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Are Annuities Too Cheap?

Annuities have a bad reputation. Although they allow investors to obtain income payments spaced out for the rest of their lives regardless of how long they live, they're best known for their high fees, surrender charges, and other costs that make them unattractive in comparison to other investments, such as mutual funds. Often sold to unsophisticated investors who don't always understand the nuances of annuities and their limitations and restrictions, annuities raise a lot of hackles among some who feel that they've been burned by them.

Given the general antipathy toward annuities, it's surprising to hear that one finance professor has changed his view toward them. In the latest issue of the magazine Research, however, Professor Moshe Milevsky presents evidence that companies offering variable annuities may in fact be charging too little for a particular feature most annuities now include. Although this may sound like good news, bad decisions by insurance companies about their risk management may leave investors out in the cold. Before turning to Professor Milevsky's research, however, you first need to understand the recent innovations in the annuity industry that his research addresses.

Lots of new annuity features
When you do research on annuities, one of the first things you discover is that there are a huge number of optional features you can choose. These features, sometimes called riders in the insurance industry, allow annuity investors to obtain some additional benefit not offered within the primary annuity product. In the past, the most typical feature was one that gave investors a guarantee that when they died, their heirs would be entitled to at least the amount of money that the investor paid. For instance, if a person bought a variable annuity tied to the stock market in 2000 and died in 2002 after it had dropped in value, the person's heirs would receive not the current value but rather the initial purchase price as a death benefit.

In the recent past, there has been an explosion in the number of options given to annuity investors. Rather than focusing on the death benefit, these new features give investors certain benefits during their lifetimes. These features have become an important part of the annuity marketing efforts for some insurance companies, such as Prudential (NYSE: PRU  ) , Manulife (NYSE: MFC  ) , and Sun Life (NYSE: SLF  ) . Professor Milevsky's research focused on three different types of features that many variable annuities now offer.

First, you can obtain a guarantee that you will be able to make periodic withdrawals from your annuity over your lifetime that will be at least equal to the amount you paid for it. Known as a guaranteed minimum withdrawal benefit, this benefit lets you withdraw a certain amount each year, regardless of whether or not there is enough money left in the annuity to cover the withdrawal. Once the annuity is depleted, the insurance company must step in to pay the remainder of the guaranteed benefit. This protects you against a severe drop in the value of the annuity.

In addition, you can include an annuity provision that will not only guarantee the value of your initial investment but also some appreciation over time. Guaranteed minimum accumulation benefits ensure that the value of your annuity will rise by at least a specified amount over a period of time, irrespective of how the investments underlying the annuity actually perform. Some companies allow investors to lock in gains by resetting the provision. For example, if you had purchased a variable annuity tied to the stock market with a guaranteed minimum accumulation provision in 1994, you might have been able to reset the provision at the market top in 1999, locking in the gains of the previous five years and insulating you from the decline in value during the ensuing bear market.

Finally, another guarantee focuses on those who have already retired and are seeking to stabilize the amount of income they receive from their annuity. A provision called the guaranteed minimum income benefit allows investors who choose to annuitize their annuities to receive at least a set amount of income each year, regardless of whether the underlying investments support that income level. In essence, this provides variable annuity investors some of the same certainty that those who invest in fixed annuities receive.

No free lunch
Many of these options are extremely attractive to investors, especially those who are risk-averse and can't afford to suffer unforeseen drops in the value of their investments. However, they come at a cost. For each option you select for your annuity, the insurance company generally adds an annual fee based on the amount you invest. For example, if you invest $100,000 in an annuity that has an option that costs 35 basis points or 0.35%, then you'll pay $350 each year for the protection that option provides. Selecting multiple features can make your expenses add up quickly.

Although these add-on fees seem expensive and add to already-high expenses on many annuity products, what Professor Milevsky concluded was that insurance companies aren't charging enough for these new products. The second part of this article discusses this research and its impact on annuity investors.

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For retirement guidance, take a look at Foolish expert Robert Brokamp's Rule Your Retirement newsletter service. You can try it for free for a whole month. Doing so will give you access to all the past issues, which feature a host of "Success Stories" profiling people who retired early and are willing to share their strategies.

Fool contributor Dan Caplinger never bought any annuities but has helped those who did. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy is always free.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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