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Are Annuities Ever Not Stupid?

Here at The Motley Fool, we tend to scorn financial products that enrich the people who sell them, but offer investors subpar returns.

So it should come as no surprise that we really don't like most annuities.

By and large, annuities are the kind of product Fred Schwed was thinking of when he wrote his classic book, Where Are the Customers' Yachts?:

An out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said, "Look at those bankers' and brokers' yachts." The naive customer asked, "Where are the customers' yachts?"

The high (often crazy-high) fees and low returns on most annuities mean that the folks selling them are the ones buying the yachts, not the customers.

You'd think investors would avoid these products. Yet no less an eminence than retirement whiz John Greaney, a regular Fool contributor and former engineer who successfully retired at age 38, has said repeatedly that under some circumstances, one type of annuity can be a useful component of your overall retirement strategy.

Writing in the March 2005 issue of the Fool's Rule Your Retirement newsletter, Greaney showed how adding a lifetime income annuity to your retirement portfolio can help ensure that you don't outlive your retirement savings.

While you should check out his article for the full analysis (if you're not a Rule Your Retirement subscriber, just grab a no-obligation free trial for 30 days of access), the essence of it is quite simple.

But first, a bit of background about annuities.

One of Wall Street's favorite products
An annuity is a contract between you and (usually) an insurance company. In exchange for a big chunk of cash today, the insurance company agrees to pay you an income for a specified period, which can be a specific number of years, or the rest of your life.

There are many types of annuities, but for our purposes, we will describe three broad categories: The (sometimes) good, the bad, and the ugly. In reverse order:

The ugly: Equity indexed annuities. These products are one of the most notorious salesman-enrichers out there. They can even end up doing more harm than good. Sold on the promise of a "guaranteed" rate of return based on the performance of an index, the equity-indexed annuity's fine print inevitably ensures that your return will be several percentage points lower than the index's.

Worse, the return is often capped. When the S&P 500 has a big 25% year, which history says it will every now and then, you're likely looking at no more than a 10% return. And that's before fees, which are somewhere between outrageous and insane. Don't even start me on the tax disadvantages.

Let's just say that a well-built portfolio of stocks should trounce this boondoggle of a product's performance easily, and would include:

  • Dividend-rich blue chips, like Kraft Foods (NYSE: KFT  ) and Eli Lilly (NYSE: LLY  )
  • Global powerhouses like Toyota (NYSE: TM  ) and South African energy giant Sasol (NYSE: SSL  )
  • Small up-and-comers like CAPS favorites Arch Chemicals (NYSE: ARJ  ) , China Medical Technologies (Nasdaq: CMED  ) , and helicopter-blade and guitar maker Kaman (Nasdaq: KAMN  ) .

The bad: Variable annuities. I ranted, er, wrote about these high-fee products (nearly 2.5% a year on average, compared to about 0.2% for an index fund) and their disadvantages at length last year. The fees are high, the returns are iffy, the "surrender charges" imposed if you need your money back are brutal. There some tax advantages, but they usually don’t come close to compensating for the downsides.

The sometimes good: Lifetime income annuities. These are basic, classic annuities -- you hand over a lump sum, you get a specified income for the rest of your life. While they won't give you the returns of a well-structured portfolio of stocks and bonds, as Greaney points out, the best of them can provide you with cost-effective insurance against outliving your money. They're worth serious consideration if you're near retirement and your nest egg isn't as big as you'd like.

Even if you think your nest egg is big enough, and you're concerned about managing an investment portfolio while you're retired -- and don't want to be dependent on an advisor -- a lifetime income annuity can make some sense.

There are tradeoffs. You'll probably have less money monthly than you would with a regular investment portfolio, and you could be giving up a large estate -- but for some, those are worth the peace of mind.

If you're considering this option, look for low-fee offerings backed by highly rated insurers -- Vanguard and Fidelity both have a number of good offerings available.

And do look at Greaney's article for a fuller exploration of the pros and cons of annuities -- and if you're new to Rule Your Retirement, check the excellent asset allocation road map in the most recent issue while you enjoy your free trial. You might decide that sticking with an investment portfolio is easier than you thought.

