Annuities – The Unnecessary Evil
July 18th, 2011 | Author: weissheiss
Most annuities sold in this country today are completely unnecessary. Investors would be better off without them, but stockbrokers, insurance agents and other product pushers, addicted to big commissions, will never stop peddling them.
In this section, you’ll learn more about two annuities that are poor investments for just about everybody: variable annuities and equity index annuities.
Variable Annuity
Introduction: The variable annuity is an investment wrapped inside an insurance product. The insurance is intended to protect the cash sitting inside from a market fiasco. Unlike a fixed annuity where you receive a fixed interest rate, the variable annuity invests in a variety of mutual funds, which in insurance lingo are called “sub-accounts”. The variable annuity will fare as well as the underlying funds (minus fees) which is why it’s called “variable” (because your return can vary).
The variable annuity’s much hyped insurance protection only covers heirs. So if you buy a $100,000 annuity and a bear market shreds the value to $80,000, you won’t recoup your cash. The insurance protection only kicks in if you pass away and your account is valued at less than its original amount (minus any withdrawals). Frankly, few heirs will benefit from this protection because most accounts, if they’ve been around for awhile, have appreciated. This renders the insurance protection worthless.
Unlike IRA and Roth IRAs, investors can stuff as much money as they want inside a variable or equity index annuity. Salesmen will probably tell you that the more cash the better, but for whom?
Bells & Whistles: Recognizing the inherent weakness of the insurance protection and to boost flagging sales, insurers have rolled out variable annuities that promise extra features such as bonuses, principal loss protection, living benefits and guaranteed returns. All these extras should be avoided as they only add additional layers of fees to an already expensive product.
Tax Consequences: Variable annuities grow tax-deferred just like an IRA. Salesmen who love to promote this tax benefit often conveniently forget to mention that the tax party ends abruptly with withdrawals.
Distributions from a variable annuity would be taxed at your own marginal tax bracket. In contrast, if you had invested in a taxable account and later sold some assets for a distribution, you’d be taxed at long-term capital gains rates (federal 15% or lower).
Furthermore, annuities are ticking tax bombs. When an investor dies, the heirs will owe tax on any annuity profit. So if the annuity was originally worth $100,000 and it increased in value to $190,000, the beneficiaries would owe capital gains tax on the $90,000 profit.
Contrast this scenario with what would have happened if the money had been left in a taxable investment account. The loved ones who inherited the money would have benefited from something called a “stepped-up basis”. What this means is that the value of the account, for tax purposes, would be set at whatever the price was upon the death of the owner. Suppose someone inherited a mutual fund that was purchased for $100,000 and it grew to $190,000 by the day of the owner’s death. If the loved one sold that mutual fund for $190,000 or less, no taxes would be owed. And that’s obviously a much better deal.
Costs: Most variable annuities are stuffed with exorbitant fees, which make them far more expensive than owning individual mutual funds outright.
The mortality and expense (M&E) charge, which provides the insurance coverage discussed above, averages around 1.25% according to the SEC. Some contracts could be 2% or higher though. The cost of the mutual funds, or sub-accounts, averages around 0.9%. That brings the annual cost of owning a variable annuity to about 2.15%. That is quite a drag on portfolio performance.
The insurance costs are only the beginning. The typical variable annuity also includes a surrender charge that’s intended to keep disillusioned customers from fleeing. Surrender charges are typically around 7%, but can be as high as 15%. You can think of the surrender charge as the commission that the agent made on the sale. The insurance company doesn’t subtract the commission from your investment, instead they pay the agent out of their own pocket, and impose a surrender period on you. Surrender periods usually last about 7-10 years, although 12-15 years isn’t uncommon. Over time the surrender charge decreases as the insurance company makes their money back.
If you are interested in what the NASD has to say about Variable Annuities, I suggest you read their Investor Alerts on their website.
Equity Index Annuity Definition:
The equity index annuity is a complicated insurance product that insurance agents promote as a miracle investment that delivers great stock market returns while protecting their owners from Wall Street’s occasional crash-and-burn routines.
Many contracts provide a minimum guaranteed interest rate of 3%, but promoters promise that investors can often capture far higher returns.
EIAs don’t invest directly in the market. Instead a small amount of the premium is used to buy options on the value of the stocks that make up a particular benchmark, such as the Standard & Poor’s 500 Index.
EIA Drawbacks
While these annuities promise stock returns without the risk, the way the contracts are designed will dramatically reduce the EIA’s performance. For instance, the guaranteed return is typically based only on 80% to 90% of the premium. Sometimes the interest is only credited if the investor holds onto the annuity to maturity which can be many years.
Further, a customer only gets to participate in a percentage of the market return. This is called a “participation rate”. and it does not include stock dividends. If the return is 12% and your participation rate is 80%, then your potential return is, at best, 9.6%. The word “potential” was used because some companies do not include stock dividends in their index and some put a cap how much you can get. If the insurance company has an 8% cap, in the above example you’d get 8%, not 9.6%. The complicated performance calculations often suppresses an EIA’s return so that typically it is no better than a certificate of deposit.
If you are interested in what the NASD has to say about Equity Indexed Annuities, I suggest you read their Investor Alerts on their website.
Tax Consequences: Because this annuity is intended for retirement, investors are penalized if they pull the money out before reaching the age of 59
Posted in Indexed Annuities | 
Tags: Bear Market, Equity Index Annuities, Fiasco, Heirs, Insurance Agents, Insurance Protection, Mutual Funds, Variable Annuity