Annuities Give Income Security, but at a Price

With old-fashioned pension plans disappearing, Americans today often shoulder sole responsibility for managing their money throughout retirement. While some retirees take to the task with gusto, plenty of others may long for the days when all you had to do was go to your mailbox to pick up a monthly pension check.

For investors who crave income security, the financial services industry has an answer: the annuity, a contract sold by an insurance company that will guarantee you a regular income throughout your lifetime.

But before purchasing an annuity, you need to weigh the typically higher costs of the investment against the benefits, which include a guaranteed income stream, an assured inheritance for your family and tax perks. Depending on your situation, you may be better off investing in plain old stocks and bonds.

To help get you up to speed on your options, we offer a primer on annuities below.

You'll Pay a Price for Security

First, there are two basic types of annuities: fixed and variable. Fixed annuities guarantee a given dollar payout, regardless of the stock market's performance.

Variable annuities provide a regular payout that fluctuates with the performance of the market. They offer the potential for extra return, but also the possibility for losses. With a variable annuity, you choose from dozens of mutual-fund-like accounts to invest in.

What distinguishes a variable annuity from a plain vanilla mutual fund is that the annuity typically also offers a death benefit. For example, a contract might stipulate that if you die, your heirs will receive a sum equal to your initial investment (or sometimes more). Say you invest $100,000 in a variable annuity and the market tanks, driving the value of your investment to $80,000. If you die, your heirs would receive $100,000.

But -- no surprise -- you pay extra for that insurance protection, and that's the biggest rap against annuities.

With a variable annuity, you'll pay a policy fee, a mortality and expense charge, an administrative charge, and an operating expense fee (that covers the costs of actually managing the investment). Taken together, annuity costs typically run to just over 2% of your investment -- up to twice the cost of a low-priced mutual fund.

It's impossible to say exactly what a fixed annuity costs because the expenses are lumped into the rate of interest that you're offered. Basically, if you're told you'll earn a fixed interest rate of 5% from a fixed annuity, you can assume the insurance company will earn more.

Depending on your annuity contract, you could also have to pay sizable surrender charges if you withdraw part of your investment within the first three to seven years.

Annuities have a bad reputation because of their high expenses. But you can buy reasonably priced, no-load annuities directly from outfits such as TIAA-CREF and Vanguard to avoid the steep sales charges and fees often charged by brokers.

The Tax Lowdown

In addition to the death benefit, annuities offer another perk: the opportunity to let your money grow tax-deferred until you take it out. At that point, it's taxed as ordinary income.

As a related benefit, you can rebalance your investments within a variable annuity without having to pay capital gains tax. This would have been a big help if you'd invested in stocks early in the '90s and wanted to roll some of that money into bonds toward the end of the decade. If you'd invested in an annuity, you could have avoided some whopping capital gains when you made the transfer.

Because of the tax-deferral provision with an annuity, your money has the chance to accumulate faster there than in a fund. Click here for a previous TSC story comparing the tax advantage of variable annuities with that of mutual funds.

A few other points of comparison: If you're contributing money to an annuity with after-tax dollars, you can invest as much as you want. If you contribute to an annuity or any other investment within an IRA, you're subject to the $3,000 maximum contribution limit.

Unlike with an IRA, you're eligible to receive the tax-deferral benefit with an annuity no matter how high your income.

Are Annuities Worth It?

It's tough to give rules about who should buy annuities because the answer depends not just on your financial situation, but also on intangible preferences. How important is it for you to know you'll be receiving a given income? With an annuity, "you know you'll have an absolute floor of benefits every month, plus your Social Security," says John Richardson, a financial adviser at AIG Valic Advisors.

To be sure, with a little work, you (and perhaps a financial planner) could design your own portfolio to provide a regular, annuity-like income stream, featuring equity investments and laddered bonds. Click here for a description of how such a portfolio would work.

If a self-designed plan doesn't appeal, have an adviser crunch some numbers to figure out if the tax-deferral benefits you'd receive with an annuity are worth the higher expenses you're likely to pay.

If you earn a high income and are saving for retirement, an annuity investment could conceivably make sense after you've maxed out your 401(k) and IRA contributions. You could plunk any extra retirement savings in an annuity and receive the tax-deferral benefit -- a perk that mutual funds can't offer.

But you have to balance that tax-deferral against the extra fees you pay for the death benefit guarantee. If you chose to simply invest in the stock market instead of an annuity, it's likely that in two decades your heirs would be able, at least, to recoup your initial investment, if not far more. In other words, if you buy an annuity, you may pay relatively higher expenses over two decades for a guarantee you don't need.

It's a little easier to make a case for annuities in the short term. If you expected to die within the next five or six years, especially if you have a relatively small portfolio, maybe you'd take comfort in knowing that your spouse would receive a death benefit worth a given sum. In effect, buying an annuity would insulate your heirs from any sharp drop in the market that occurs before your death.

But "if you don't need that death benefit or don't value it that highly, you're better off in a mutual fund," says Jim Sager, vice president of retirement and investor services at Principal Financial Group, a financial services company.