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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

These days it seems investors are looking for safety and security more than ever, especially after the major stock market correction witnessed from 1999-2002. Four years later, numerous brokerage and variable annuity accounts still have not recovered their losses from that time period. Unfortunately, many investors were counting on those funds to provide income during their retirements.

Thus the introduction of the equity indexed annuity, or EIA, to the main stream marketplace. Designed to provide a greater return than the traditional fixed annuity, the equity indexed annuity can be a reliable alternative to a brokerage account. Only fifteen years old, several billion dollars have been deposited into these accounts.

Annuities in General

First, a potential investor should have a little background information. Generally, an annuity functions in the following manner: The investor, usually called an owner or annuitant, agrees to deposit funds with an insurance company for a specified period of time, say 7 years. The annuity is said to be in deferral during that period of time. While in deferral, most annuities will allow for partial distributions of interest gains or a yearly 10% free withdrawal or the required minimum distribution mandated by the I.R.S. (Many annuities allow for larger distributions if the owner is confined to a nursing home or is terminally ill.) Still another way to distribute annuity dollars is through a systematic withdrawal, referred to as an annuitization, based on a pre-determined schedule, say 5 years. However, if the consumer decides to take the entire contract out as a lump sum before the annuity has matured, then penalties are invoked based on the surrender schedule in the annuity contract. If the investor passes away, the lump sum of the annuity is paid to a beneficiary at passing unless other arrangements have been made.

Technically, equity indexed annuities are characterized as fixed annuities by the various Departments of Insurance in each state. That is to say, at no point does the investor ever own any variable type of security like a stock, bond or mutual fund within the EIA account. These accounts do not fluctuate in value like a variable annuity might. Yet the equity indexed annuity is not like your typical fixed annuity either.

The Equity Indexed Annuity Advantage

What makes EIAs different than a traditional fixed annuity is how interest is credited to the account. Typically, the insurance company will buy an option in a particular index like the DOW, S&P 500 or the NASDAQ. After a period of time, usually one year, the option contract comes due. One of two things will then occur. If the market index has advanced, the option is cashed in and interest is credited to the annuity principal. Conversely, if the market has retreated, the option expires and no interest is credited to the account for that year.

In practice, the annuity either gains or maintains value each year, but the investment cannot lose value due to negative market fluctuation. (It is also important to note that all EIAs have a minimum guarantee associated with their returns. For example, this guarantee might state that if the market declines every year over the life of the annuity, the insurance company will guarantee payment of 2% on 88% of the premium deposited. However, it is practically unheard of for this safety feature to be utilized.) Investors should also know that most equity-indexed annuities have a fixed interest account as an additional investment option. When interest rates are high and the stock market is in decline, the fixed account might be used to credit interest to the annuity principal.

Equity Index Performance

How do these annuities perform? Historically many of these accounts have averaged returns of 7% or better. In years when the broader markets have performed well so have EIAs. It is not uncommon for investors to enjoy interest payments during these prosperous years of 10-20% or better. But the crucial value of these accounts is realized during rapid market declines, when the equity indexed annuity will maintain its principal as well as interest gains from past years.

These facts may explain the recent popularity of EIAs, especially among retirees looking to preserve a lifetime’s worth of hard work. With the market advancing and declining so rapidly, many consumers are looking for safety and security without having to sacrifice reasonable interest returns. Granted, these annuities will not return 50% in one year, like a fortunate stock or fund pick might, but the peace of mind investors gain knowing their investment cannot decline has many placing a portion of their retirement funds into these accounts.

Have you heard about equity-indexed annuities? If so, you might have been tempted to invest in them. After all, they promise returns on your investment if the stock market surges, and no losses in the event of a crash. The truth of the matter is that the only people who get rich from equity-indexed annuities are the folks who convince you to invest in them.

Boiled down to their simplest form, equity-indexed annuities are basically fixed income funds minus commissions, profits, and taxes. So where’s the deal in that? What happened to the promises of grand returns on your investment, “100% of the average increase of the S&P 500 index”? They’re all just a scheme to reel you in.

Equity-indexed annuities are offered by insurance companies. As you might imagine, that fact brings with it a nightmare of tricky wording, hidden fees, and fuzzy math. Let’s use the quoted example from above. This is a realistic example of the wording in equity-indexed annuity sales pitches. But it’s horribly misleading.

For one thing, the S&P’s returns depend on dividends and stock price gains. But what the salesman won’t tell you is that you’ll only receive returns based on the stock price gain. If the S&P rises by 8%, but only 5% of that came from stock price gains, your returns will be tied to that 5%.

For another thing, the average increase of the S&P is different from the total increase. These annuities base their returns on monthly averages. At the end of the year, they tally up the S&P’s average gains per month, then divide by 12. Remember how we used 5% as a figure for stock price gains? The average increase is statistically inclined to be half of that – 2.5%.

But the gouging doesn’t stop there, because the insurance companies deduct fees from the average. After all is said and done, the returns on an equity-indexed annuity can be very modest, if not downright laughable. If you plan to pull your money out after a few years, expect to be hit with hefty penalties. And we won’t even go into the fees, terms and conditions associated with these products.

