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This is a personal finance question as annuities are only as good as the company that insures them.

Annuities from reputable companies often yield 7% or more on paper before any fees, taxes or distributions etc.

The question is: how are annuities able to yield that much, what exactly are the contents of annuities. Other passive investments such as savings accounts, bonds and CDs only yield a fraction of a percent currently. Regarding bonds, low interest means it is less risky.

I haven't been able to get a straight answer from anyone, even investment bankers and annuity sellers about this, I have a general idea though but need it confirmed. I know for a fact some annuities are practically guaranteed by new people opening annuities, and even if that wasn't the original intent, that is the outcome after a steady stream of clients comes in (ie. continuous retirees in a state run institution).

The reasons its difficult to get a straight answer is because:

1) The issuer gets to collect SEC mandated 10b-5 fees. This is usually a percentage of the annuity. They don't care about the contents of the annuity

2) The sellers gets a commission for selling the annuity, regardless of how good it is for the client. Again, they don't care about the contents of the annuity

Regardless of what kind of discretion is required by their various licenses, I personally know people in that business that don't know and don't care and make 7 figures of income from this bliss.

So maybe its better just to not say that some are analogous to a ponzi scheme, despite how institutionalized the products are, but since they are not currently insured any industry agency or government agency, I am just curious how one would know or find out how exactly the annuity makes the 7+% per year.

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Are these annuities offered under prospectus? –  Chris W. Rea Dec 23 '12 at 20:12
    
good question, I can look for those. But even in variable/equity linked annuities, they simply offer a percentage premium and say they are in the S&P even though the stock market isn't offering nearly those returns –  CQM Dec 23 '12 at 20:39
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3 Answers

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An annuity is a contract. Its contents are "a contractual obligation from the issuing company". If you want to evaluate how your annuity is likely to fare, you're essentially asking whether or not its issuer will honor its contract. They're legally required to honor the contract, unless they go bankrupt. (Even if they do go bankrupt, you will be a creditor and may get a portion of the assets recovered by the bankruptcy process.) Generally, the issuer will take the proceeds and invest them in the stock market (or possibly in similar instruments - e.g. Berkshire-Hathaway bought a railroad and invests some money in it directly). They invest in these places because that's where the returns are.

One of the reason that annuities may have a good rate on paper is that they may end up taking some of your principal, because many are structured as some form of survivor's insurance policy. Consider: If you're 65 years old and have some retirement savings, you'd like to be able to spend them without fear of them running out because you live longer than you expected (e.g. you survive to your 90s). So, you could invest in the stock market and hope for a 7% return indefinitely and then plan to spend the returns - but if those returns don't materialize for a few years because there's a big stock market crash, you're in big trouble! Or, you could buy an annuity contract which will pay you 7% a year (or more!) until you die. Then you're guaranteed the returns unless the issuer goes bankrupt. (Sure, you lose all your principal, but you're dead, so hey, maybe you don't care.) The insurance company essentially sells risk-tolerance.

Other annuities aren't structured like this, and may be marketed towards non-retirees. They're usually not such a good deal. If they appear to be such a good deal, it may be an illusion. (Variable annuities in particular are hard to reason about without a good deal of knowledge about how the stock market behaves on a year-to-year basis: many of them have a maximum return as well as a minimum, and the stock market may pile up a lot of its returns into one year, so after a "crash and recovery" cycle you might end up behind the market instead of ahead.)

Annuities are a form of safety. Safety can be very expensive. If you're investing your own money, consider whether you need that safety. You probably needn't worry quite so much about the issuer being crazy-fraudulent or Ponzi-esque: you should worry mostly about whether it looks better on paper than it is.

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This is really two questions about yield and contents.

