The Annuity Con Game

Many prospective clients that call us to discuss working with us have already met with a financial planner or insurance agent that recommends the purchase of a large annuity for tax benefits. What these people fail to realize really how lucrative the commissions are on these products.

Annuities may add up for you in some cases, but normally they don't unless you happen to own shares in a company pushing them. The most common type is the tax deferred annuity. In the case of a deferred annuity, you pay up front or with a whole series of installments, and then your investment will increase without the IRS taking its pound of flesh until you withdraw. You can then look forward to regular income to tide you over in your old age.

Does much of this sound familiar? Of course. Retirement plans like an ordinary IRA can postpone the day of reckoning with the IRS until long after your investments have compounded mightily. You might say that tax-deferred annuities are redundant since other plans are already posting the payments. Why buy them, then? In fact, with some important exceptions, we believe that you normally should pass on annuities unless you wish to live the good life vicariously through the broker or life insurance rep whom you put in that multimillion-dollar mansion.

Forbes' latest advice, offered in an article mentioning an SEC examination of the practices of some leading annuity marketers, does not even come with a qualifier: "Don't buy an annuity." The magazine passes on the horror story of a retired couple in Potomac, Maryland, who lost many thousands of dollars by following the suggestion of a Certified Financial Planner peddling annuities on commission. Not all CFPs, alas, are Fee-Only.

Here is the case that the Motley Fool, business magazines and Fee-Only investment advisors have made against annuities:

1. Tax-related arguments exist beyond those already given. Remember, capital gains that you make in the market are taxed at a lower rate if you hold your stocks long enough before selling. On the other hand, Uncle treats annuity payouts as ordinary income (minus the amount you've paid for the annuity).

2. Most annuities cost too much. With everything added in, you do not enjoy the same low fees over time that you would through a Fee-Only planner or Vanguard-style index fund. You're hit with all kinds of bizarre charges such as "mortality and expenses charges."

Certain annuities are not so bad (some of the better possibilities come from Vanguard, T. Rowe Price and TD Waterhouse and have low yearly expenses). But Fortune says most are "still sold by commission-paid insurance agents, stockbrokers, and financial planners. These folks earn more selling annuities than they could selling virtually any other investments." Fortune says that the sales commissions on variable annuities--discussed later in this article--"average six to seven percent and go as high as 15 percent. Commissions on load mutual funds average more like three to four percent."

On top of other outrages, you may pay surrender charges as high as seven percent the first year if you cash your annuity in ahead of time.

Plus, you'll pay management fees, just as with a mutual fund. Normally they will be lower--but not as small as those that an index fund charges. When all's said and done, your annual fees may approach two percent--or just about twice as what a Fee-Only planner would charge.

3. The insurance coverage that annuities offer isn't that great a deal. They don't even work out well as death benefits. Fortune has said that annuities are "an inefficient way to buy life insurance, and almost no one collects on it anyway."

4. To grow your investment, the annuity providers will often rely on means that are less than stellar in yields. Fixed annuities mean assure you a certain return ahead of time, but then it's so low that inflation could pose a real threat to you in retirement.

Within a variable annuity, you can indeed decide to an extent how to invest your money. But it will have to end up in the equivalent of in-house mutual funds. Some choice, eh? Does this not sound a little like the incestuous dealings of brokerages where not-so-objective planners direct you to their own dogs?

Another choice might be a equity-index annuities. Yes, you'll be guaranteed a return of perhaps several percent, but then your upside from the stock market would be limited, too. If you're a long-term investor, why not simply invest in the funds yourself--perhaps in an index without the handicap?

5. Annuities tie up your money so you can't invest it more profitably.

In fairness to annuities, there are occasions when they might make sense. According to the Motley Fool, they "are desirable only (if ever) for those who:

• "Have contributed the maximum to their 401(k) plans and IRAs and desire further tax deferral on investment gains."
• "Prefer investing in mutual funds as opposed to individual securities.
• "Will keep the annuity for at least 15 to 20 years." But, let us add here at ElderAdo, that argument is rather irrelevant to most people who are retired or close to it.
• "Are in a 28 percent or higher income tax bracket today, but expect to be in a lower income tax bracket in retirement."
• "Don't need the annuity proceeds prior to age 59 1/2.
• "Are unconcerned that heirs must pay ordinary income taxes on any appreciation.
  
• "Desire a 'guaranteed' income for life in retirement."

The later argument can be powerful. But remember the tradeoff. If history repeats itself, the "guaranteed income will most likely be much smaller than the rewards of investing regularly and prudently in the market.

A outrageous example of the risk of trusting annuity-pushers comes from our own back yard in Potomac, Maryland, where a CFP urged an elderly couple to trade in an annuity he had sold them four years before. He said they would get a $50,000 reward for making the switch. He said it would more than cover the old model's $25,200 surrender charge, which was 1/25 of the original investment ($630,000). They would enjoy a $24,800 profit.

But as Forbes revealed, there was a catch: "The annual expense was 1.7 percent compared with 1.25 percent on the old account, and the surrender charge, which started out at an exorbitant eight percent, would take nine years to go away. If the couple had kept their original annuity for three more years, they could have surrender it with no penalty.

"Sadly, the husband then was diagnosed with terminal cancer, and he needed cash for estate tax purposes and medical expenses. "But getting out meant paying a surrender fee of $80,000 plus reimbursing the insurer the entire $50,000 bonus. The market's 2000 slump eroded the annuity's value, so they walked away with a paltry $605,000. Now they're suing their planner for deceptive sales practices."

Did this happen to financially naive people? Hardly. The couple had gotten well off through ownership of apartment buildings.

With such cases in mind, the SEC is examining the marketing materials of the biggest underwriters of annuities, including, says Forbes, ING Golden American, American Skandia and Allianz Life. It quotes Paul Roye, director of the agency's Divsion of Investment Management: "The industry is on notice."

Enough said. If you feel you must buy an annuity, just be certain that the person recommending it is not on commission. Do not shy away from asking how he or she will benefit directly or indirectly from a sale, and watch out not just for present fees but for those down the road.

RESOURCES

• Annuity Gratuity, Carrie Collidge, Forbes, Feb. 19, 2001.
• Annuities: What's to Like?, The Motley Fool, July 5, 1999.
• The Money Manager: Finally, a Warning about Annuities, Carolyn T. Greer, Fortune, July 5, 1999.
• The Great Annuity Rip-Off, Carolyn T. Greer (same writer, different magazine), Forbes, Feb. 9, 1998.
• The $6.4 Billion Ripoff, Barron's, March 27, 2000.