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So in my retirement and personal investing I have some stocks (very little), a Roth IRA, a Roth 401K and a Traditional 401K (later two are from work and I split things right now).

At my age and research I don't run across a lot of annuity type of things but when I talk to my dad (mid-60's) that's all he hears about and has some investments in annuities.

So are they good or bad? Is it an investment that I should eventually look into down the road?

Don't know much about them or what an 'annuity' means.

Any explanation would be appreciated!

  • 3
    If you have very little in stocks, how are your IRA and 401(k) accounts invested? How are you splitting between the 2 401(k) flavors? – JoeTaxpayer May 1 '13 at 20:00
  • 4
    One of the most important things to understand is why investment people will apply the hard sell for this type of investments. The commissions/fees are massive and generate a LOT of profit for the broker. Keep in mind that motivation whenever you hear a broker (aka salesman) pitch them. – JohnFx May 2 '13 at 2:39
  • 3
    @JohnFx - why not offer a detailed answer addressing these high cost annuities? My answer below should be joined by others to offer a comprehensive response to Valien – JoeTaxpayer May 2 '13 at 2:54
  • 2
    DC - the link has a high level overview, I am still hoping to see someone offer an objective description of a commonly sold VA. – JoeTaxpayer May 4 '13 at 16:13
  • 1
    @JoeCoderGuy - the challenge is set before you, a full answer describing why would be great. – JoeTaxpayer May 6 '13 at 4:41
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+100

If you're looking for a quick answer about variable annuities, jump down to the Summary and Citations/Resources sections below. My answer is mostly specific to the US.

I'll try to give an overview of variable annuities and some of the benefits and drawbacks to them, since they're both heavily marketed and highly complex. The answer is pretty long because VA's are complex investment vehicles, but I wanted to give as thorough answer as possible. I gleaned much of the information from the SEC and added points that weren't covered sufficiently. I hope other members can give detailed answers about other forms of annuities.

Overview

In their simplest form, annuities normally have two phases:

  1. The accumulation phase - The customer (you) deposits money into the account
  2. The distribution/payout phase - The insurance company pays the customer until the death of the person(s) ("annuitants") listed in the contract.

Investopedia defines a simple annuity as:

An insurance contract in which, at the end of the accumulation stage, the insurance company guarantees a minimum payment [to the customer]. The remaining income payments can vary depending on the performance of the managed portfolio.

The managed portfolio usually invests in a mixture of mutual funds, but variable annuities differ from mutual funds in a standard brokerage account or other investment vehicles, like IRA's, 401K's, etc., in several ways. (Much of the following information is summarized from the SEC's thorough page on variable annuities.)

  1. Since variable annuities allow you to receive periodic payments for either the rest of your life or the rest of a designated person's life, they protect you against the possibility that, after you retire, you outlive your assets, e.g. your IRA, 401K, etc.

  2. Many variable annuities come with a death benefit. If you die before the beginning of the distribution phase, your designated beneficiary is guaranteed to receive a specific amount. This amount is typically at least the amount of your purchase payments. Your beneficiary may even profit financially if, at the time of your death, your account value is less than the amount guaranteed by the insurance company. Some annuities offer a "stepped-up death benefit," in which the death benefit is greater than the amount of the payments. However, additional fees will most likely apply (see below).

  3. Variable annuities are tax-deferred investment vehicles, so you pay no taxes on the income or investment/capital gains from your annuity until you withdraw your money. However, when you withdraw money out of a variable annuity, you are taxed on the earnings at ordinary income tax rates rather than the lower capital gains rates. In general, the benefits of tax deferral will outweigh the costs of a variable annuity only if you hold it as a long-term investment to meet retirement and other long-range goals, and even then, this might not be the case.

The third point, especially the part I emphasized, is extremely important. The SEC page gives the following warning, and I think it's best if I quote it in its entirety (and obviously, that anyone interested in a variable annuity reads it completely):

Caution!

