By Mark Henricks
Special to The Washington Post
Wednesday, October 15, 2008
For most people, annuities are as much of a mystery as commodities options. But those who do know what they are tend either to love them or hate them.
Scot Millen, a fee-only financial planner with Baltimore-Washington Financial Advisors in Columbia, isn't much of a fan. "It's not something we actively promote for our clients," Millen said. Like many financial advisors, he says that investors pay too much in fees and charges for tax-deferral and other benefits annuities offer.
Don't tell that to Scott Scharpen of Mission Viejo, Calif. He's a satisfied annuity investor. Scharpen, 39, has been putting money into annuities for years because he was already putting the maximum into other tax-deferred accounts such as his 401(k) and IRA. His annuity allows nearly unlimited contributions to grow on a tax-deferred basis, says Scharpen, a small business owner with an economics degree from Stanford University. "It just made sense for me given our situation," he said.
An annuity is a contract between an individual and an insurance company. The individual pays the insurance company a lump-sum amount or a series of payments. In return, the insurance company agrees to make periodic payments to the individual. Payments to the individual may start immediately or in the future. Taxes on the money an annuity earns typically are deferred until withdrawals begin. Annuities usually also offer death benefits much like regular life insurance policies.
Annuities come in two major types: fixed and variable. Fixed annuities usually guarantee that money in the annuity will earn a minimum interest. They also usually guarantee that periodic payouts will be no less than a certain amount. Payouts may last a specific period, such as 20 years, or an indefinite period such as the lifetimes of you and your spouse.
Variable annuities let individuals direct annuity assets into different investment vehicles such as mutual funds. The amount the annuity grows as well as the size of the eventual payouts, depend on investment performance. In addition to the basic fixed and variable annuities the industry has devised many variations. Equity-indexed annuities track a stock index, for instance. A flat death-benefit cost annuity charges you a flat fee for the insurance portion of the annuity rather than taking a percent of the assets in your annuity. Flat-death benefit annuities generally have much lower costs than those that charge a percentage for insurance.
In the second quarter, U.S. annuity sales topped $68 billion, a 4 percent increase over 2007, according to LIMRA International, an insurance research firm in Windsor, Conn. However the total value of annuity assets stayed essentially flat during the period because of variable annuity losses in the falling stock market.
The most interesting development was that fixed annuity sales during the period soared 46 percent, while variable annuities dropped. For the past several years, variable annuities have grown much faster than fixed-annuity sales, hitting a record in 2007, said Dan Beatrice, a LIMRA analyst. In 2008, as the stock market fell, investors fled variable annuities for the safety of fixed annuities, he said.
Those guarantees come with significant costs, however, starting with hefty sales commissions. "Annuities are highly complicated products, and firms get paid 6 percent to 7 percent to sell them," Millen said. Insurance agents sell most annuities, although banks are also important channels for fixed annuities.
Fees also add up. The premium for the insurance component of an annuity typically drains 1.3 to 1.5 percent of the assets of the annuity every year, said Mark Stinson, a planner with Baltimore-Washington Financial Advisors. In the case of variable annuities, owners must also pay the expenses of the mutual funds held within the annuity.
The insurance benefit guarantees that, if the owner of the annuity dies, the beneficiaries will receive at least the amount that was put into the annuity. "There's a guarantee of principal that people find comforting," Stinson said. "Of course, you only get that if you die."
Because of their costs, annuities are best used when individuals, like Scharpen, have put the limit into other tax-deferred savings vehicles. "One of the classic needs is an individual that's 30 years old, he's maxed out his 401K at work and his IRA, and he's looking for additional ways to accumulate on a tax-deferred basis," said David Stoeffel, a vice president at Northwestern Mutual Life Insurance in Milwaukee.
Annuities should generally be only one part of a portfolio, said John H. Putnam, a Charlotte financial planner who sells annuities for Northwestern Mutual. Only rarely should individuals put all of their retirement assets into an annuity. "I guess if I thought long and hard, I'd find a situation where it makes sense," Putnam said. "But usually, a diversified holding can bring benefits to people."
While the search for a guaranteed income that cannot be outlived draws investors, the spectacle of the government bailout of the world's largest insurer, American International Group, raises questions about the strength of those guarantees. Investors should always check the financial stability rating of an annuity issuer with a third-party rating agency, Stoeffel said.
However, even in AIG's case, most annuity owners should not suffer any losses. That's because AIG's subsidiary insurance companies are healthy even though the parent company was in dire financial straights before the federal government loaned it $85 billion, said Kelly Campbell, a fee-based financial planner with Campbell Wealth Management in Fairfax.
"Right now, there's not an impact," he said. He's likely right. When insurer Conseco entered into bankruptcy proceedings in 2002, holders of annuities issued by its companies were not hurt.
Insurance companies are covered in most states by funds that protect fixed annuity holders in the event of a default. Additionally, variable annuity assets -- mutual funds, for the most part -- are held in separate accounts so investors would not be directly affected by the issuer's troubles. "Even if the company were to fold, they still have those positions," Campbell said.
Planners like Millen still say that most people can do better investing in the market outside of an annuity over the long term. They liken the guarantees to betting on your own longevity. "If you walk out the door and get hit by a bus, the insurance company wins," he says. "If you live to be 110, you win."
Still, for retirement savers like Scharpen, the combination of safety and tax-avoidance that annuities offer makes them attractive. As long as there are people like him, annuities will find ready buyers. "Some people will look at an annuity and say, 'I'd never do that,' " Stoeffel said. "Someone else says, 'That helps me sleep at night and I'm okay with the cost.' "