Pros and cons of annuities

• Sheyna Steiner
• On 6:00 am EDT, Friday October 23, 2009

At face value, annuities offer a pretty good deal: guaranteed income for life. But they are not the most straightforward of products.

Annuities can be a cash cow for insurance companies and the people who sell them -- making it vital for you to understand them and trust your source of information.

There may be less expensive ways to achieve the same outcome with another investing strategy. As with any big investment, discuss what is right for you with a trusted adviser who knows your entire financial picture.

Beyond sheer complexity, annuities have certain characteristics.

Mortality credits

Annuities are insurance against outliving your money, and the reason they make sense for some people is the mortality credits.

Mortality credits should be viewed as a threshold investment return that is required to beat the income from the annuity, wrote Moshe Milevsky, associate professor of finance at the Schulich School of Business at York University.

It's complex stuff, but here's a simple explanation: Imagine that 10 people at age 75 all invest $1,000 at 5 percent interest.

Collectively they put in $10,000 and receive $500 interest. Everyone gets back their $1,000 plus $50.

"Now say only the people at the end of the period who are alive will share in the proceeds. At the end we know there will be $10,500 but we assume only nine people will be alive," says Larry Swedroe, principal and director of research at Buckingham Asset Management in St. Louis.

"Insurance companies have big pools of people and they know actuarially that there will be nine people left. If there were nine people left and no insurance company involved, each person will collect $1,167 so the return jumps to almost 17 percent," he says.

The difference between 5 percent and 17 percent -- 12 percent -- is the mortality credit.

The older you get, the bigger the mortality credits get. By buying an annuity that pays income for life, you're betting that you will live longer than the average person who buys an annuity. Obviously, the insurance company believes you will do otherwise.

"If you're young, the odds of you dying in the next 10 years are close to zero so the mortality credits are close to zero," says Swedroe.

Bottom line: For many people, it won't really pay to buy an annuity until their mid-70s, when the mortality credits get to be large enough to make it worthwhile.

Taxes

Though deferred annuities allow you to put off paying taxes, they don't eliminate taxes altogether.

Through the end of 2010, the capital gains tax rate is zero percent for the two lowest tax brackets and 15 percent for everyone else. Beginning in 2011, capital gains rates go up to 10 percent and 20 percent, respectively, unless Congress intervenes. That's still lower than most ordinary income tax rates, which go as high as 35 percent.

That means long-term gains on most investments that you sell in a taxable account are taxed at lower rates.

But withdrawals from annuities get a different tax treatment than regular investments.

In a deferred annuity, "If I'm in the first period, the accumulation period, and I pull money out, it's LIFO -- last in, first out. So what I'm withdrawing first is interest. So it's 100 percent taxable income: no capital gains rate, no preferred dividend rate," says Mark LaSpisa, CFP with Vermillion Financial Advisors in South Barrington, Ill.

After annuitization, the income investors receive is taxed slightly differently. Part of the payment is considered return of principal, so it is untaxed.

As for the earnings: "Part will be considered income and part will be considered capital gains. That is where you come up with this blended (tax) rate on the payment that you get," says LaSpisa.

Your heirs are also taxed differently if they inherit an annuity as opposed to another type of investment, such as a stock or mutual fund.If your beneficiaries take the money from an annuity in a lump sum, then the entire account becomes taxable the year they receive it, and it's taxed as ordinary income.

Contrast that with other investments, such as stocks and bonds.

"When I die, those assets get a step up in basis; the annuity does not," says LaSpisa.

That means that if you inherit a mutual fund that your Uncle Fred bought for $100,000 five years ago and it has since appreciated to $200,000 on the day he died, his cost basis was $100,000. But your cost basis is now $200,000, and you're taxed based on your cost basis if you decide to sell it.

Fees and expenses

The more complicated the annuity, the more expensive it's going to be. A straight fixed payout annuity with no riders will be less expensive than a variable annuity with any guarantee.

Longevity insurance -- a single-premium annuity purchased at age 65 with payouts beginning at age 80 or 85 -- may make the most sense, though it's not an inheritable asset. It's cheap relative to other annuities.

"If you have a variable annuity, there are mutual fund fees on top, commissions, monthly fee, annual contract fees. There are a lot of costs at the end of the day that average consumers have no idea that they are paying," says LaSpisa.

Restrictions and loss of liquidity

Annuities come with what is known as a surrender period.

After buying an annuity, that money is locked in for a certain period of time, typically between six and eight years, according to the SEC. You can take the money out, but you pay a certain percentage in surrender charges for access to your money. That fee typically decreases by 1 percentage point each year until it disappears. You may also pay penalties if you withdraw before age 59�, plus taxes.

After annuitizing the account, your money is basically gone. You've given the account to the insurance company in exchange for a regular income.

"The problem is that most people don't realize when they annuitize, they give up the account," says LaSpisa.

"When you lock in these strategies, you don't have an escape hatch," he says.

The guarantors

The income that annuities guarantee is backed up only by the insurance company, and to a certain extent, the state. Every state has a guarantee association that each insurance company doing business in the state has to pay into, which guarantees a certain level of protection for policyholders. In general, the amount protected varies between $150,000 and $300,000, depending on the state.

But there is no FDIC to ride in and give you your money back if the company fails.

If the insurance company fails, "it falls to the assets of the corporation or the insurance company. If we were sitting here a year ago, no one would have said there is anything wrong with AIG," says LaSpisa.

"They would have said they're the biggest (insurance company) and have a AAA rating," he says.

When you purchase an annuity, you become a creditor of the insurance company, so it's likely that you will get money that is owed to you for a couple of reasons.

"That book of annuity business was probably built on actuarially sound principles. The insurance company that is out of business would probably be able to sell that to somebody else, so you as a contract holder would not even see any disruption -- the checks would just start coming from somewhere else," says Craig Hemke, president and founder of Buyapension.com.

The risk to your money from an insurance company going belly up may be slight, but more cautious annuity investors may want to employ a diversification strategy.

"If you want to buy $1 million of annuities, you want to spread them around enough companies so that the guarantee is there. Because who knows what can happen to a company over 20 or 30 years," says Swedroe.

Further you should only buy from highly rated companies.

"You want to make sure that the credit risk is very low. You shouldn't necessarily buy the one with the highest interest rate -- stick to the companies with the highest rating," says Swedroe.

Annuities are a tool, and they can be very useful in the right circumstances. Prospective annuity buyers should make sure they understand all the benefits and drawbacks before jumping in.

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