Other investment vehicles, such as IRAs and employer-sponsored 401(k) plans, also may provide you with tax-deferred growth and other tax advantages. For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity.

In addition, if you are investing in a variable annuity through a tax-advantaged retirement plan (such as a 401(k) plan or IRA), you will get no additional tax advantage from the variable annuity. Under these circumstances, consider buying a variable annuity only if it makes sense because of the annuity's other features, such as lifetime income payments and death benefit protection. The tax rules that apply to variable annuities can be complicated – before investing, you may want to consult a tax adviser about the tax consequences to you of investing in a variable annuity.

Remember: Variable annuities are designed to be long-term investments, to meet retirement and other long-range goals. Variable annuities are not suitable for meeting short-term goals because substantial taxes and insurance company charges may apply if you withdraw your money early. Variable annuities also involve investment risks, just as mutual funds do.

If you invest in a variable annuity through a retirement plan, not only will not receive any additional tax benefit, but the fees and charges will probably add up to provide you less benefit than had you invested in similar mutual funds in your retirement plan directly.

Charges and Fees

Variable annuities often come with various charges and fees that decrease the overall return on the investment and may potentially make them unsuitable investments for some people.

  1. Surrender charges - If you withdraw money from a variable annuity within a certain period after a purchase payment, the insurance company will usually charge you a percentage of the amount withdrawn. This percentage usually declines gradually over several years until it no longer applies. The length of time in which is applies is called the "surrender period," and it varies from contract to contract. Some insurance companies will allow you to withdraw a small percentage of the account value each year without paying a charge.

  2. Mortality/expense risk charge - Insurance companies normally charge you a certain percentage of your account each year, typically in the range of 1.25% a year. Depending on the performance of the managed portfolio in which the annuity is invested, this could absorb a good portion of the portfolio's return.

  3. Administrative fees - This is a general fee the insurance company assesses your account. It could be either a flat fee ($25-$30 a year, usually) or a small percentage of the account's value.

  4. Expenses of the underlying fund(s) - These are the fees and expenses imposed by the mutual funds that comprise the annuity. Although you pay these regardless (all mutual funds have expenses), some mutual funds have more than others. As a hypothetical example, two annuities could claim that they invest in an index fund of the S&P 500, but if one invests in a Vanguard Admiral Shares fund, the expense ratio could be as low as 0.05, while the other annuity could invest in an index fund that attempts to match the same index, but with a much higher expense ratio. Mathematically, the returns won't be the same.

  5. Other fees and charges - Special features, like the stepped-up death benefit described above, long-term care insurance, etc. will almost certainly come with additional fees. Consult the annuity's prospectus to find detailed information.

Bonus credits

Some insurance companies are now offering "bonus credits," which promise to add a bonus to your account value based on a certain percentage, usually 1% to 5% of your purchase payments. As usual, however, there are potential downsides. (I'm going to quote the SEC page almost verbatim here.)

  1. Higher surrender charges - Surrender charges may be higher for a variable annuity that pays you a bonus credit than for a similar contract with no bonus credit.
  2. Longer surrender periods - Your purchase payments may be subject to surrender charges for a longer period than they would be under a similar contract with no bonus credit.
  3. Higher mortality and expense risk charges and other charges - Higher annual mortality and expense risk charges may be deducted for a variable annuity that pays you a bonus credit. Although the difference may seem small, over time it can add up. In addition, some contracts may impose a separate fee specifically to pay for the bonus credit.

The SEC provides the following warning:

Before purchasing a variable annuity with a bonus credit, ask yourself – and the financial professional who is trying to sell you the contract – whether the bonus is worth more to you than any increased charges you will pay for the bonus.

You should also note that a bonus may only apply to your initial premium payment, or to premium payments you make within the first year of the annuity contract. Further, under some annuity contracts the insurer will take back all bonus payments made to you within the prior year or some other specified period if you make a withdrawal, if a death benefit is paid to your beneficiaries upon your death, or in other circumstances.

