Annuity Puzzle

I don't like to invest in anything I don't understand. I think the greatest investor of our time, Warren Buffett, has expressed similar sentiments from time to time as well. So if a brilliant investor like Warren Buffett won't put his money where his brain can't get to, why should you or I?

What I'm talking about are annuities; variable, fixed, deferred, immediate, purple, and pink. There are so many different types of annuities all packaged differently from different insurance companies and sold under different names, it is very difficult to understand which would be most appropriate, if any, for your portfolio. This confusion leads investors (the purchases of these products) to ultimate confusion and into the arms of a perhaps untrustworthy "Investment Advisor" aka insurance salesman.

Many "Investment Advisors" will direct their clients (prey) into these products with promises of tax deferral heaven, compound returns, and the big S - safety. I'll do my best to rebut all of these benefits here, but please keep in mind that this is merely the tip of the annuity iceberg, and that each annuity contract (yes ladies and gentlemen, an annuity is a contract, and if you break its terms, guess what, you bought it, and it will cost you substantial fees) is very different and needs to analyzed on its own merits.

Tax deferral heaven. Annuities allow purchases to defer taxes on earnings and interest until the money is taken out of the annuity. These tax savings are therefore allowed to continue to compound over time, and increase overall earnings. But here's the rub, those deferred taxes, when paid, are paid out as income taxes, rather than the much lower capital gains rate your earnings would be subject to if, for example, you had simply invested at retail (sent the fund company a check directly) in an index based mutual fund. In addition, most experts agree that taxes will be higher in the future than they are today, so you will be paying at an even higher rate. As an aside, this belief that taxes will be higher in the future is what makes the Roth IRA such a powerful tool.

Compound returns. Yes its true that your annuity money will earn on its earnings over time, and you will experience compound returns, however, those compound earnings will in no way compare to the compound earnings you could have earned historically in the United State stock markets, and again if historical results are any guide (who else can guide us?), you will end up with considerably less money than if you had simply invested in that previously mentioned S&P 500 Index fund.

The big S - safety. For example, most deferred annuities will guarantee at least a very low rate of return, like 3%. They will also very often guarantee that your annuity contract will be worth at least the amount originally invested when you begin to take disbursements many years later. They will also charge you a tremendous amount for these insurances. There is often a 1-2% (of the total value of your annuity) charge for guaranteeing survivor benefits, a .1-.3% charge to guarantee a stated growth rate for death benefits, fees for waiver of withdrawal charges (a fee to waive a fee! What a terrific idea!), and a fee for something known as 'total protection.' If you feel confused, you're not alone. The important truth here is all of these fees work to reduce your earnings, and therefore the amount that is available to compound. Are you really safer with less money? Too little risk is very dangerous!

Annuities are insurance products. Your money is usually invested in the same types of instruments that you could invest in yourself, again like that S&P 500 Index fund, only there are at least two more sets of hands in the money pot: the insurance salesman aka "Investment Advisor" (who is often an independent broker who works on commission), and the insurance company. They both need to get paid for their services, and they both get paid from your money. With so many hands in the pot, someone will be left short, and it won't be the mutual fund managers who get a fixed percentage of the monies they manage, it won't be the salesman who gets a fixed commission for selling you the annuity, and it won't be the insurance company who gets paid by insuring your money against all future catastrophe, it will be you!

Annuities are appropriate for some portfolios at some times, but they are a highly commissioned financial product, and are largely oversold for this reason. Please remember that a financial advisor has a great deal of interest and incentive in persuading you to purchase one of these products. If you are considering an annuity of any kind, make sure you understand all of the fine print, even if your financial advisor does not.