WARNING !

The Annuity Bust

On July 2, 2004, Florida became the most recent state to enact legislation that requires insurance companies and agents offering annuity products to seniors to document why they sold the product to the consumer.  Although annuities can be an effective way to guarantee a retirement income stream, many seniors are targeted by insurance agents that are motivated by commission payouts and not necessarily the financial well being of the client.  

In many states, life insurance and annuities are protected from creditors while other states offer no protection at all.  Knowing this, many life insurance agents are using the asset protection front to push the sales of life insurance and annuity products to those concerned with developing an asset protection plan.  With the amount of new retirees on the rise, it's no secret that there has been a rise in annuity sales.  Along with this, we have also witnessed a small percentage of agents using annuities in an inappropriate manner.  The NASD (National Association of Security Dealers) is initiating new regulation on annuities, and so are the states.  So far, four states have passed some form of education or suitability requirement for selling these products and many more states are expected to follow.  

To make an educated decision on annuities, you'll first need to know a little bit about them.  Annuities are investment products issued and backed by insurance companies that contain both insurance and an investment element.  The two types of annuities available are Immediate annuities and Tax-deferred annuities.  Under the immediate annuity, your payments start immediately, whereas; under the tax-deferred annuity you can allow your money to grow tax-free until you decide to start withdrawals.  The investment options include a Fixed Annuity (carries an interest rate) or Variable Annuity (selection of mutual funds).  

So what is all the concern about?  One of the primary concerns of the NASD is the turnover of a current annuity for another annuity product.  Every time a new annuity product is sold, a new commission is paid to the sales agent.  In some cases, I've seen the seller's commission to be as high as 9%!  That's a $45,000 commission to the selling agent on a $500,000 annuity investment.  Are you now starting to see the motivation?  Along with the high commission payout, there are other factors that can drag down the attractiveness of an annuity investment, such as the following:  

Mortality and Expense Risk Charge- Here, you're paying for the insurance component of the annuity.  Typically these fees range from 0.75 to 1.50 percent.  

Administrative Fee- This is the fee charged by the insurance company to administer the contract.  These fees typically range from 0.50 to 1 percent per year.

Mutual Fund Expenses- These are the fees charged by all mutual fund companies to pay for the fund manager and other expenses associated with the operation of the mutual fund.  Typically 0.50 to 1.5 percent  

Surrender Charges- If you withdraw your money within the first six to eight years, you can expect to pay a penalty fee, known as a "surrender charge".  This is usually 6 to 8 percent in the first couple of years, then declining to 0 percent over time.  

Income taxed as Ordinary Income- When you annuitize or start taking payments from the annuity, the income is taxed as ordinary income.  Not good if you're in a high tax bracket (i.e. 28 to 35%), and the capital gains rate is 15%.  

Tax Penalty for Early Withdraw- Should you have earnings in your annuity and withdrawal the earnings prior to reaching age 59 1/2, you may be subject to an additional 10% early withdrawal penalty.  

Limited Investment Options- Most variable annuity products have a limited number of mutual funds from which you can select.  

Annual Contract Charge- Many annuities will charge an annual contract fee between $25 to $50 dollars.  

With all these bad pointers regarding annuities, why would anyone want to buy one in the first place?  To the credit of annuities, they can add value for some families where a lifetime income stream is a concern.   But in most cases, our advice is to just stay away.  You've heard the old saying…"buy term and invest the difference", well this is one that I'd have to agree with.  If you absolutely have to buy life insurance, then buy term insurance.  Go to a financial advisor or discount brokerage for your investment portfolio, keep the two separate.  

Over time, paying the additional M&E and Administration expenses (i.e. extra 1.25 percent per year) will hurt your investment's average annual return.  When developing an investment portfolio, most investors should consider annuities as a last resort.  If asset protection is your major concern, consider the following quote from a respected estate attorney- "While the asset may be protected, clients would be better off financially by putting their money into stock or mutual funds and protecting them with a family limited partnership (FLP) or offshore trust".   Make sure you max out your 401(k), Roth or Traditional IRA, and any other tax-deferred vehicles available to you first.  Do your homework first, so you're not sorry later - an eight year surrender penalty charge can put a damper on any short-term liquidity plans.

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