Content

As others have noted, an annuity is a contractual obligation, not a portfolio contained within an investment product per se. The primary difference between whether an annuity is fixed or variable is what the issuer is guaranteeing and how much risk/reward you are sharing in. Generally speaking, the holdings of an issuer are influenced by the average "duration" of the payments. However, you can ascertain the assets that "back" that promise by looking at, for example, the holdings of a large insurance or securities firm. That is why issuers are generally rated as to their financial strength and ability to meet their obligations. A number of the market failures you mentioned were in part caused by the failure of these ratings to represent the true financial strength of the firm.

Yield

As to the second question of how they can offer a competitive rate, there are at least several reasons (I am assuming an immediate annuity) :

1) Return/Depletion of Principal

The 7% you are being quoted is the percent of your principal that will be returned to you each year, not the rate of return being earned by the issuer.

If you invest $100 in the market personally and get a 5% return, you have $105. However, the annuity's issuer is also returning part of your principal to you each year in your payment, as they don't return your principal when you eventually die. Because of this, they can offer you more each year than they really make in the market.

What makes a Ponzi scheme different is that they are also paying out your principal (usually to others), but lie to you by telling you it's still in your account. :)

2) The Time Value of Money

A promise to pay you $500 tomorrow costs less than $500 today

A fixed annuity promises to pay you a certain amount of money each year. This can be represented as a rate of return calculated based on how much you have to pay to get that annual payment, but it is important to remember that the first payment will be worth substantially more in real purchasing power than the last payment you get. The longer you live, the less your fixed payment is worth in real terms due to inflation!

In short, the rate of return has to be discounted for inflation, it is not a "real" rate of return. In other words, if you give me $500 today and I promise to pay you $100 for the next 5 years, I am making money not only because I can invest the money between now and then, but also because $100 will be worth less five years from now than it is today. With annuities, if you want your payment to rise in step with inflation, you have to pay more for that (a LOT more!).

These are the two main reasons - here are a few smaller ones:

3) A very long Time Horizon

If the stock market or another asset class is performing well/poorly, the issuer can often afford to wait much longer to buy or sell than an individual, and can take better advantage of historical highs and lows over the long term.

4) "Big Boy" investing

A large, financially sound issuer can afford to take risks that an individual cannot, such as in very large or illiquid assets, such as a private company (a la Warren Buffet).

5) Efficiencies of scale

Institutional investors have a number of legal advantages over individuals, which I won't discuss in detail here. However, they exist. Large issuers are also often in related business (insurance, mutual funds) such that they can deal in large volumes and form an internal clearinghouse (i.e. if I want to buy Facebook and you want to sell it, they can just move the stock around without doing any trading), with the result that their costs of trading are lower than those of an individual.

Hope that helps!

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For a variable annuity, you need to know the underlying investments and how your returns are credited to your account.

For a fixed annuity, the issuer is responsible for the commitment to provide the promised rate to you. In a sense, how they invest isn't really your concern. You should be concerned about the overall health of the company, but in general, insurance companies tend to know their business when they stick to their strengths: writing insurance on groups and producing annuity contracts.

I don't care for VAs or the fixed annuities you asked about, but I don't believe they resemble a ponzi scheme, either.

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I know these things, but my main concern is that nobody knows or is concerned about the contents of their investments. I get it, but for example Lehman Brothers had a great credit rating (dictating their health) the day before they filed for bankruptcy. Annuity issuer or not, the point is that someone should be able to answer the question about the contents and it concerns me, is that the reality or am I looking in the wrong place –  CQM Dec 27 '12 at 2:59
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I don't believe they have 'contents' they are an obligation of the company. They are very different from a VA or mutual fund. –  JoeTaxpayer Dec 27 '12 at 3:03
    
thanks, so as long as the company keeps its cashflow stable, regardless of where that cashflow comes from.... I understand, good to know –  CQM Dec 27 '12 at 3:17
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@CQM - I'd say that's my suggestion. I didn't mean to be dismissive regarding the company itself. I could have a million dollar life insurance policy, and think I did the right thing, but proper diligence means researching the issuing company's financial stability. –  JoeTaxpayer Dec 27 '12 at 23:03
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