Are Annuities a Good Deal or a Rip-Off?

September 26, 2013

A couple of weeks ago, my colleague Linda Robertson wrote a blog post about annuities, in which she described how happy her father was about a variable annuity that she sold him when she was a financial advisor. That may sound a bit puzzling since variable annuities have gotten a lot of bad press due to their high fees. But for those fees, you’re basically buying some form of insurance, which is why they’re sold by insurance companies. Here are some situations in which an annuity might actually make sense for you depending on what you’re looking to insure:

Principal

If you’re looking for protection for your principal, you have a couple of options. CD-like fixed annuities pay a fixed interest rate for certain number of years, during which you get penalized for cashing them out early. Unlike CDs, the interest also grows tax-deferred but there’s a 10% tax penalty for cashing them in before age 59 ½ so make sure you won’t need the money before then.

I’ve also seen variable annuities that let you invest your money with a guarantee that you won’t get less than your principal after 10-12 years. For that guarantee, you have to pay an annual fee and there might be limitations on what you can invest in. They have the same tax-deferral and penalties for early withdrawal.

Income Now

If you’re retired, you may be more concerned with protecting your income. One rule of thumb is that you can safely withdraw 4% of your retirement assets and increase the amount with inflation over 30 years. However, if you need to live on more than 4% of your nest egg or if you’re worried that the 4% rule may not work in today’s market environment, one option is to purchase an immediate annuity from an insurance company. With this product, you exchange a lump sum of money for an income guaranteed for the rest of your and a survivor’s life. It’s kind of like buying your own pension. Just be aware that you’ll get a significantly lower payout in exchange for inflation protection and you generally lose access to your money.

Income Later

Finally, there are variable annuities that allow you to invest the money with a guarantee of a certain amount of income in the future. For example, Linda’s dad has an annuity that lets him get an immediate annuity in the future (called “annuitization”) as if his principal had grown 6% a year or withdraw 5% a year, regardless of how poorly the investments have done. For these “living benefits,” (as opposed to “death benefits” that guarantee a specified amount to your heirs even if the investments lose value) you can pay a pretty hefty annual fee. I’ve seen them as high as 3-4% a year, not including the investment management fees.

Since you’re unlikely to actually need these guarantees, the main benefit is to act like a guardrail on a bridge. After all, how many times have you ever hit a guardrail on a bridge? Now, how fast would you drive over a bridge without one? These annuities can serve the same purpose by allowing someone to invest more aggressively than if they didn’t have the annuity. While they would most likely be better off without the fee and the guarantee, they’d also probably be better off than if they had left that money in cash earning less than 1%. (Of course, there’s always the chance that a long bear market means they DO need the guarantee, in which case they’ll be glad they have it.)

Annuities aren’t necessarily all good or all bad. For the right person in the right situation, the right annuity can be a good deal. As with all insurance, buy as much as you need but no more.