Are Annuities Right for Your Nest Egg?

By Kathy Chu December 1, 2006

This article appears at the following website: usatoday.com

Annuities are among the most complex and misunderstood financial products you can buy. Yet investors are starting to take a closer look because they're the only way — outside of Social Security and pensions — to assure a lifetime flow of income in retirement.

An annuity is a contract with an insurance company that lets you create your own pension-like payout during retirement. These days, anything that mimics a pension is mighty appealing, because so many employers are phasing out traditional pensions, which guarantee a payout based on years of service, and the future of Social Security looks hazy.

Annuities come in four main flavors: fixed deferred, variable deferred, fixed-income and variable-income. Below, we spell out each one for you. Keep in mind that annuities tend to carry heavy costs. And there are 101 features you can add — if you pay additional fees or accept lower payouts. Here's how to navigate the annuity maze.

Fixed-income annuities

You buy the annuity with a lump sum and start receiving monthly payments immediately. The payments generally last your entire lifetime.

Your payment generally doesn't change from month to month. The older you are when you buy the annuity, the higher your payments will be, because you have fewer years to live.

Pros:

You can get a set monthly payout to cover living expenses, such as mortgage and utility payments.

Such a stream of income can give retirees, such as Doug and Mary Heinlen of Sarasota, Fla., comfort that no matter how well or poorly their portfolio performs, they'll always be able to pay their bills. "Since we don't have a big pension, you need something that's your basic income, that won't run out," says Mary Heinlen, 60, a former bank vice president.

The Heinlens plan to wait a few more years to buy a fixed-income annuity, to increase their lifetime payouts.

Cons:

Your fixed payments won't keep up with inflation. Some newer fixed-income annuities give you a rising payout each year to make up for inflation. But you'll have to stomach a lower initial monthly payout.

How to figure out if the inflation protection makes sense for you? "Consumers need to think about how long they expect this annuity to pay out," says Judith Alexander, a director at Beacon Research, a provider of annuity information. Generally, "The longer you want it to pay out, the more the protection is worth it, because inflation will erode the balance over time."

The costs of fixed annuities usually aren't immediately clear. That's because the fees are built into your monthly payouts. The higher the fees, the lower the monthly payouts. That's why it's important that retirees compare payouts from different companies, at sites such as www.immediateannuities.com.

Some insurers say fixed-income annuities, after years of meager growth, are finally gaining some popularity. New York Life, one of the largest sellers, says its sales have been rising 45% to 50% annually in the past few years. This year, New York Life expects fixed-income annuity sales to exceed $600 million, says Paul Pasteris, a senior vice president at the company.

"People have been told for the past 20 years to accumulate assets," he says. "What's supposed to happen (now) is a shift from accumulation to distribution. This is a big opportunity for financial services firms."

Deferred fixed annuities

Your money grows at a set interest rate until you're ready to withdraw it in retirement. Typically, this interest rate is adjusted every few years to reflect market conditions.

As with deferred variable annuities, you can withdraw your money in retirement as either a lump sum or a stream of income. You pay no tax on the earnings until you take the money out. But, as with other retirement accounts, such as IRAs and 401(k)s, if you withdraw the money before you reach age 59½, you'll face a 10% tax penalty.

"These (annuities) tend to be for people who are more risk-averse, more conservative" and want some investments outside the stock market, says Steven McDonnell of Soleares Research, a consulting firm.

Pros:

You can sometimes enjoy an interest rate that's higher than those of long-term bank certificates of deposits. The balance in the account doesn't vary with stock-market fluctuations. These annuities also let investors who've maxed out their 401(k)s and IRAs sock away more money for retirement, tax-deferred.

Also, some withdrawals from both deferred fixed and variable annuities count as a "return of your principal." That means it's not taxed (because this money was taxed going in). That is also important if you're drawing Social Security benefits. Up to 85% of your Social Security payouts may be taxed if you have other income, but annuity principal doesn't count in this calculation.

