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"Dave, you work in insurance. Should I buy an annuity?" -- Various friends over the years
I have earned my living for the past 17 years by working for, managing money for and analyzing the insurance industry. Most of my work was with life insurers. I have designed annuities, analyzed investment and hedging strategies for annuities, reserved annuities, projected their cash flows and run an annuity line of business. I've done almost everything with annuities in a life insurance company. In general, you should have a bias against anything that someone tries to sell you. If you really needed something, you would've researched it and bought it without the influence of a sales rep. This is particularly true of investment products, where the results are intangible and uncertain. Whether you should buy an annuity or not depends on a host of factors, but most of them are unusual:
Have you maxed out your contributions to deductible and nondeductible IRAs, 401(k)s and other tax-deferred investment options?
Are you trying to shelter assets from bankruptcy or avoid probate?
Do you want income that lasts for your lifetime (but with the forfeiture of your principal)? In general, if you have not maximized your contributions to other tax-deferred vehicles, annuities have little value. Deferred annuities provide tax-deferred compounding of investment results, but in this environment of low taxes on dividends and capital gains, that's not worth as much as it once was.
Disadvantages of AnnuitiesThey're expensive. The insurance company has to recover the commission that it paid to the agent, typically 5% to 10% of the premium paid. It also has to cover the maintenance expenses and ancillary benefit costs and earn a profit margin that compensates it for the capital that it employs, which is around 0.1% to 0.2% for variable annuities and 0.35% to 0.60% for fixed annuities. The companies may have larger profit margins, if they can get away with them, but competition limits that. With variable annuities, which invest in mutual funds, there is the added expense of the mutual fund. Unless you are dealing with Vanguard or one of the better mutual insurers, the added expense can more than eat up the tax advantages.
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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback.
Brokerage Partners
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