Fool contributor John Rosevear does not own any stocks mentioned. Kraft and Eli Lilly are Motley Fool Income Investor choices. Sasol is a Global Gains pick. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy is a road map to disclosure nirvana.

Read/Post Comments (4) | Recommend This Article (21)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 25, 2008, at 12:35 AM, prginww wrote:

    In our opinion, Mr. Rosevear did not adequately answer the question he posed, so here is our answer. We believe that our answer does a better job of explaining why annuities are popular financial products.

    Are annuities ever not stupid? Of course. Immediate, fixed, indexed, and variable annuities all provide an attractive value proposition to certain customers.

    Immediate annuities: Retirees face a dilemma. They have a limited amount of savings, and if they dip into the principal to provide an adequate cash flow during retirement, they face the prospect of running out of money one day. Immediate annuities are the one financial product that can allow you to liquidate your principal yet be guaranteed not to run out of cash flow, no matter how long you live. This is because insurance companies pool the longevity risk across a large number of annuity owners, ensuring that there is adequate money to pay those who live a long time. As Mr. Rosevear mentions, the March 2005 issue of the Motley Fool’s Rule Your Retirement newsletter includes an article showing how adding a lifetime income annuity to your retirement portfolio can help ensure you don’t outlive your retirement savings.

    Fixed annuities: Fixed interest rate annuities include so-called “CD-style” annuities. They are available in a variety of durations with a variety of interest rates. They are very comparable to bank CD’s and are often sold by insurance-licensed employees of banks. Because of the different investment strategies employed by banks versus insurance companies, there are times when fixed annuities offer much higher interest rates than bank CD’s of the same duration. When they do, fixed annuities are a smart choice for consumers who would otherwise put their money in bank CD’s.

    Indexed annuities: Indexed annuities get some bad press because some writers and consumers by mistake think that these annuities are designed to replicate stock market returns. They are not designed to do that. They are designed to have similar safety of principal features as bank CD’s, money market funds, and savings accounts. They are an excellent choice for consumers who are looking for safety of principal yet the potential for a higher return than those other comparable products. You can even make a good argument that indexed annuities are more attractive than bond mutual funds. See our article, “Turning the Fixed Indexed Annuity Critic into an Advocate” at

    Variable annuities: Variable annuities get some bad press because some writers (including most at the Motley Fool) believe that all customers should be willing to bear stock market risk in order to achieve stock market returns. But there is some risk of losing money in the stock market, even over long periods of time, and many consumers cannot stomach bearing that risk. So, variable annuities offer a way for such consumers to put money in risky securities. Consumers give up some of the return in the form of fees to the insurance company, which provides various guarantees to protect the invested principal. This provides a way for risk-averse customers to achieve some element of stock market return at a risk level that is comfortable for them.

  • Report this Comment On June 30, 2008, at 10:40 AM, prginww wrote:

    stone944, my short answer to your long sales pitch is that the fee levels on nearly all annuities add up to extremely expensive payments for insurance of, at best, limited value. Nearly all "customers", as you call them, are better served by looking elsewhere. You guys just don't earn those fees, period.

  • Report this Comment On November 28, 2008, at 12:27 PM, prginww wrote:

    I'll bet there are alot of retirees that are in their 60's, 70's, or 80's that sure wish they would have had money in indexed annuties this year instead of the stock market. They would not have lost one dime over the last 6 months. I don't care how many arguments you make against them, they are the right product for some people, but not all. Why do you always compare them to the stock market and condemn them because you don't get all of the gain in the index or the return is capped? It costs money to protect on the downside, so it doesn't take a genius to know that if you don't get any of the downside, you sure aren't going to get all of the upside. Don't compare them to the stock market, compare them to CD's and money market funds, with a very good chance of returning higher yields than these products, but also offering all of the same safety and guarantees.

  • Report this Comment On August 02, 2012, at 12:44 AM, prginww wrote:

    After reading the pros and cons,I am more confused.ihave 2 annuity proposals,one from Ameriprise offering 6%return at a fee of 2.5%,surrender charge upto 10 years.the money is from Ira,after 1year of depositing when I turn 65 (I am 64).this is my husbands Ira,and it is joint has no surrender charge after 1 month,but the return is 4%,cost is 1.5%.if I live 22.5years,is it not better to have 6%return with a higher expense?can someone analyze this.thank you.

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