If you already own a variable annuity and are thinking of exchanging it for a different annuity with a bonus feature, you should be careful. Even if the surrender period on your current annuity contract has expired, a new surrender period generally will begin when you exchange that contract for a new one. This means that, by exchanging your contract, you will forfeit your ability to withdraw money from your account without incurring substantial surrender charges. And as described above, the schedule of surrender charges and other fees may be higher on the variable annuity with the bonus credit than they were on the annuity that you exchanged.

Tax-free "1035" Exchanges

Again, the SEC says it best:

Section 1035 of the U.S. tax code allows you to exchange an existing variable annuity contract for a new annuity contract without paying any tax on the income and investment gains in your current variable annuity account. These tax-free exchanges, known as 1035 exchanges, can be useful if another annuity has features that you prefer, such as a larger death benefit, different annuity payout options, or a wider selection of investment choices.

You may, however, be required to pay surrender charges on the old annuity if you are still in the surrender charge period. In addition, a new surrender charge period generally begins when you exchange into the new annuity.

Obviously, you should compare both annuities carefully, and remember that since variable annuities are only really useful as long-term investments (if at all), are you willing to, in effect, start your investment horizon over with a new annuity? Just because you don't pay taxes on the old annuity doesn't mean you won't pay fees. If you surrender the old annuity for cash and then buy a new annuity, you will have to pay tax on the surrender.

Other pitfalls

These are other pitfalls with variable annuities; I mention these specifically because they aren't mentioned on the SEC page. I quoted verbatim where indicated because the descriptions were detailed enough in the original article.

  1. Investment options are normally limited and usually have high underlying expense ratios. These expense ratios can eat away at your return above and beyond the various fees.
  2. "Annuities are disadvantageous to inherit if they don’t go to a spouse. If the money formerly was after-tax dollars, the heir receives no step-up in basis on accounts with gains. If you invest the same dollars (after tax) in a stock fund, your heirs benefit from a step-up in basis at the date of death or 9 months later."
  3. "Variable annuities typically lack liquidity and can tie consumer money down with prolonged surrender penalty periods."
  4. "Variable annuities convert lower capital gains rates on taxable income (if the annuity is purchased with after-tax dollars) into a higher tax rate levied on ordinary income. This can cost consumers significant tax dollars down the road."

Potential benefits

The Forbes article, as well as this page, describe a few specific cases where buying a variable annuity may make sense, and I tried to scrounge up more information to see if there were any other circumstances where such vehicles may prove advantageous. As always, consult a professional (and the summary below) before making a decision. Vanguard also offers some points about deciding if certain types of annuity are good for you.

  1. Three-quarters of US states protect variable annuity assets from creditors. Regular IRA's don't benefit from protection under the Employee Retirement Income Security Act (ERISA) and may therefore be more vulnerable to creditors. A tax professional with more experience in debt negotiation may be able to provide more information. This may be an option for you if you're a potential target for lawsuits.
  2. You are a retiree who has barely enough money to live on and needs to receive a monthly payout to survive, and for whatever reason, you have no other options like Social Security, dividends, etc.
  3. You want to benefit from market upturns during retirement but want some protection from downturns. There are better investment mixes that could offer this, but it's something to think about.

If you fall into any of the above categories, it doesn't mean that you should immediately run out and buy a variable annuity. All of the details and potential pitfalls discussed in this answer still apply.

Questions to ask yourself

The SEC provides a checklist of questions you should ask yourself, and I'm going to post them here as well because they're both sensible and necessary, in my opinion. I've added a few notes to them, so see the SEC link for the originals.

