Should you buy an annuity?

The basic question to be answered by someone considering this investment is whether the cost of the insurance coverage is justified for the benefits that are paid. In general, the answer to that question is one that only a specific individual can answer based on his or her specific circumstances. Either a 'yes' or 'no' answer is possible, and there may be much support for either position. People who oppose use of annuities will point out that it is unlikely (less than 50% probability) that the insurance guarantees will pay off, so that the guarantees are expected to reduce the overall return. People who favor use of annuities tend to suggest that not buying the guarantees is always an irresponsible step because the purchaser increases risk. Both positions can be supported. But the key issue is whether the purchaser is making an informed decision on the matter.

Now it's time for some cautionary words about the purchase of annuities. Many experts feel that annuities are a poor choice for most people when examined in close detail. The following discussion compares an annuity to an index fund (see also the article on index funds elsewhere in this FAQ).

Variable annuities are extremely profitable for the companies that sell them (which accounts for their popularity among sales people), but are a terrible choice for most people. Most people are much better off in an equity index fund. Index funds are extremely tax efficient and provide, overall, a much more favorable tax situation than an annuity.

The growth of an annuity is fully taxable as income, both to you and your heirs. The growth of an index fund is taxable as capital gains to you (which is good because capital gains taxes are always lower than ordinary income) and subject to zero income tax to your heirs. This last point is because upon inheritance the asset gets a "stepped up basis." In plain English, the IRS treats the index fund as though your heirs just bought it at the value it had when you died. This is a major tax advantage if you care about leaving your wealth behind. (By contrast the IRS treats the annuity as though your heirs just earned it; they must now pay income tax on it!)

If you remove some money from the index fund, the cost basis may be the cost of your most recent purchase (or if the law is changed as the administration currently recommends, the average cost of your index investments). By contrast, any money you remove from an annuity is taxed at 100% of its value until you bring the annuity's value down to the size of what you put in. (The law is more favorable for annuities purchased before 1982, but that's another can of worms.)

Tax considerations aside, the index fund is a better investment. Try to find some annuities that outperformed the S&P 500 index over the past ten or twenty years. Now, do you think you can pick which one(s) will outperform the index over the next twenty years? I don't.

Annuities usually have a sales load, usually have very high expenses, and always have a charge for mortality insurance. The expenses can run to 2% or more annually, a much higher load than what an index fund charges (frequently less than 0.5%). The insurance is virtually worthless because it only pays if your investment goes down AND you die before you "annuitize". (More about that further on.) Simple term insurance is cheaper and better if you need life insurance.

Annuities often invest in funds that are difficult to analyze because independent reports such as Morningstar are not available. However, you may find insurance companies that use portfolios for which Morningstar reports are available, which will help with analysis of their annuity contracts.

Annuity contracts are very difficult for the average investor to read and understand. Personally, I don't believe anyone should sign a contract they don't understand.

Annuities offer the choice of a guaranteed income for life. If you choose to annuitize your contract (meaning take the guaranteed income for life), two things happen. One is that you sacrifice your principal. When you die you leave zero to your heirs. If you want to take cash out for any reason, you can't. It isn't yours anymore.

In exchange for giving all your money to the insurance company, they promise to pay you a certain amount (either fixed or tied to investment performance) for as long as you live. The problem is that the amount they pay you is small. The very small payoff from annuitizing is the reason that almost no one actually does it. If you're considering an annuity, ask the insurance company what percentage of customers ever annuitize. Ask what the payoff is if you annuitize and you'll see why. Compare their payoff to keeping your principal and putting it into a ladder of U.S. Treasuries, or even tax-free munis. Better yet, compare the payoff to a mortgage for the duration of your expected lifespan. If you expect to live to 85, compare the payoff at age 70 to a 15-year mortgage (with you as the lender).

For a fixed payout you would be better off putting your money into US Treasuries and collecting the interest (and keeping the principal).

Now let's consider a variable payout, determined by the performance of your chosen investments. The problem here is the Assumed Interest Rate (AIR), typically three or four percent. In plain English, the insurance company skims off the first three to four percent of the growth of your investments. They call that the AIR. Your monthly distribution only grows to the extent that your investment grows MORE than the AIR. So if your investment doesn't grow, your monthly payment shrinks (by the AIR). If your investment grows by the AIR, your monthly payment stays the same. When the market has a down year, your monthly payment shrinks by the market loss plus the AIR.

If you do decide to go with an annuity, buy one from a mutual fund company like T. Rowe Price or Vanguard. They have far superior products to the annuities offered by insurance companies.