Annuities Attract Many, but Choices Are Complex

Looking to diversify her investments, Phyllis McQueen bought a variable annuity tied to a mutual fund for $47,000 in 1999.

She said she was drawn to an annuity because it offered certain safeguards for her principal. Annuities also provide tax deferral, an insurance component and the promise of regular payments over a defined period or over a lifetime.

Those features are attractive to many investors. Despite the market downturn, payments into annuities rose 7 percent to $292 billion in 2002.

But in the four years that McQueen has held her annuity, its value has dropped to $36,000. She can't opt out of it until 2005 without incurring big penalties. And she says she won't buy an annuity again.

"I don't like the idea of my money being locked up for so long," said McQueen, a counselor in private practice in Dallas who is in her 50s.

Experts say consumers sometimes buy these complex investment contracts without fully understanding them. And the choices are becoming more complicated. As millions of baby boomers barrel toward retirement, insurance companies are adding more bells and whistles to their products in hopes of attracting this group.

Certain annuities have their place in a retirement portfolio, particularly for retirees who want the guarantee of a fixed income each month, experts say. For investors who are vexed with losing money in the market, this investment option can offer protective features such as a guaranteed death benefit.

But annuities are not for everyone. Depending on the type of annuity you buy, you could face expensive fees, large sales commissions and punitive surrender charges if you opt out of an annuity in the first few years. And when the final calculations for expenses and earnings are worked out, annuities can offer poorer average returns than mutual funds or even certificates of deposit.

"You must ask whether an annuity should be part of your overall investment profile," said Alan Goldfarb, a certified financial planner in Dallas. "With an annuity, you are pretty much locked into a lot of things." People heading into retirement must thoroughly consider their options before picking an annuity, experts say, because the market is going to be flooded with new versions.

"The products are really starting to evolve quite a bit," said Dorit Murciano, vice president of MetLife Retirement & Savings. "The baby boomer generation, more than any other group of retirees, faces a lot more challenges in retirement. The needs are more present than ever before for products that guarantee income."

Annuities come in two types: immediate and deferred.

When you buy an immediate annuity, you pay a lump sum, say $100,000, and you start getting a payout either for a fixed term or for life. It's called an immediate annuity because the payouts start immediately. In a deferred annuity, there's an accumulation phase in which the money builds up over time and you get payouts later in life.

Both immediate and deferred annuities have two subtypes: fixed and variable.

Fixed annuities offer a fixed rate of return over a certain time frame, while variable annuities are tied to stock funds or bond funds and the returns vary depending on the performance of these funds.

The most criticized annuity is the variable deferred annuity. The money typically is invested in sub-accounts that are tied to stock funds or bond funds. Experts have pointed out that the expenses on these annuities can run higher than 2 percent per year. Sales commissions are also high, and the returns are often unattractive.

And now, with the reduction in tax rates on capital gains and dividends, variable annuities have to work even harder to catch up to other investments. "The tax deferral is not significant enough to offset having to pay all the expenses," said Glenn Daily, a fee-only insurance consultant in New York. Sometimes, "taking into account the taxes, you might be better off buying municipal bonds."

But insurance companies are working to make annuities more appealing by offering options that allow you to split the risk between an immediate annuity and a deferred annuity. They also allow laddering of annuities so that you get a mix of returns.

Here are some things to consider before buying an annuity:

First, do you want a long-term investment like this?

Many choices that you make on an annuity are binding, and you may have to incur great costs to alter your decisions. Find out what the costs and penalties are for dropping it.

Typically, you shouldn't put all your money in an annuity. Experts say you should maximize your 401(k) and other tax-exempt vehicles before turning to this option.

Compare annuities to other investment vehicles and find out if you can get better deals elsewhere. For instance, would you get a better return for your money through a mutual fund, which may not have as many expenses?

Rodger Mitchell, a 73-year-old Dallas resident, says he looked at fixed annuities a few months ago but decided not to buy. The former banker was offered returns of 2 percent to 3 percent.

"Knowing that you are going to get a fixed amount of money over a certain term obviously has some attractions for older investors," he said. "But currently annuities are not attractive as long-term investments because of the low-interest-rate environment."

Find out if you can buy a low-load or no-load annuity _ that is, with little or no commission expenses.

Determine your flexibility in terms of investment choices in the subaccounts. Are you wedded to the family of funds that you first choose, or can you switch when you want to?

Think through the implications of inflation. Ask yourself: If I opt for fixed payouts today, will this be enough of a supplement 20 years down the road when my cost of living might be much higher?

Make sure you guarantee income for both you and your spouse. This can be done through "joint" or "survivor" clauses that stipulate the monthly payments go to your spouse when you die. The monthly payout will be lower in such cases because you are spreading the benefit.

Be cautious about when to start taking payments from the annuity. Whether you decide to annuitize at 55 or 65, once those payments begin, the original investment begins to diminish.

"The number one planning consideration is the availability of assets," said Shashin Shah, a certified financial planner in Addison, Texas. "Once you annuitize, you've essentially taken that money to buy a future cash flow."

If you've decided to buy an annuity, the next tough decision is whom to buy from. Financial planners, stockbrokers, bankers and insurance agents sell them, and most earn commissions.

"Shop for a planner as much as you shop for an annuity," Goldfarb said. "Look for a financial adviser who is well-schooled in annuities."

Experts say the only truly objective piece of advice could come from a fee-only insurance planner who makes money by the hour and not through commissions. "Agents can make a lot of money, depending on the type of annuity," said Craig Hoogstra, manager of financial products at AARP Services. But "how much an agent makes is not disclosed to the consumer."

You should ask how much your agent is benefiting from your purchase.