Annuities: The Good, The Bad, and the Ugly (May 2005)

Dominick Paoloni

When striving to create a balanced portfolio, many investors have asked me if I feel annuities are a wise way to allocate funds. I always answer this question the same way: it depends on what kind of annuity you’re talking about and what investment goals you’re trying to achieve. It’s also important to consider the insurance company issuing the annuity. Annuities are as diverse as mutual funds, stocks, or automobiles, so you want to find a good fit for your needs.

Annuities are recommended for their tax advantages and are issued by insurance companies. They can be broken down into three main product categories: fixed annuity, variable annuity, and equity index annuity. Each type of annuity has strengths and weaknesses that must be analyzed based on the investor’s profile and risk tolerance.

The problem is that the best annuities for seniors are those that tend to pay the least commission. Conversely, the annuities that tend to be the worst pay the highest commission. In a nutshell, what we find is that banks, brokerage firms and insurance agents tend to push lower quality annuities simply because these products deliver the highest kick backs, commissions and trailers. Given this trend, you definitely want to make sure that you understand all the terms and conditions of the contract you’re purchasing.

FIXED ANNUITIES: Fixed annuities are the most simple and straightforward contracts you can own, however, understand that “the devil’s in the details.” Many fixed annuities will boast a high “interest rate” that’s guaranteed. What they don’t tell you is this rate is often only guaranteed for the first year—the subsequent contract years, which you are locked into, usually yield substandard rates, as little as 1 or 2 %. This can tie your money up for 7-10 years, depending on the contract’s life, making your overall return similar to that of a poor CD.

To illustrate, when Wells Fargo advertises a 7-year, 6% fixed interest rate annuity, at first glance you think, “Wow! 6% interest, guaranteed for 7 years and on a tax-advantaged basis? Sign me up!” When a CD is paying 3%, it seems like an easy choice. The catch is in that in the fine print of the Wells Fargo annuity, the 6% is only guaranteed for the first year—the subsequent years can go down, and now you’re locked in for another six years!

Even if interest rates should rise in the marketplace, you’re locked in and at the mercy of the insurance company to raise interest rates for your contract. Obviously this rarely happens. These kind of annuities are typically sold at banks, so beware of products your banker may recommend and be sure to see documentation noting a GUARNATEED FIXED RATE for each year of the life of the contract. In recommending fixed annuities, I always look for those that guarantee my client a high fixed rate for a fixed period over the life of the contract.

VARIABLE ANNUITIES: Variable annuities are essentially products that purchase actual mutual funds inside the annuity. One advantage of variable annuities is when you buy and sell mutual funds inside the annuity, there are no tax consequences; another advantage is if the stock market should drop and you should die, a variable annuity will refund your original investment amount to your beneficiaries.

However, I am not a fan of variable annuities for numerous reasons. First, the expenses to own a variable annuity can cost you as much as 2-3% a year. You don’t always see this expense, but it’s built in to the product and is reflected in lower returns. Second, the choices of mutual funds available through the variable contract are typically sub par, which means you’re not getting the best management on your dollars. With over 17,000 mutual funds available on the market today, most variable contracts offer anywhere from 10-50 funds to choose from. Sometimes even if there is a good mutual fund within the annuity contract, it may be closed out to investors—so it does you no good anyway.

Third, you must tie your money up in a variable contract for typically 7-12 years, depending on the contract, which means if you want to get out of the annuity, you’ll have to pay a surrender charge, which is usually quite steep. Fourth, the money coming out of the variable annuity is not taxed as capital gains, it’s taxed as ordinary income. This means your ordinary rate could be considerably higher than the capital gains rate (maximum capital gains rate for 2004 is 15%, compared to a maximum federal income tax rate of 35% and another 5% state).

Fifth, if you decide to move your money into the money market account in the variable annuity, which many seniors do after suffering a minor coronary when they watch the account plunge with the markets, the fees in the annuity are still assessed—giving you a negligible and sometimes negative return! Finally, a lot of financial planners recommend variable annuities because the commissions are high—this is good for them, but is it good for you?

EQUITY INDEX ANNUITIES: Equity index annuities are the newest invention from the insurance industry and allow investors to participate in market gains while not suffering market losses, unlike variable annuities which sustain risk. Over the years, index annuities have afforded investors some amazing returns with zero risk, and during down years, investors don’t experience losses. Some of the benefits of equity index annuities are quite obvious—to participate in the stock market gains without taking stock market risk makes this a strong investment for growth and preservation.

However, what started as a great concept in 1995 when this product was introduced has been gutted in the last several years. I haven’t seen more creative writing in annuity contracts since the Warren Report. Currently there are over 200 different index annuities currently being sold through insurance companies and I find that most are not worth the paper they’re written on. This does mean they are not real investments, only that the contracts are written to limit the gains investors can realize. Things like caps, spreads, averages, and participation rates all determine the equation used to calculate your annual gain. Many brochures that promote equity index annuities are written in a way to make you believe you are buying one thing, when in fact you are purchasing something entirely different.

In my practice, we evaluate scores of index annuities and currently I am only recommending a handful of these that are worth portfolio consideration. Unfortunately in the annuity business, a lot of annuities are sold that do not reflect the best interests of the client, but are certainly motivators for agents because of high commissions.

Statistically, trillions of dollars are passed to heirs from annuities each year, because many seniors buy annuities for their tax advantages (they grow on a tax deferred basis which means you don’t pay tax on any gain, nor do you have to calculate the gains toward social security tax each year). However, at death, annuities must be taxed to the heirs within five years of the owner’s passing. This inheritance is considered income to the heirs and must be reported on their 1040 forms. In some cases, this presents loved ones with a substantially larger tax bill than they would have otherwise incurred. These issues must be addressed when building an estate plan.

Many insurance agents recommend annuitizing annuities, creating a monthly income stream. This is something I very rarely recommend, because the internal rate of return on an annuitized contract is substantially lower than the market place interest rate.

In conclusion, proper annuities may have their place in your portfolio, but please fully understand all the pitfalls and potholes that can exist in contracts, duping investors and padding agents’ pockets.