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In recent months, insurers have experienced a new surge of demand for their annuity products, with sales hitting record highs. But as one of the most hotly debated financial products available to consumers, annuities may not be the best option for your investment funds. Here are the top three reasons why you should avoid annuities.
What is an annuity?
First off, we should cover what an annuity is and what it can do for your retirement. Though there are a number of types, the most basic explanation of an annuity is that you give a lump sum of funds up front to an insurer in exchange for an income stream either right away (immediate annuity) or down the road (deferred annuity). The payments you receive can be based on fixed or variable interest rates, or even indexed to certain funds and equities.
Annuities are popular products for those who are concerned that they will outlive their funds. Plus with deferred taxes, your money grows tax-free until you begin receiving payments, at which time the gains are treated as ordinary income. So those are the pluses. Now, let's take a look at the big drawbacks.
1. Takes money to make money
The top complaint from financial planners and investors alike in terms of annuities? Their cost. Not only do you generally have to pay an annual fee for the management of your money, but you'll also find fees attached to many of the big benefits you're looking for. Want a guaranteed rate of return? Could cost you. So could a guaranteed lifetime payment or an early withdrawal.
Though the basics of an annuity provide a decent investment option, the cost of the product cuts into your returns to the point where another investment vehicle may have given you a better result.
2. The times they are a-changin'
If you bought an annuity with a guaranteed lifetime payout back before the financial crisis, you probably got a great deal. Because the financial crisis and low-low interest rates have caused annuities to be big financial strains for the insurance companies, many have made big changes to their products.
In its second-quarter earnings call, American International Group (NYSE: AIG ) reported a record level of sales in variable annuities. The company reported similar results for its fixed annuity products during the third quarter. But customers saw some changes to the products this year -- namely, no more guaranteed lifetime benefits. Since 2010, AIG has been "de-risking" its annuity products by adding in features such as minimum investment allocations and various index fees in order to stave off the big losses the company experienced a few years earlier. Likewise, ING U.S. (NYSE: VOYA ) and MetLife (NYSE: MET ) have introduced similar changes to their annuity products.
As a savvy investor, you need to remember that though the insurers are offering you products that appear to fit your retirement needs, they will also have to tweak those products in order to make them profitable.
3. Securing your retirement
There are no guarantees in investing (or annuities -- see above). But when purchasing an annuity product, consumers may get a false sense of security that their money is in safe hands. But annuity products do not provide the same kind of security as a bank's depository account, like a CD would. Without FDIC coverage, the risk of losing your funds lies with the financial strength of the insurer.
As we saw back in 2008, the top annuity provider, AIG, nearly collapsed -- taking all of its assets under management with it. Though the company has made it through near-bankruptcy, investors should still be cautious when approaching an insurer for financial planning products.
Approach with caution
Even before the financial crisis, annuities were a debatable financial product. With difficult-to-decipher terms in the fine print, even experts couldn't be sure just how the products would perform. Now, with the benefit of hindsight, insurers are doing more to protect themselves from losses, making it harder for the average consumer to get just what they're looking for in an annuity. If you're still considering an annuity, make sure to comparison shop and talk to your financial planner (not a broker). Otherwise, check out more Fool.com articles for alternative ways to boost your retirement income.
The clearest path to retirement success
Annuities are like Monet paintings -- they look good from far away, but up close it's difficult to connect the dots. Though there's no guaranteed way to succeed in the stock market, the best investment strategy is to buy shares in solid businesses and keep them for the long term. In the special free report, "3 Stocks That Will Help You Retire Rich," The Motley Fool shares investment ideas and strategies that could help you build wealth for years to come. Click here to grab your free copy today.