Annuities

COSTS ASSOCIATED WITH ANNUITIES

In exchange for the various features offered by annuities, investors must pay a number of costs. Many of the costs are due to the insurance aspects of annuities, although they vary among different sponsors. One common type of cost associated with annuities is the insurance cost, which averages 1.25 percent and pays for the guaranteed death benefit in addition to the insurance agent's commission. There are also usually management fees, averaging 1 percent, which compensate the sponsor for taking care of the investments and generating reports. Many annuities also charge modest administrative or contract fees.

One of the more problematic costs of annuities, in the eyes of their critics, is the surrender charge for early removal of the principal. In most cases, this fee begins at around 7 percent but then phases out over time. However, the surrender fee is charged in addition to the 10 percent government penalty for early withdrawal if the investor is under age 59 1/2.

All of the costs associated with variable annuities detract somewhat from their attractiveness as a financial product when one compares them to mutual funds. The costs also mean that there are no quick profits associated with annuities; instead, they must be held as a long-term investment. In fact, it can take as long as 17 years for the benefits of tax deferral to outpace the administrative expenses of an annuity. For investors who wish to put money away for an extended period, a variable annuity may be a very good investment vehicle.

DISTRIBUTION OPTIONS

On the positive side, investors in annuities have a number of options for receiving the distribution of their funds. The three most common forms of distribution—all of which have various costs deducted—are lump sum, lifetime income, and systematic payout. Some investors who have contributed to a variable annuity over many years may elect to take a lump-sum withdrawal. The main drawback to this approach is that all the taxes are due immediately. Other investors may decide upon a systematic payout of the accumulated assets over a specified time period. In this approach, the investor can determine the amount of payments as well as the intervals at which payments will be received. Finally, some investors choose the option of receiving a guaranteed lifetime income. This option is the most expensive for the investor, and does not provide any money for heirs, but the sponsor of the annuity must continue to make payouts even if the investor outlives his or her assets. A similar distribution arrangement is joint-and-last-survivor, which is an annuity that keeps providing income as long as one person in a couple is alive.

Annuities are rather complex financial products, and as such they have become the subject of considerable debate among experts in financial planning. As mentioned earlier, many experts claim that the special features of annuities are not great enough to make up for their cost as compared to other investment options. As a result, financial advisors commonly suggest that individuals maximize their contributions to IRAs, 401(k)s, or other pre-tax retirement accounts before considering annuities (investors should avoid placing annuities into IRAs or other tax-sheltered accounts because the tax shelter then becomes redundant and the investor pays large annuity fees for nothing). Some experts also prefer mutual funds tied to a stock market index to annuities, because such funds typically cost less and often provide a more favorable tax situation. Contributions to annuities are taxed at the same rate as ordinary income, for instance, while long-term capital gains from stock investments are taxed at a special, lower rate—usually 20 percent. Still other financial advisors note that, given the costs involved, annuities require a very long-term financial commitment in order to provide benefits. It may not be possible for some individuals to tie up funds for the 17 to 20 years it takes to benefit from the purchase of an annuity.

Despite the drawbacks, however, annuities can be beneficial for individuals in a number of different situations. For example, annuities provide an extra source of income and an added margin of safety for individuals who have contributed the limit allowed under other retirement savings options. In addition, some kinds of annuities can be valuable for individuals who want to protect their assets from creditors in the event of bankruptcy. An annuity can provide a good shelter for a retirement nest egg for someone in a risky profession, such as medicine. Annuities are also recommended for people who plan to spend the principal during their lifetime rather than leaving it for their heirs. Finally, annuities may be more beneficial for individuals who expect that their tax bracket will be 28 percent or lower at the time they begin making withdrawals.

Annuities may also hold a great deal of appeal for small businesses. For example, annuities can be used as a retirement savings plan on top of a 401(k). They can be structured in various ways to reward employees for meeting company goals. In addition, annuities can provide a nice counterpart to life insurance, since the longer the investor lives, the better an annuity will turn out to be as an investment. Finally, some annuities allow investors to take out loans against the principal without paying penalties for early withdrawal. Overall, some financial experts claim that annuities are actually worth more than comparable investments because of such features as the death benefit, guaranteed lifetime income, and investment services.

A small business owner considering setting up an annuity should consider all options, look carefully at both the costs and the returns, and be prepared to put money away for many years. It is also important to shop around for the best possible product and sponsor before committing funds. "Before investing in an annuity, make sure the insurance company that will sponsor the contract is financially healthy," counseled Mel Poteshman in Los Angeles Business Journal. "Also, find out from the sponsoring company the interest rates that have been paid out over the last five to ten years and how interest rate changes are calculated. This will give you an idea of the annuity's overall performance and help you identify the annuity that provides the best long-range financial security.

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