The Good, the Bad, and the Ugly of Annuities

The following is a summary of our recent podcast interview, which can be accessed on our site here or on iTunes here.

For many, an annuity can be a great way to shelter capital for retirement, however, as with most contracts, all of the nuances, fees, expenses, and details need to be understood up front.

This time on Financial Sense we spoke with Rob Bernard, a financial advisor at PFS Group, about what investors need to know when considering annuities, and how to make the most of the benefits annuities offer.

The Ins and Outs of Annuities

There are three types of annuities: fixed, variable, and immediate.

A fixed annuity is set for a period of time, normally at a fixed interest rate, often with a teaser rate for a year, and a floating thereafter.

A variable annuity is set up with various mutual funds inside of it. It incorporates stock market performance into its valuation and will gain value with the markets.

An immediate annuity is annuitized right away, allowing an investor to begin receiving payments from the start.

For someone needing stable income right away, an immediate annuity may be the way to go. For those still in their accumulation phase, it may be best to choose a fixed or variable option.

What Are the Benefits?

Investors need to understand what each type of product offers, and what they can expect.

For one, annuities allow investors to insure their money. Additionally, they come with tax benefits. With a fixed annuity, for example, an investor can choose a term, and all interest earned in this period will compound at a tax-deferred rate.

At some point in time, investors can request a check for the interest only, or for both principle and interest. That way, the tax liability is under the customer’s control.

Variable annuities are long-term, tax-deferred investments with stock market participation. These types of annuities are the most popular right now, Bernard noted. They may offer asset allocation models or even the option to build a model that the customer prefers.

They also have withdrawal options and penalties, as with a fixed annuity.

“Most people like that ability to have stock market gains, but not pay taxes on them until they wish to,” Bernard said.

Variable Annuity Features

Variable annuities have many different features investors can take advantage of.

“It’s like an a la carte menu,” Bernard said. “(Each option) comes with a particular cost.”

These options can include a living benefit, a death benefit, a stretch benefit, a minimum growth guarantee, and other possibilities.

Each of these options will have an associated cost. If an investor wants a guaranteed 4 percent return with a variable annuity, that guarantee may have a cost of 50 to 70 basis points, for example.

This annuity may also come with a minimum growth guarantee, in some cases up to 6 percent, all for that 70 basis point charge. With such a product, if the account doesn’t grow by at least 6 percent, the insurance company comes in and gives a credit to their account for 6 percent.

Some variable annuity companies will offer a strategy for a fee that will lock in the highest value of an account.

For example, if an investor has $250,000 in a variable annuity, but the value later falls, that $250,000 becomes the high water mark. If the account owner passes away, that $250,000 is what a beneficiary receives.

What’s the Downside?

In all annuities, except with the no-load variety, customers need to be aware of surrender charges or penalties that can apply.

Investors need to know what fees they are paying, as well. Most variable annuities have mutual fund fees, mortality expense, and admin fees, and most start off at 1.2 to 1.5 percent.

However, a fully loaded variable annuity with everything off the cart, so to speak, could be as much as 3 percent, sometimes as much as 3.25 percent.

Fee drag is another issue, where that fully loaded variable annuity account grows from, say, $200,000 to $700,000 over time.

“You can see how that would be a drag on the return of your portfolio,” Bernard said. “But your money is still insured.”

Ultimately, the biggest reason annuities get a bad rap is that they’re not always properly understood.

“I would say the reason (annuities) get the bad rap is that they’re not properly disclosed,” Bernard said.

All of the nuances, fees, expenses, and details need to be understood up front.

These issues are vital so that investors are aware when they can and can’t take out lump sum payouts. For example, once an investor begins the process of annuitization, that payout is locked in, and it isn’t possible to get the principle out after that point.

“If somebody understands that and needs that income … that’s totally fine,” Bernard said. “But the biggest problem out there is that when you annuitize any contract … you lose control of your assets. I think that is where the problem arises.”

It’s necessary to go in with eyes wide open when purchasing an annuity, Bernard stated.

“Make sure you totally understand everything — what you’re paying for, what your fees are — and what your financial advisor does for you,” he said.

Audio Link | Other Expert Interviews | iTunes | YouTube | Comments or Inquiries

About the Author

fswebmaster [at] financialsense [dot] com ()