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Annuities: How Much of What People Hear is True?

Feb 11th 2016
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People have a love/hate relationship with annuities. They’ve been around since Ancient Rome. They are designed to provide what Social Security or a defined benefit pension delivers – a steady stream of income during your lifetime. Unlike those two vehicles, which are funded by payroll deductions, annuities are often purchased for a lump sum by individuals. Many issues come up, few with simple answers.

I’m giving my money away. I can never get it back. The general belief is once you hand over your money and buy an annuity from an insurance company, the money is theirs. You can’t get it back. Annuities operate in either the accumulation phase or the distribution phase. During the accumulation phase, the money is growing on its own. You aren’t drawing any income, similar to keeping your money under the mattress. During this period, the owner can withdraw all or part of his or her money, subject to penalty charges, which usually decline over time. Logically, this is because the insurance company uses long-term investments to earn the return. It doesn’t want owners treating it as a short-term investment.

Why it’s true: Once you enter the distribution phase and start drawing scheduled payments, either for your lifetime or an agreed period, the rules change. You are betting you will live forever. The insurance company has other ideas. The outcomes for large numbers of people usually distribute along a bell-shaped curve, which the insurance company uses for predictive purposes.

Why it’s false: During the accumulation phase, you haven’t taken any money out. You can withdraw all or part of your money, subject to declining penalties.

Annuities pay more than CDs, treasuries, and corporate bonds. It’s often a belief that insurance companies offer higher payments because they have found great investments that banks and brokerage firms have somehow missed.

Why it’s true: Once you annuitize and start receiving regular payments, those amounts might seem like a generous return when divided by the lump sum you handed over.

Why it’s false: During the distribution phase, the insurance company is making payments made of both interest earned and part of the original principal. The checks are larger because you are getting your own money back. This is a major reason why “the money isn’t yours anymore” once you annuitize.

Annuities are safe because they are guaranteed. It’s a belief when we Americans think of “guaranteed” as it applies to financial instruments, we usually assume the federal government or another government body is ready to pay us back if something bad happens. We were raised seeing “FDIC”-insured signs in banks.

Why it’s true: The annuity is an obligation of the insurance company that issued it. It is “guaranteeing” it.

Why it’s false: The insurance company operates in the private sector. It can go out of business. Although some states require insurance companies to segregate specific financial assets to back up policies written, other states do not. You need that insurance company to stay in business.

The fees are too high. The financial press constantly talks about fees. We believe low fees are good, and high fees are bad. It makes sense. We shop for groceries based on finding the best price. It should apply to other fields, too. Annuities and other insurance products are often used as examples of products with high fee structures.

Why it’s true: Annuities might have three types of fees built into a product: those associated with the investment itself, another set of fees for providing insurance, and a third set for compensating the salesperson. That second extra set is important because the death-benefit amount might be higher than the value of the underlying investments if you died at an inconvenient time.

Why it’s false: “Their” fees are high implies another product’s fees are not. There are many ways of earning money on a client’s investments within the financial services industry. They aren’t all easily measured. For example, if an investment product “buys” stocks, the price at which the individual stock purchases are made can be an issue. Transaction and administrative costs play a role. The industry is making money somehow.

Tax deferral is a major advantage. We believe if given the choice between paying taxes now or later, later is better. It’s difficult for money to grow if a portion of the appreciation is regularly removed to pay taxes.

Why it’s true: Albert Einstein famously remarked, “Compound interest is the eighth wonder of the world.” It’s better to defer because the underlying assets have the ability to compound, increasing overall growth.

Why it’s false: Few, if any, reasons, although taxes will need to be paid someday.

Annuities are good for estate planning. “Don’t ever die if you own securities.” Settling an estate can take time. It’s natural to want to minimize estate taxes. Annuities and other insurance products are often considered to offer some advantages in estate planning. As a CPA, you understand how this works better than most people.

Why it’s true: Death benefits from insurance usually bypass probate. This means the insurance proceeds gets to those named beneficiaries quicker.

Why it’s false: Everyone wants magic investments that leave the government’s hands off their money. The rules might allow beneficiaries to get their money quicker, but taxes still must be paid, although some companies allow annuities to be stretched, like inherited IRAs. Others do not. This can become an issue for the estate and for the beneficiary.

Annuities and other insurance products have a place in many clients’ portfolios. They need to understand what they are buying and what the product is designed to do.

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