indexed annuities. Fisher Investments has long studied annuities and has a wealth of information about the pros and cons of annuities, providing data that is very helpful when doing analysis of a particular annuity being considered. Using their data, it appears that average variable and index annuity investment returns are about half of the returns of the S&P500 index. A diversified portfolio of many asset classes, using a multiple index approach results in similar comparisons, in which annuities greatly underperform in all categories and portfolio examples. The bottom line on performance is that annuities do not perform as well as these market benchmarks, largely because of the fees and expenses that annuities charge but also because the returns are limited by floors and caps as well.

A GUARANTEED DEATH BENEFIT: As for having a death benefit, it is much less expensive to buy it as term life insurance, usually for a period of time until you will no longer need it. You will pay less for the death benefit and not pay all of the high fees that the annuity charges. At some point, most people with a good financial plan no longer need much, if any, life insurance. What they do need is a solid, well diversified investment plan that is cost-efficient, straightforward and understandable, and which can produce a stable stream of income that is flexible and inflation protected. Annuities do not provide these benefits.

In summary, if you want a guarantee, prefer having a death benefit in your investment portfolio, don’t mind paying sales commissions and fees of up to 3%-4% annually and you are not concerned about the effects of inflation on a fixed income in retirement, an annuity may be ok for you. If you do mind and want to avoid the fees and limitations of an annuity, it will not work for you. The bottom line is: know what you are getting before you make this important financial decision.



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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©2018

Mary Lynn Dahl can be reached at


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