Insurers Will Invest Clients’ Money, but Some Options May Be Costly
I expect most BetterInvesting members aren’t heavy annuity buyers. We prefer to invest on our own. But annuities can be appealing and, despite bad press and low interest rates, still are being aggressively marketed. You should at least know the basics in case you become tempted.
When you buy a fixed annuity, you pay money upfront to receive a fixed return for a certain
amount of time and at the end of that term, you can either roll it over at the new rate, take the money out or convert that lump sum into income payments (usually monthly).
There are two stages in an annuity’s life: accumulation and distribution. The accumulation phase is the time when the money within the annuity is growing tax-deferred. At some point, you can either withdraw the money with no penalty or allow the insurance company to keep your lump sum and promise to pay you a regular income.
The Security of a Steady Income
The predictable income stream is the most appealing feature of an annuity. You can choose whether it will be for a guaranteed period, the rest of your life or that of a surviving spouse, or even the maximum of the two. Your choice of how long the payments need to continue will affect how much you receive on each payment. Provided the company that issued you the annuity stays in business and honors the agreement, you won’t have to worry about how long your money will last or what the return on that investment will be. Annuities are a personal version of the old employer-administered fixed pension.
They can also offer tax advantages, too. The money inside an annuity grows tax-deferred, allowing it to compound at a quicker rate than if you were paying income tax on those earnings every year. After you’ve contributed the maximum to your retirement accounts, an annuity might allow you to defer even more money, though unlike a contribution to a traditional individual retirement account or to your employer’s 401(k), you won’t receive any tax deduction for that initial investment.
But so far, all well and good. If a fixed annuity rate is high, you don’t need the money immediately and the insurance company has a solid rating by AM Best, the global credit rating agency, you might find the certainty appealing enough to buy one. The insurance company makes money by investing all that annuity money at slightly higher rates than what it pays out. That allows it to accept the risk that you or anyone else on your contract will live longer than the company expected, as it anticipated its payments while hoping for a decent profit.
Unfortunately, there are two concerns with annuities. The first is the cost of that guaranteed growth, and the second is the cost and uncertainty of all the whiz-bang features attached to them.
Insurance companies profit because most investors automatically think uncertainty is bad, but interest rates can work in our favor just as much as against us. When we lock in money for an extended time, we’re writing off the opportunity to reinvest at a higher rate. Granted, most annuities allow early withdrawal while you aren’t taking the annuity payments, but you might have to pay penalty taxes and high fees.
But then the industry introduced variable annuities, principal guarantees and any number of features that sound appealing but eat into the returns in a big way. Variable annuities allow you to invest money into subaccounts that mirror popular mutual funds and indices. Once you have maxed out your retirement contributions, you might find that tempting because of the tax- deferred growth.
But check those charges very carefully. They can be far costlier than the mutual fund alternative. The same is true of many of the principal and income guarantees. The guarantee might sound great, but its cost won’t be and some of those guarantees are misrepresented. Yet insurance agents sell tons of them to people who want to invest in the market but are afraid to lose money.
Most investors can earn far higher returns simply by cutting out the insurance agent and investing their long-term money into lower cost and higher return options. Financial services firms often overcharge for their guarantees and their features. You may even do better after taxes by simply committing to a buy and hold strategy instead of paying the internal charges or receiving lower rates from the insurance company.