And don’t be taken in by up-front signing bonuses when you make a deposit. The reason those bonuses are available is because the annuities yield such poor returns.

Use the words “insurance” and “investment” in the same sentence these days and most people will think of some pretty negative things, like the government bailout of the huge insurance firm, AIG. Despite the bad publicity, however, insurance is still one of modern life’s basic needs. And insurance companies still offer interesting ways to protect your money as well as your life, health and auto. Annuities are a perfect example.

Annuities are very interesting financial instruments, and one of the main products of insurance companies. Essentially they are “future repayment” contracts between you and an insurance company, which you fund with either a single lump-sum payment or scheduled remittances in advance of the first payout date. The insurance company agrees to make periodic payments of a certain calculated amount, according to an agreed-upon schedule.

Annuities usually feature tax-deferred earnings and might also contain death benefits. Since it is not a replacement for life insurance, the amount that it will pay the beneficiary is some guaranteed minimum amount, often the total of your initial pay-in amount.

Kinds of annuities Generally speaking, there are two types of annuities, fixed and variable. Fixed annuities earn a specified minimum rate of interest while your account is maturing toward its payout date. The insurance company will then guarantee that the periodic payments will be a specified amount for each dollar in the account, payments that could last for either a defined period (15 or 20 years) or for indefinite periods like your lifetime or your spouse’s.

When you opt for a variable annuity, you can select from among various different investing options, mostly mutual funds. The amount you eventually receive will depend on the returns earned from the investments you selected.

Equity-indexed annuities are where the insurance company credits you with a rate of return based on changes in an equity index like the S&P 500 Composite Stock Price Index. Most insurance companies will guarantee a certain minimum return, which rates vary greatly from firm to firm. Following the accumulation period, you will receive periodic payments according to your contract terms, unless you prefer a lump sum payment.

The legal distinctions Each annuity product is a different kind of financial instrument. Fixed annuities are not considered securities and therefore are not regulated by the Securities and Exchange Commission (SEC). On the other hand, variable annuities are securities, so the SEC does exert some oversight of those products. Equity-indexed annuities combine features of other, more traditional insurance products (like a specified minimum rate of return) as well as standard securities (return pegged to the markets).

Because they are constructed in different ways, even within the same company, equity-indexed annuities may or may not be considered securities. It is all according to their particular design. Most equity-indexed annuities marketed today, as a matter of fact, are not registered with the SEC. This means it is more important to check the company, its history and its own financial health if you are going to risk your money on its products.

Fitting into the plan

You can learn more about all the kinds of annuities by doing online research, as well as ordering information from the various insurance companies that deal in the products. A good financial planner, especially one who is also a licensed insurance agent, will be able to help you determine just how you can work an annuity into your financial formula. Again, it is up to you to determine the amount of risk you can stand, and the way you want to structure the deal, because there are no concrete guarantees in any financial instrument, truth be told. The history of annuities, however, should give one sufficient confidence to proceed if everything – the company, the people, the deal, etc. – checks out.

One primary challenge in creating a comprehensive financial plan is making the best use of your funds and limiting the amount of overlap in benefits. That is, if you have other income-producing investments, you don’t need to use annuities for the majority of your future living expenses. Instead, if you anticipate paying for college for a kid or two, you could set up an annuity for that purpose, or according to some other plan that you develop. You can use annuities as a component of various, very effective financial plans, so don’t overlook them.

You might have heard of a Variable Annuity- but what does GLWB mean?

It stands for guaranteed lifetime withdrawal benefit. You may find the popular GLWB contract rider with some equity-indexed annuities also. Before I did some deep analysis, I constantly had clients telling me that it sounded too good to be true. Well, like many things that sound too good to be true, this one probably is.

From a limited perspective as an agent, it sounded great- An annuity owner’s income benefit is generally guaranteed to grow at 7% annually. When withdrawals begin, the contract owner receives a guaranteed income of 5% of the income benefit value for life, regardless of actual account performance. With this product, I was essentially off the hook in regards to account management. No matter what, my client would get 7%. Boy oh boy, life is easy now!

Not so fast. Did you read that last paragraph carefully? If it sounds too good to be true, you’d better take a second look. I’ll save you the trouble and just explain what’s going on here. There’s a big difference between the income benefit and the account value. Let’s define those:

Income Benefit- This equals the initial investment plus the guaranteed interest rate, compounding yearly until withdrawals begin. $100K invested today will grow to $200k in ten years, assuming 7% interest.

Income Benefit is NOT how much money you have…

Account Value- This is the actual value of the account as it performs in the open market, less annual fees, which can exceed 3%.

Account Value can be DRASTICALLY Lower than the Income Benefit- leaving you locked in.

So, the income benefit is a guaranteed $200K but as far as the account value goes, your guess is as good as mine. It may be more or less. With a 3% annual fee, the account must gain at least 10% to keep up with the guaranteed income benefit. Has the market ever done that? Have you ever seen the market hit exactly 10% annually for ten straight years? It has not. The market has done better and it has done worse. Sounds kind of like rolling the dice. Thank God for that GLWB.

