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Are Annuities Ever Not Stupid?

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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, not the customers they supposedly serve, end up buying the yachts.

You'd think that 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 year like 2009, in which it gained 26%, you might be 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. Such a stockpile would include:

  • Dividend-rich blue chips, like Procter & Gamble (NYSE: PG  ) and AT&T (NYSE: T  ) .
  • Global powerhouses like GlaxoSmithKline (NYSE: GSK  ) and energy giant Total SA (NYSE: TOT  )
  • Small up-and-comers like CAPS favorites Titanium Metals (NYSE: TIE  ) , Foster Wheeler (Nasdaq: FWLT  ) , and optionsXpress (Nasdaq: OXPS  ) .

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 a few years ago. 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 trade-offs. 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.

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 out the excellent materials on asset allocation while you enjoy your free trial. You might decide that sticking with an investment portfolio is easier than you thought.

This article, written by John Rosevear, was originally published on June 12, 2008. It has been updated by Dan Caplinger, who doesn't own shares of the companies mentioned. optionsXpress Holdings and Titanium Metals are Motley Fool Stock Advisor selections. Procter & Gamble and Total SA are Motley Fool Income Investor selections. The Fool owns shares of GlaxoSmithKline and Procter & Gamble. 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 (8) | Recommend This Article (19)

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 March 10, 2010, at 4:27 PM, noryakerson wrote:

    I would think that a good fixed lifetime annuity would have its place in a retirement portfolio right along with stocks and bonds. I like the idea of a mix. The annuity would protect a retiree against econmic bumps, providing that fixed monthly income. A well diversified portfolio of stocks and bonds would allow the retiree to take advantage of the market's upticks. My own plan, on retirement, is to move 25% of my stock holdings into a good lifetime annuity.

  • Report this Comment On March 10, 2010, at 4:42 PM, noryakerson wrote:

    I think a good fixed-income annuity has its place right alongside stocks and bonds and real estate holdings when it comes to retirement. My own plan is to move 25% of my stock holdings into a lifetime annuity shortly before retirement. It's nice to have that fixed monthly income to help ride out economic dips.

  • Report this Comment On March 10, 2010, at 5:40 PM, MellowGuy1 wrote:

    A lifetime annuity is good, but consider:

    The payout depends on the current long interest rate which is now very low.

    The payout depends on your age so it pays to wait.

    The annuity can be depreciated so your tax bill will be less until it is fully depreciated. The depreciation rate is highest for those over 70.

    If you are unhealthy, you may die before you can collect nearly what the annuity costs. When you die the payments will stop.

    A large lifetime annuity can function as a substitute for assisted living insurance.

    immediateannuity.com can give you estimates as what an immediate annuity will yield.

    Money spent for an immediate annuity won't go to your heirs unless you gift them every year.

  • Report this Comment On March 11, 2010, at 7:22 AM, mk3509 wrote:

    I love my lifetime income annuity. Once a month I receive a $4000 check in my mailbox till I die. I bought it four years ago and I am very happy with it. I never run out of money.

  • Report this Comment On March 11, 2010, at 8:48 AM, devandev wrote:

    I'm in the "have a mix" camp. My retirement starts this year and I have a pension, a fairly decent stock/bond portfolio, and an immediate annuity which returns 6.4% annually. Not exceptional, but not ludicrously below the average market return of 8% and it's guaranteed. It's main disadvantage, aside from never seeing that initial deposit again, is the lack of inflation protection, but then that's why one has a portfolio as well.

  • Report this Comment On March 11, 2010, at 6:09 PM, lovethelight wrote:

    MY COMMENTS BELOW ARE IN CAPS:

    I'M HOPING THE AUTHOR OF THIS ARTICLE HAS THE INTEGRITY AND CHUTZPAH TO RESPOND TO ME.

    The ugly: Equity indexed annuities. These products are one of the most notorious salesman-enrichers out there:

    SALESMEN ENRICHERS?

    HOW ABOUT SELLING A CAR (WHICH IMMEDIATELY DEPRECIATES)?

    OR

    SELLING A HOUSE (COMMISSIONS UP TO 6% OF THE SELLING PRICE- WOW!)

    THE GOAL OF SALES IS TO MAKE MONEY.

    NOT ONLY FOR THE COMPANY WHOSE PRODUCT YOU'RE SELLING, BUT ALSO AS A SALES PERSON.

