Guaranteed Returns

By Carrie Coolidge June 9, 2003

This article appears at the following website: forbes.com

Richard Rothstein was worried sick to have so much of his wealth tied up in the stock market. So he parked $750,000, one-third of his liquid assets, in a single-premium deferred annuity. This one is pretty safe. It pays a fixed CD-like return.

Computer consultant Rothstein had shied away from annuities in the past, put off by fat sales commissions paid to insurance agents and brokers. But this one let Rothstein, 57, lock in a better interest rate than he could get from a bank CD or ten-year Treasury. Plus it was an insurance product, so it had tax-deferred compounding of interest.

CD-like fixed annuities have been around, if little noticed, since the late 1990s. Most brokers and agents lacked much incentive to push them; they could earn more selling other products. Now there's demand from return-starved investors. CD-like annuities are unlike other fixed annuities because their interest rate is guaranteed for the entire period of the contract, typically between six months and ten years. In that respect they are, as their name suggests, like a CD sold by a bank. The interest rate for traditional fixed annuities is guaranteed for only the first year, after which the insurance company may lower it.

Here's how these things work: An investor decides how long he can tie up some of his capital. The longer that is, the higher the interest rate credited for the period (see table). As with a CD, only one payment is made, called a single premium. At the end of the period the annuity holder has 30 days to roll over the principal and earnings into a new annuity, or cash out and receive a lump sum. Tax at ordinary rates is due at cash-out; if the holder is then under 59 1/2, an additional 10% penalty tax is due.

These annuities are quite competitive with bank products. You can get 3.5% on a $100,000 investment in a five-year annuity; five-year jumbo CDs from banks average only 3.3%. The tax deferral helps a little, too. For someone in a combined 40% state and federal bracket (and who is now 54 1/2), the annuity yields 2.2% after-tax while the bank CD yields only 2%.

Unlike variable annuities, the CD-like annuities are no-load products that don't have annual management fees or expense charges. "What you see is what you get," says Hersh Stern, publisher of Annuity Shopper, a semiannual publication. While you do have access to your earned interest without penalty, don't consider this annuity if you need to get at your original investment. Like all other annuities, there will be hefty surrender charges to pay if you pull all of your money out early. If interest rates happen to be up, there could be an extra exit charge.

An alternative: Series I, inflation-indexed U.S. savings bonds currently paying 4.66% and earning interest for up to 30 years. They are tax-deferred, exempt from state and local income tax and are somewhat liquid (they must be held for at least one year and are subject to a three-month earnings penalty if cashed before five years), but the maximum that can be invested per Social Security number is only $30,000 annually.