How good is that guarantee, really? Our $100K will guarantee a lifetime income of $10,000 per year in ten years.(5% of $200K) In all honesty, that’s a paltry payout compared to other income products.

With an immediate annuity, it would only take about $134K to equal the GLWB payment for a 60 years old male. For a joint life payout, you would need a little over $153K. You would need to earn roughly 3% and 4.5% respectively to compete. That sounds a lot easier to me, and you are not locked in along the way.

At age 60, immediate annuities pay around 7.5% for a single life and 6.5% for a joint life payout. That means it takes a lot less money to guarantee a higher level of income in the future.

Another plus for immediate annuities is that the income rate goes up with each year of age. If you wait until age 61 to begin payments, the level of income will be a little bit higher. The GLWB will generally increase the payout to 6% at age 70. By that time, the immediate annuity would pay about 9.3% for a single life and 7.5% for the joint life option.

The GLWB never catches up. So why is this type of product so heavily sold? My guess is that many advisors are in the same position as I was. When a client buys into the income guarantee, they usually feel a sense of relief and the advisor looks like a hero. A better advisor would do some in-depth analysis to find other options with higher income potential. After all, you’re in it for guaranteed income, right?

Also, use of the GLWB annuity is commonly seen as a way to stay in the market with a great safety net. I already showed you how it only takes a 3-4.5% investment return to get an equal payment. With the heavy fees, any market gains are seriously watered down.

My advice: if you want to stay in the market, stay in the market but without the annuity. I know this is unlikely to give me more business now but it’s more ethical advice. The potential for good investment returns is much higher without the fee structure of the variable annuity. That income guarantee isn’t free, by the way.

If you want to guarantee future income right now, find someone who is willing to work to give you a few more options. Educate yourself and find an advisor who is worth his salt. But first, read the whole GLWB report. That actually is free.

With the recent market turmoil and uncertainty, equity indexed annuities may be a good option for someone nervous about having their retirement savings being exposed to the volatility of the stock market. Equity indexed annuities were introduced in 1995 and have become increasingly popular ever since. Index annuities are underwritten by insurance companies that provide a minimum guaranteed return with excess interest crediting based on the performance of an outside index, such as the S&P 500, Russell 2000, etc.

So how do you know if you are suitable for such a product? That depends on several factors – most importantly, the investor’s time frame and purpose of the investment. If you are a short term investor looking for maximum return, then an equity indexed annuity is not for you. Annuities are meant for long-term retirement savings. If you are looking for double-digit returns on your investment, you are not going to find them in an index annuity. If you feel you need to adjust your portfolio on a regular basis, an equity indexed annuity may not be for you. So who may be suitable for such an investment? Long term savers who have a low tolerance to risk when it comes to loss of principle and are more comfortable with a steady paced return on investment are great candidates for an index annuity. If you are seeking potential higher rates of return than a savings account or CD and protection of principle, an equity indexed annuity may provide that. Equity indexed annuities also have the advantage of tax deferral of the earnings which make it a great retirement savings vehicle. Keep in mind, an annuity may only be one piece of your overall retirement plan portfolio.

Some Contract Features:

Guaranteed Minimum Rates of Return

Regardless of market performance, an equity indexed annuity guarantees a minimum rate of return – typically 3% credited to some portion of the account value during the contract’s term.

The Stock Index

Equity-indexed annuities credit the return under certain circumstances based on the change in the level of a stock price index such as the S&P 500 or other indices. Although, unlike an index mutual fund, dividends and capital gains are not included in the annuity interest calculation.

Participation Rate

Participation Rate describes the extent to which the contract holder shares in an index increase. The participation rate (a percentage) is multiplied by the index change (also a percentage) to arrive at the interest rate to be credited to the policy. A 50% participation rate means the contract holder shares in, or ‘participates in’, half the index change for the period.

Caps

A Cap is a ceiling or upward limit on the interest that may be credited to the annuity. A cap usually represents the maximum interest that can be credited to the annuity in any one period.

An investor must be aware that equity indexed annuities have fees that will get you in the back-end if you access your money prior to the maturity of the contract. These fees, known as surrender fees, can be extremely expensive in some annuities. The surrender charges usually decline over a period of years, but not always. As stated earlier, equity indexed annuities are for long term investors so it is important to be able to commit your funds for the life of the contract.

There are many different factors when considering this type of investment. Annuities vary from contract to contract and insurance company to insurance company, which can become very confusing very quickly. Each contract has its own unique fees, surrender charges, participation rate, cap, annual reset, among other things. Equity indexed annuities have gotten a bad rap over the past few years. That is mostly because of inexperienced, unknowledgeable or unqualified sale agents marketing to clients who may be unsuitable for the product. It is highly recommended that you speak with a knowledgeable investment advisor who has experience working with equity indexed annuities and the ability to accurately assess your financial suitability before committing your money.