Commercial Annuities

Much, if not most, of the reporting these days about commercial annuities (contracts issued by insurance companies) generates more heat than light. It's easy to understand why someone could be confused.

Annuities exist in two basic forms: immediate or deferred. An immediate annuity provides, in exchange for a premium payment, regular, predictable income over a specified period. A typical immediate annuity settlement would be for the payments to last for the life of the annuity owner, and perhaps for the life of the spouse. A deferred annuity is a specified investment that grows over a period of time. This growth has certain tax advantages, and when it's time to take out the funds, the contract can either be converted to an immediate annuity, or the annuity owner can take out whatever portion of the funds is desired, or all of the funds at once.

There are two basic investment bases for annuities: a fixed rate contract or a variable contract.

Fixed rate annuities operate like certificates of deposit, in that a rate is established for a certain term, and after the expiration of the term, a new rate is established. That is all the fixed annuity holder gets -- that specified rate of return. Fixed rate annuities also have contract guarantees that protect the principal from ever declining in value. A frequent criticism of fixed rate annuities is that the rates the contracts pay is very low.

A variable annuity has a range of investment options that are called sub accounts. These sub accounts look and act like mutual funds. When one opens a variable annuity, the investor determines how the funds are allocated into the various sub accounts. Many financial people consider this to be a convenient way to implement an asset allocation strategy.  A common criticism of variable annuities is that they are expensive to own, in that the insurance company charges the contract owner various annual fees, such as an expense ratio, mortality charges and contract charges, all of which are charged whether or not the contract actually makes money in any one year.

There is another investment base for a deferred annuity, and that is known as an index-based annuity. These contracts, which have only been widely available since 2000, are fixed annuities, as they offer a minimum return and provide contract guarantees.  But because they are linked to a stock market index (such as the Standard & Poor's 500), they offer the opportunity to get a better return than in a regular fixed rate annuity contract. A common criticism of index-based annuities is that they are difficult to understand and that many of the agents selling them do not explain them well to their clients.

A gripe about ALL annuities is the surrender charge. Although the structure of the surrender charge in a fixed annuity is different than in a variable annuity, both versions have them. A surrender period is specified, and if the account owner wants to take out more than a certain amount from the contract during that period, a charge will be incurred. I am not defending the surrender charge concept, but it is important to understand why it is there. The use of the funds invested in an annuity provides the insurance company with a profit making opportunity on a long-term basis. So, when one opens an annuity contract, one is essentially saying to the insurance company: "You have the use of my funds for (at least) the surrender period, except for whatever penalty free withdrawals the contract lets me make." Therefore, if one "breaks" that promise to the company by withdrawing the funds before the expiration of the surrender period, the company feels it has to have the ability to recover some of the investment losses it might incur.

However, the existence of surrender charges illustrates a critical point: if there is any reasonable likelihood that an investor will need funds beyond the contract's specified liquidity, than deferred annuities are not a good choice, in my opinion. Annuities are designed to be long-term investments, places where funds can be put away for extended periods, to grow and to supplement retirement needs.

Most of the problems I see with annuities, particularly deferred contracts, are that people often get sold them for the wrong reason. All annuities are designed to provide retirement income, yet they are often sold for reasons that don't really fit why the product exists. Variable annuity salespeople like to tout the death benefits in the contract, pointing out that, at the death of the annuitant, the beneficiary will always get at least what has been put into the contract. That may be true, but remember, an annuity is generally bought to supplement one’s retirement income, and the last time I checked, dead people didn't have retirement income needs. In my view, one of the huge drawbacks to variable annuities is that the account value during the life of the investor can decline -- perhaps precipitously -- and those funds thought to be available for retirement have taken a hit. So, when the use of a deferred annuity seems to be appropriate for a client, my current recommendations usually run to index-based contracts, as they offer what may be the best of both worlds: contract guarantees DURING YOUR LIFE; and, the opportunity to get better than fixed rates of return. Yes, there is a lot of negative reporting about index-based annuity contracts, but I feel most of the criticism in unjustified.

Nevertheless, the use of any financial product is a complex matter, and its appropriateness for use in any particular situation ought to be determined after a sound review of one’s financial circumstances with a competent advisor.  Don't make a mistake -- get proper, objective advice before committing your hard earned funds to any program or product. And, make sure you understand what you are doing, and why you are doing it.