Being a Jane Austen fan, I decided to rent the movie Sense and Sensibility last week. Set in early 19th century England, it is the story of a second wife and her three daughters who find themselves impoverished after the father's death. According to English law, the manor and its contents went to the male heir, the lord's son from his first marriage. On his deathbed, the father makes his son promise to provide for his second family.
The son and his wife consider how to fulfill this promise with the least amount of sacrifice to themselves. They start with one sum and began lowering the figure until the son suggests an annuity, an annual payment until the death of his stepmother. His wife's objection? Stepmum might live too long!
Webster's dictionary defines an annuity as "an amount payable yearly or at regular intervals." It is a type of contract, and as you can see from the above story, the idea has been around for a long time. What is missing from Webster's definition is the phrase "tax-deferred." This characteristic is part of our modern definition and has been the driving force behind the growth of this investment vehicle.
Today, in twentieth century America, what really is an annuity? It is, quite simply, a type of mutual fund, a pooled fund. You are putting your money together with other investors, giving it to a professional money manager, and requesting it be invested in a certain way.
There are two basic types of annuities: fixed and variable.
A fixed annuity is just what it says. The insurance company guarantees you a fixed rate over some period of time. They may contract with you to pay 6% for each of five years, at which time you renegotiate. Or they may contract with you to pay 6% for this year and reset the rate on the anniversary date each year, guaranteeing you a minimum, such as 4%.
These fixed annuities, or pooled funds, typically invest in bond-type investments (fixed income). If you study the report on their holdings, you will probably see many Treasury bonds, government agency mortgage backed securities, and maybe some corporate bonds. Occasionally, they invest in real estate.
While the word "guaranteed" is reassuring to many people, remember your contract is only as good as the insurance company which is managing your money. If it defaults, you lose. Many companies like to quote their AM Best or S&P ratings, and while these are helpful, it's not the full story.
Ask the people who bought Executive Life annuities. Also, remember these companies operate on the "spread." They make money by earning more on your money than what they have to pay you. If they guarantee you 6%, they may be earning 8% on your invested money. It's a trade-off.
The second type is a variable annuity, and like the word says, the rate you earn varies. The insurance company does not guarantee a rate but gives you various choices in mutual funds. The funds you choose to invest in will determine how much your money earns. If you start a variable annuity and invest everything in a money market fund, you will earn money market rates (3-5%). If you invest in a bond fund, you will earn bond market rates. If you invest in a stock fund, you will earn stock market rates. Since annuities are considered long-term investments, your best choice is to have most of your money in stock funds.
Back to this tax-deferred thing. The change in regulations to allow annuities to be tax-deferred breathed new life into the insurance industry. The intention was to give people more opportunities to save for retirement. If you purchase a fixed annuity with a guaranteed rate of 6% for five years, you will have $26,764 at maturity. Tax-deferred status means none of the interest you earn each year on this annuity shows up on your income tax. That's good. It means faster growth of your money as it compounds unimpeded by Uncle Sam.
If you take out the money at maturity, the amount that shows up on your income tax for that year depends on whether this is a qualified (IRA or retirement) annuity or a non-qualified annuity. If it is non-qualified, only the interest ($6,764) will be declared as income for that year. This allows you to time income declaration to minimize tax consequences. That's good, too.
So, what's bad? Higher administrative costs than regular mutual funds. Mortality and expense ratios averaging 1.25%. Surrender charges for the first 7-9 years of the policy. Commissions ranging about 6-8%. Fees, fees, fees.
With all the constraints of the typical annuity and the extra cost involved, who really needs an annuity? Well, someone who is already contributing the maximum to a retirement account and needs another avenue of saving. Someone who is in a high tax bracket and needs to shelter income. And someone who can afford to lock up funds for an extended period of time (enough to cover the surrender period).
So why do I keep seeing 70 year old retirees with annuities? And 30 year olds who will want their money to buy a house? And 45 year olds who are using it as a college savings place? And WHY, WHY, WHY do people continue to use these for their IRAs? That's like turning on your air conditioner and leaving the window open! You probably won't notice the difference in comfort, but I'll guarantee you'll pay more in utility bills. If you already have the privilege of tax-deferral with an IRA account, why would you pay for it again in an annuity? No sense and sensibility here.
Unless, of course, you're an insurance salesman.
If you happen to fit the criteria mentioned above and need an annuity, there are alternatives out there. Annuities with no surrender charges, lower administrative costs, lower mortality and expense ratios, and no commissions. The problem is you'll never find out about them without some effort. Groups like Vanguard, Fidelity, T. Rowe Price, and Schwab, to name a few, are offering such annuities.
Annuities can be quite sensible investments. Use all your senses (eyes and ears) when t he sales pitch begins, and make sure your needs match. Sense and sensibility.
--Nancy Lottridge Anderson, Mississippi Business Journal, August 19, 1996
BONUS MATERIAL: Nancy on Midday Mississippi to discuss Annuity Pitfalls.