Fixed Income Annuities, a Worry-Free or Risk-Filled Ride?

Straight-shooting personal finance author Peter Passell demystifies guaranteed payout plans — and the insurance agents who sell them — in his latest book, Where to Put Your Money NOW: How to Make Super-Safe Investments and Secure Your Future.

Annuities are contracts that assure you a series of payments at specified dates in the future. The classic annuity contract designed to minimize the investor’s risk is an old-fashioned “defined-benefit” pension plan from an employer, in which you get a monthly check in a fixed amount until you (and usually your spouse) die. The ultimate annuity, one could argue, is Social Security. It pays every month for as long as you live and adjusts the payout to the cost of living. Social Security is, of course, backed by the commitment of Congress to deliver on the deal.

Annuities sold to individuals by insurance companies can, in theory, be the answer to a lot of the worries of conservative investors. In the simplest form, they work like pension plans, guaranteeing a fixed monthly payment for life. Lots of other investments provide reliable periodic payments — think of a U.S. Treasury bond with a thirty-year term, which delivers interest every six months for thirty years, then returns the principal. But few investments other than annuities can guarantee that you won’t outlive your savings, and few allow you to spend the principal along the way.

Using annuities to guarantee a predictable income in retirement has major problems, however. First, the idea of the annuity has strayed far from the simple pension-like contract; with all the bells and whistles that sellers add, the typical annuity contract is hard to understand. Since no two annuity contracts are alike, it is also difficult to comparison shop. Second, annuities are traditionally sold the way life insurance is sold: an agent spends hours or days with the client, working as hard as possible to sell the deal that generates the fattest commissions. Few of us are immune to this sort of salesmanship, thus few of us are likely to opt for the objectively best deal.

Third, changes in the tax laws several decades ago changed the focus of annuities from relatively simple, pension-like contracts to tax-sheltered savings accounts called deferred annuities that allow you to use the proceeds to buy a real annuity later on. The resulting contracts can look good on first glance, but almost always have drawbacks that make them less flexible and less rewarding than alternative, equally conservative investments.

Let’s start by getting off the table those tax-sheltered savings accounts that morph into annuities. With a deferred annuity, you plunk down a wad of money, the money earns income either at a fixed, CD-like rate or at a return keyed to the insurance company’s returns on a specified investment portfolio. Then, years down the road, you have the option of taking out the proceeds and paying the taxes on the earnings (which have been deferred), or trading the accumulated cash for an immediate fixed annuity that pays out like a pension. The sellers of deferred annuities generally stress the tax-sheltered savings rather than the annuity features because few buyers ever trade in their accounts for true annuities.

Still, what’s wrong with the concept of a deferred annuity? The devil is in the details. First, deferred annuities are illiquid. The insurance company sponsor almost always penalizes withdrawals before the five- or six-year mark. The IRS exacts its own (10 percent) penalty if you withdraw any cash before you are 59½. Second, deferred annuities are expensive: the insurance company sponsor typically charges fat fees to “manage” the account.

More important, the gimmick that made deferred annuities so attractive when they were invented — the ability to defer taxes on investment income — has been overshadowed by tax-sheltered individual retirement accounts (IRAs) and employer-sponsored 401(k) retirement accounts. With these, you get a tax break on contributions to the account, still get to defer taxes on income earned within the account, and generally pay far smaller fees. The bottom line: don’t even consider deferred annuities as a means of saving for retirement unless you’ve maxed out your contributions to your IRA and/or 401(k).

That still leaves ‘immediate” annuities, the classic annuity contract, to consider. On the plus side, they offer a certainty about retirement income that other investments can’t match. On the minus side, the contracts are inflexible, and the returns to your investment are apt to be quite low because somebody has to pay the salesman for his considerable efforts.

An annuity is, in effect, a bet about when you’ll die. Most of the people who buy annuities are healthy and expect to live a long time. The insurance companies understand this and set annuity payout terms accordingly. Thus annuities are generally a bad deal for people who don’t expect to live as long as their contemporaries.

If you do value the pension-like properties of annuities enough to invest in one, the trick is (a) to deal only with an insurance company that has the financial cojones to make good on its side of the bargain far into the future, and (b) to get the most for your money by shopping around.

The former task is relatively easy. Don’t be entirely put off by the collapse of AIG, America’s largest insurance company, in the financial meltdown. The companies that actually guarantee the annuity contracts are state-regulated subsidiaries of larger companies, and they are under government orders to behave far more conservatively with their reserves. Even AIG’s annuity subsidiary is generally considered solid.

Note, too, that state insurance commissions maintain reserve funds to meet the obligations of insolvent insurance companies in their jurisdictions. State-by-state information about insurance regulation is available from individual state Web sites. All of these sites are accessible through a site run by the National Association of Insurance Commissioners.

Another independent source on the quality of the insurance companies behind annuities is the credit rating agency A.M. Best, which, incidentally, came out of the mortgage-backed securities ratings scandals unscathed. A.M. Best provides ratings information online at no charge, provided you fill out a “membership” form. Visit ambest.com for the particulars. When you go shopping for an annuity, consider only companies with the two highest rankings, A++ and A+.

As noted earlier, comparison shopping for immediate fixed annuities is difficult. But a few guidelines will help:

  • Avoid annuities that charge up-front fees or “loads.” In theory, they may be as good a deal as annuities that collect all of their fees annually. But loads are too often a sign that the insurer is relying heavily on its commission- based sales force, rather than the underlying quality of its financial products, to sell annuities.
  • Keep it simple. Like new cars, annuities come with all sorts of optional extras—in particular, guarantees that some or all of the investment will be returned to the heirs if the annuity-holder dies young. But there’s never a free lunch. Such bells and whistles make it (even more) difficult to compare annuities. Besides, it is practically impossible to assess the value of such features.
  • Focus on insurers affiliated with investment firms that are generally inclined to compete for business on the cost of services rather than on the charm of their sales force (see below).
  • After finding the annuity that pays the most, perform at least one reality check. Could you generate almost as much income from interest payments on, say, a newly issued U.S. Treasury bond and still have the principal left over after thirty years? If so, the annuity plainly isn’t worth it.

There is no substitute for comparison shopping, but four companies are a good place to start because they have both strong financial ratings and reputations for treating consumers fairly:

TIAA-CREF
The primary business of this gigantic organization is to manage pensions (annuities) for college teachers. But it will sell annuities to anybody. Visit tiaa-cref.org.

Vanguard
The gold standard among full-service investment firms, known for low-fee financial products. The company sells immediate annuities through the Vanguard Lifetime Income Program. Visit vanguard.com or call the annuity line at 1-800-523-0352.

Fidelity
The chief competitor to Vanguard in the low-cost, full service investment business. Visit fidelity.com or call 1-800-345-1388.

USAA
This company provides excellent financial services at good prices—but only to military personnel (active or retired) and their families (including grown children). Visit usaa.com or call 1-800-531-8722.

ABOUT THE AUTHOR
Peter Passell, author of Where to Put Your Money NOW: How to Make Super-Safe Investments and Secure Your Future (Copyright © 2009 by Peter Passell), is a senior fellow at the Milken Institute and the editor of the Milken Institute Review, and has been a columnist for the New York Times. He is the author of many guides to personal finance, including Where to Put Your Money, The Money Manual, and How to Read the Financial Pages.

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19 thoughts on “Fixed Income Annuities, a Worry-Free or Risk-Filled Ride?

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