    They can even end up doing more harm than good.

    BECAUSE WE ALL KNOW IT'S TERRIBLE AND HARMFUL TO HAVE MONEY PROTECTED AND GUARANTEED 100% WITH AN INSURANCE COMPANY THAT HOLDS $1.05 IN RESERVE FOR EVERY $1.00 YOU INVEST.

    THE FDIC (I.E. BANK INSURERS) DOESN''T EVEN GET CLOSE TO THAT TYPE OF FINANCIAL BACKING. LOOK IT UP FOR YOURSELF.

    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.

    THIS MAY BE TRUE. HOWEVER, FOR SOME PEOPLE, 50% OF SOMETHING BETTER THAN NEGATIVE 50% OF SOMETHING. YOU SEE, WHEN THE MARKETS GO DOWN AND YOUR MONEY IS INVESTED IN STOCKS, MUTUAL FUNDS E.G., AND THEY PLUMMET, THE VALUE OF YOUR ACCOUNT GOES DOWN, TOO. THE QUESTION YOU MUST ASK YOURSELF IS THIS: DO I WANT TO TAKE THE CHANCE OF LOSING 20%, 30%, OR EVEN 50% OF MY LIFE SAVINGS?

    Worse, the return is often capped. When the S&P 500 has a big year like 2009, in which it gained 26%, you might be looking at no more than a 10% return.

    CAPS, YES. BUT IF STRATEGIZED AND PLANNED PROPERLY, WHICH IS WHAT WE DO, WE HAVE SEEN RETURNS THIS YEAR FOR SOME OF OUR CLIENTS WITH EQUITY (FIXED) INDEX ANNUITIES IN THE NEIGHBORHOOD OF 22-35%.

    And that's before fees, which are somewhere between outrageous and insane.

    THERE ARE NO FEES IN AN EIA!

    UNLESS YOU ATTACH A VOLUNTARY RIDER TO IT, WHICH USUALLY COSTS SOMEWHERE IN THE NEIGHBORHOOD OF 30-45 BASIS POINTS.

    VARIABLE ANNUITIES, WHICH WE DO NOT ADVOCATE, USUALLY HAVE HIGH FEES.

    Don't even start me on the tax disadvantages

    REALLY? PLEASE GET STARTED, BECAUSE I'D LIKE TO HEAR ALL ABOUT THEM...(THAT IS, IF YOU CAN DIG THEM UP, SOMEWAY, SOMEWHERE, SOMEHOW...)

    AUTHOR: PLEASE EMAIL ME IF YOU COME UP WITH SOME.

    Lovethelight26@aol.com

  • Report this Comment On March 24, 2010, at 11:54 AM, BPWM wrote:

    I have run a wealth management practice for over 20 years and manage the majority of client assets utilizing individual securities. However, annuity vehichles have been and will continue to be a part of many clients portfolios. Fixed annuities have tax benefits and typically higher guaranteed interest rates than Bank CD's. Annuitixzation over life expectancy is a life saver for older people who simply need a higher guaranteed cash flow and can't risk running out of money or suffer the consequences of some of The Motley Fool's more foolish stock picks.I am not a huge han if Equity Indexed Annuities, however some of the products have improved and are appropriate at times. Lastly, Variable Annuities (VA) have powerful guarantees that allow an otherwise conservative investor to get equity market exposure without all of the downside risk of equity markets. The expenses for these vehichles are high, however, buying put and call option straddles around an equity portfolio is typically more expensive than the VA expenses. I direct any reader of my comments to Google "Variable Annuities WSJ July 22" , the Wall Street Journal discusses how Variable annuities have been one of the best investments of the decade.Whomever, the author was of this piece knocking annuity products,clearly does not understand them. I would be more than happy to debate the subject in an open forum with the author.

  • Report this Comment On May 11, 2014, at 11:28 AM, ruffian wrote:

    Small wonder why financial gurus disdain annuities. The annuity community is taking billions of dollars out of the casino known as Wall Street, the institution that plummets 2 to 5% everytime some irresponsible CNN analyst or fed chairman spews some contrived negative malarkey! And how about that "10% or more correction" that could be coming any time now?

    There's always a place for an annuity in a seniors portfolio. A senior who doesn't want to be in a bread line after he's scrimped and saved for an entire lifetime.

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