Cons:

When you withdraw the earnings, you'll have to pay ordinary income taxes. (This is true of both deferred fixed and variable annuities.) By contrast, other investment gains — such as those on mutual funds — face lower capital-gains taxes.

Fixed annuities also impose stiff fees if you withdraw your money before a certain amount of time, up to 15 years. The insurer usually doesn't charge upfront fees. Rather, the charges are built into the fixed interest rate you're paid.

These insurance contracts generally gain popularity in a bear market, when many people shift away from investments in stocks.

Deferred variable annuities

The most complex annuities available on the market. Deferred variable annuities are basically mutual funds covered in a life-insurance wrapper.

Your investment grows tax-deferred; its growth depends on how the stock market performs. Once you retire, you can opt to take this money as a lump sum or as a lifetime stream of income.

Pros:

Besides 401(k)s and IRAs, deferred variable annuities are another way for investors to sock away money for retirement, tax-deferred. You pay no tax on the investment gains until you take the money out.

With this hybrid mutual fund-insurance product, your money generally grows along with the stock market. The life insurance feature kicks in if you die before you start withdrawing the money: Your heirs will get a guaranteed payout, usually at least equal to your investment.

Cons:

The average variable annuity costs about 2.3% of assets, including a 1.3% insurance charge, according to Morningstar. By contrast, if you invest your money in a U.S. open-end mutual fund, it'll cost you, on average, just 1.3% of assets annually.

Generally, because of these annuities' high fees, investors shouldn't consider them until they've maxed out other retirement savings plans, such as 401(k)s and IRAs, says Joe Borg of the North American Securities Administrators Association.

Also, these annuities lock up your money for a set period — up to 15 years — and impose a stiff fee if you need your money before then. Those fees usually correspond to the commissions paid to the salesperson; the higher the "surrender" charge, the higher the commission.

"The highest (surrender fee) I've seen is 15%" of the withdrawal amount, says Jim Poolman, North Dakota's insurance commissioner.

An increasing number of deferred variable annuity contracts, though, let you withdraw 10% of the contract value each year without facing surrender charges, says Mike DeGeorge, general counsel for the National Association for Variable Annuities.

Variable-income annuities

You buy the annuity with a lump sum and start receiving monthly payments immediately. With the most common such annuities, the payments last your entire lifetime. Your payments will fluctuate based on stock market performance.

Pros:

These annuities provide some protection against inflation. That's because your income rises when the stock market fares well.

Eric Sondergeld, head of retirement research at LIMRA, a market-research firm, expects variable-income annuities to gain in popularity in coming years because, "With people living longer and longer, a fixed payout becomes less and less valuable over time."

Cons:

Once you put money into the contract, you typically can't take it back out; the contract is irrevocable.

That means, "Your flexibility is gone if life happens and you need to make adjustments," says Jonathan Guyton, a financial planner in Edina, Minn. Also, with an income annuity, "You're guaranteed to exhaust your principal; there will (usually) be no money left" for your heirs.

Even if you die shortly after you put money into a variable-income annuity, your beneficiaries will get nothing. And if you're buying this kind of annuity to cover fixed expenses, you probably won't be happy with the fluctuating income stream.

Maybe that's why few investors are buying income annuities right now — especially variable-income annuities. Overall, income annuities made up only 5.6% of the $212.3 billion in annuity sales last year, the National Association for Variable Annuities says.

Still, "The fact that (sales) are small today doesn't mean that this is not going to be big," says Jerry Golden of the income-management division at MassMutual Financial, which offers fixed and variable annuities. "Products have their time."

Of the nearly $12 billion in sales of income annuities in 2005, only about $600 million went into variable-income products, the annuities association says.

Mark Mackey, the association president, hopes, though, that at a time of vanishing corporate pensions, sales will climb sharply as more retirees seek to create their own pension-like payouts.

"Annuities are getting more attention on (Capitol Hill)," Mackey says. Insurers are trying to make "annuities part of the solution to the puzzle that everyone's trying to solve": how retirees can make sure they don't run out of money.