  1. Will you use the variable annuity primarily to save for retirement or a similar long-term goal?
  2. Are you investing in the variable annuity through a retirement plan or IRA? Remember that this means you are not receiving any additional tax benefit and may in fact incur a loss because of fees and charges.
  3. Are you willing to take the risk that your account value may decrease if the underlying mutual fund investment options perform badly? Although you may receive a guaranteed payment, this may not be enough to cover your lifestyle if you're relying on investment returns to provide you a payment above and beyond the guaranteed amount.
  4. Do you understand the features of the variable annuity? Are you sure?
  5. Do you understand all of the fees and expenses that the variable annuity charges? Are you sure?
  6. Do you intend to remain in the variable annuity long enough to avoid paying any surrender charges if you have to withdraw money? Have you considered potential changes in your health that would require you to lapse in your payments or withdraw the money in case of an emergency? Health risks are especially difficult to anticipate, but you should be prepared for them as much as possible.
  7. If a variable annuity offers a bonus credit, will the bonus outweigh any higher fees and charges that the product may charge?
  8. Are there features of the variable annuity, such as long-term care insurance, that you could purchase more cheaply separately?
  9. Have you consulted with a tax adviser and considered all the tax consequences of purchasing an annuity, including the effect of annuity payments on your tax status in retirement?
  10. If you are exchanging one annuity for another one, do the benefits of the exchange outweigh the costs, such as any surrender charges you will have to pay if you withdraw your money before the end of the surrender charge period for the new annuity?

Summary

Before purchasing a variable annuity, you should probably do all, if not more, of the following:

  1. Read the linked SEC page in its entirety to become familiar with the terminology; I summarized a good amount of the information, but the SEC gives numerical examples and even more details.
  2. Read the prospectus of any annuity you're interested in purchasing. Keep an eye out for any and all fees, bonuses, details about the underlying funds, etc.
  3. Consult a tax adviser who isn't affiliated with the insurance company selling the annuity to see what, if any, tax benefits you will receive by purchasing an annuity.
  4. One specific point: remember that the fees, especially the mortality/expense risk charge, could absorb most of the earnings of the annuity's underlying portfolio. Remember that the typical 1.25% annual charge is in addition to all other fees, inflation, and general market risk.
  5. If you do consider buying an annuity, think about going through Vanguard or another reputable company. Although Vanguard is considered a reputable company, their annuities are sold through other companies. I like Vanguard as a company (no affiliation, however), but I don't know how they vet these companies or their products. It might be a place to start, however.

Citations/Resources

  1. The SEC page on variable annuities.
  2. The Investopedia page I linked to above gives a definition, an explanatory video, and links to concise overviews of other types of annuities.
  3. Vanguard offers a brief summary of the potential benefits and drawbacks to different types of annuities.
  • 5
    An Amazing summary. You have my vote for bounty. – JoeTaxpayer May 7 '13 at 18:55
  • Fantastic summary! Very concise and provided all the info I needed. Definitely answered my questions on what a VA and Annuities are in general. Thanks so much. Have a vote! – Valien May 20 '13 at 14:04
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Annuity is a word that doesn't have one exact meaning, unfortunately.

At its very simplest, an immediate annuity (IA) is purchased and you receive a rate that's higher than the market rate in exchange for your money. The cash stream is until you die.

For example, today a 65 year old man can get 6.80% by buying the IA. There are a myriad of options for a spouse survivor, guaranteed payouts for a number of years, etc. The 6.8% will be paid until death, but that can be a few days or 40 years away. A certain fraction of the return is considered return of principal, so not all the income is taxable.

Depending on one's circumstance, the IA can be a good decision. A 75 year old man fearing he'll outlive his money withdrawing 4-5% per year can trade the principal (i.e. his kid's inheritance) for a 9.24% annual return. Spend 6.25%, save 3% as an inflation hedge.

There are other types of annuities, Variable Annuities, Equity Indexed Annuities, etc. I hope another poster will go into detail on the others. I am not a fan of these. They tend to have a high expense, and I have formed my own opinion that they exist to fund the grad schools of the child of the salesmen who sell them.

protected by John Bensin Jun 4 '13 at 17:32

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