More on Annuities

Don Rintala: “I (still) can’t understand annuities. I get the idea, but I don’t understand why the marketplace fails to deliver any good ones. It you have some chips and you don’t know when you will be dying, then annuities could play a very useful role. This is, of course, the answer to your question as to why not stocks, or bonds. Because with them you leave your capital behind when departing this vale of tears. An annuity could, theoretically, let you live a better life, because you use up all your resources (no capital left behind), and you pool actuarially with a big group. Given the perfectly reasonable need for this kind product, why are the only ones available not very appealing? Must have something to do with the law.”

Good question.

First, to bring everyone up to speed . . . the original idea of an annuity was that you’d put up — or perhaps your spouse would arrange to put up for you in her will — some fairly large sum of money, in return for which an insurance company would promise to pay, say, $800 a month for the rest of your (or your spouse’s) life.

That’s still an option, but it’s not really what most people think of these days when they speak of the tens of billions of dollars in annuities — mainly “variable annuities” — that are being sold today . . . some, even — egad! — for use within an already-tax-deferred IRA (see “Annuity Insanity“). Variable annuities are basically huge IRAs that (a) provide no tax benefit when you put the money in; (b) allow you to put in as much as you want; (c) are invested in the stock market, which is why the outcome is “variable.” Yes, you will have the option, when you start withdrawing the funds, of receiving some fixed monthly payment for life, but you will also have the option to withdraw it all at once or in chunks. However you withdraw it, all but your initial investment will be taxed as ordinary income — not as lightly taxed capital gains.

So the first reason today’s variable annuities are not the world’s greatest deal is that all your long-term “appreciation” from the stock market, which would ordinarily be subject to a favorable capital gains rate, is fully taxed as ordinary income.

The second reason is that they are sold by insurance companies, most of which build into the deal their own high selling and overhead costs and high annual management fees, knowing that it’s hard for the layman to figure out just what those fees amount to, and that few buyers appreciate the huge difference they make over the long run.

(If you do buy an annuity, buy it, don’t be sold it. Actively shop around for the best deal, with the lowest, or near the lowest, annual expenses and fees.)

The third reason is that to satisfy the IRS requirement that these be “insurance” products (and thus qualified for the tax-deferred build-up), there has to be some element of insurance — and fee for insurance — built into the deal. Typically, what you are charged for this all-but-worthless insurance element is way out of proportion to its value.

The fourth reason is that it’s a big pain to switch variable annuities from one manager to another, so most people are essentially stuck with whoever they started with — which may well be a sub-par investment manager.

Those are the main drawbacks I see to the typical variable annuity enthusiastically marketed today. (As always: if you already have a variable annuity, good for you. You should be commended for having put money aside for your old age, and are in far better shape financially than if you had spent the same money on, say, a boat.)

But what of the traditional annuity? Namely, the option to pay a large lump sum in return for a lifetime of fixed payments? This is an appealing notion (especially if you can find an annuity indexed to keep up with inflation), and I expect it may become more competitive in this Internet age. But again there are reasons to pause.

First, to protect itself, the insurer assumes that you will live a long, long time. It will further assume that its own investment returns over that period will be quite modest (as they may be). And it will build into its calculation its selling fees and overhead costs, and a good margin for profit — as it should. If I were an insurance company, I would, too.

And actually, you want it to be conservative, so that no matter what happens, it will have the financial strength to survive and keep making your monthly payments.

But all that conservatism, overhead and profit cut into the size of the pay-out.

(I do think the Internet will allow for sharpened competition in this area, and better deals. Shop around! Shop around! But in addition to price, consider the other is the financial strength of the insurer. Yes, many states have financial guarantee funds to bail out failed insurers. But not all do, and not in every imaginable circumstance. So the more you plan to rely on annuity payments, the more closely you should scrutinize the strength of their provider. Note that while a B+ or A- was pretty darn good in high school, a B+ or A-minus rated insurer is low on the relative-strength totem pole.)

In short:

As IRA-like substitutes for a 35-year-old, I’m no fan of annuities. As annuities in the traditional sense, for you or your spouse, they can be worth a look as you near or enter old-age — especially if you just know you’re going to live to be 94 or 100. But I would personally be reluctant to trust all to an insurance company, or to resign myself to “dying broke.” I want always to feel I have some savings to fall back on, to control, and, ultimately, to leave to some worthy causes. Perhaps even to a worthy person or two. (So be nice.)