Annuities Explained

Annuities ExplainedBy Wilson Ziegler, Staff Writer

Insurance companies offering annuities are somewhat like Las Vegas casinos. They never lose. It's a highly profitable part of the insurance business and hardly any customers have a sufficient understanding of the rules of the game to able to play knowledgeably.

Annuities come in two varieties – Fixed and variable. A fixed annuity is somewhat like a CD, in that the insurance company issuing the annuity agrees to pay a fixed rate to the investor, while the investment, along with associated profit or loss, is also the company's responsibility and right. The performance of the investment is not directly coupled to the returns the investor gets. The insurance company acts as a barrier between the index and the investor, minimizing the impact by siphoning off huge spikes in both profit and loss, while passing along stable returns to the investor.

Variable annuities are merely pooled investment accounts thinly disguised as insurance products. The returns from variable annuities are directly related to asset performance and if the invested stocks tank, the investor stands to lose. The difference being that the IRS confers tax deferred status on all contributions and gains in variable annuities.

While the contract holder has a right to annuitize ( turn the investment into a lifetime income, paid back in monthly installments by the insurance company ), a majority of annuity investors stay away from this aspect of annuities. This is mostly on account of the fact that the monthly payments are tied to the life span of the investor. If you, the investor, dies early after annuitizing the contract, the insurance company gets to keep the entire balance. Therefore, in this discussion, we ignore this aspect, and focus on the performance, returns and tax issues related to a lump sum withdrawal.

Because of the high profit margins insurance companies expect from annuities, they offer their salesmen relatively higher commissions. This leads to some aggressive sales pitches resulting in customers being signed up without properly knowing what they are getting into. Secondly, the administrative costs and annual fees eat up a huge chunk of the net returns an annuity holder expects. Therefore, what you see is not always what you get. If an insurance company offers a fixed annuity with minimum guaranteed returns, it is almost a certainty that the costs will be deducted from the returns. It is advised to consult with your financial advisor regarding all the hidden costs and clauses of annuities before signing a contract.

The company has wide latitude to decide the credited rate, and very few companies pay an across the board rate to all annuity holders. The actual amount the annuity is credited with each year is calculated based on a complex set of factors including the pool of bonds assigned to the annuity and the purchase date.

If the end result is not what you expected, and the annuity is not generating the kind of returns you had in mind, getting out is even more difficult. The IRS charges a 10% penalty for early withdrawals. The issuing company may have its own rules and impose a fine of up to 8% to allow the transfer. Added to this is the fact that annuity returns are tied to the performing index. If you have a variable annuity, and you want to withdraw because of non-performance, it's safe to say that your situation is worse off than a stock trader stuck with junk bonds, because not only do you have to bear the performance losses, but also the administrative charges and the IRS penalty. With fixed annuities, the situation is slightly better, since you only face the prospect of penalties and administrative charges.

That said, annuities are still a preferable investments for a certain set of investors. These include seniors who are looking for more returns than traditional investments offer, but do not want the associated risk. Secondly, since annuities offer protection against creditors, this may be a suitable savings tool for high risk professionals such as physicians who face malpractice suits. Also to be considered is the fact that traders on the stock market might to use annuities as a way to reduce the tax burden.

The insurance company invests your funds in a bond portfolio, keeps a large portion of the returns and distributes the remaining to the contract holder. To see significant returns, investors need to wait for the duration. Short term gains are more likely to be accrued by directly investing in the market, rather than going through an annuity. Annuities offer the hope of satisfactory returns only in the long term.