In our recent two articles about annuities, we outlined the features of the three basic
types of annuities: immediate-fixed annuities, deferred-fixed annuities and variable
annuities. If you missed those articles, you can go to the Oakland Insider website (http:
//de.theoaklandpress.com) to read them in past issues or you can find them in our “In
The News” page on our website (see link below). In this final article of the series on
annuities, we will summarize some of the good and not so good features of annuities.
Let’s start with immediate-fixed annuities. This type of annuity can help significantly with
supplementing retirement income if you have no pension or Social Security income.
Studies have shown that 20%-30% of your investment portfolio invested in fixed
annuities can help make your funds last until you die. If you buy a fixed annuity, we
recommend you stick with a low-cost provider such as Vanguard, Fidelity or TIAA-
CREF.
We also suggest you stick to plain vanilla immediate-fixed annuities and avoid more
complex products known as “equity-indexed” annuities. The insurance salesman may
not call it that but if they promise you a product that guarantees a fixed minimum return
plus the possibility to obtain the return of a market index, then it’s a form of an “equity-
indexed” annuity. The problem is, these products only return a portion of the stock
index return and typically don’t include dividends. It should also be noted that most
equity-indexed annuities are not registered with the SEC (Securities and Exchange
Commission) and can therefore be sold by insurance company employees who don’t
have to be licensed to sell them.
It’s very difficult to understand the underlying formulas of equity-indexed annuities and
the costs are significant. We believe that if it’s difficult to understand such a product, it’s
better to stay away from it.
We noted in one of our previous articles that deferred-fixed annuities often offer
abnormally high teaser rates. Be wary if the seller focuses on these high rates and
forgets to point out that they are only in effect for the first year or so. After that, the rate
of return drops significantly and is locked in for several years. It is generally always true
that with higher returns come higher risks. So, if someone offers you an investment with
an exceptionally high rate of return, you’d best be very skeptical and head for the exit.
Variable annuities are touted for their tax-deferral capabilities. Unfortunately, many
annuitants have not been told that all gains will be taxed as ordinary income. A well-
designed, tax efficient portfolio can provide solid returns at a much lower cost with long-
term capital gains taxed at the much lower capital gains rate. Variable annuities often
carry annual fees of 2.0% or more, whereas a portfolio of quality, tax-efficient mutual
funds, index mutual funds and exchange traded funds (ETFs) can be designed with a
total expense ratio substantially below 1.0%. Variable annuities lock the buyer in for five
to seven years or more with surrender fees often exceeding 5% to 7%, or more. It is
not uncommon for the available funds to be limited from an asset class standpoint and
often have high fees and lackluster performance histories.
Variable annuities insure against the loss of the principle invested. If you are a long-
term investor, this feature is generally of little value except in the case of a premature
death of the policy owner. In light of all the other negatives noted above, this guarantee
just doesn’t justify a purchase, in our opinion.
A low-cost variable annuity with good investment options could be appropriate for a
younger investor who has maxed out his 401(K) and non-deductible retirement
contributions and is looking for further ways to defer taxes. If he/she will invest the funds
for twenty years or more before withdrawing, the benefits of growth tax-deferred could
offset the higher tax rates of withdrawals, especially if he/she will be in a lower tax
bracket at retirement (this is difficult to predict) or if there is an increase in the capital
gains rate. In any case, we see no benefit to purchasing a variable annuity inside a
retirement plan that already provides tax deferral. And, with their negative tax features,
they are clearly not appropriate for retirees who will be withdrawing their funds in the
near term.
A final note about variable annuities. Teachers and other education professionals utilize
403(B) qualified retirement plans instead of 401(K) plans available to businesses.
Unfortunately, the vast majority of these plans only sell variable annuities. These
professionals have been strapped with high fees, surrender charges and more often
that not, limited, investment choices. If you happen to be a retiring teacher or
educational professional you should seek advice on rolling your 403(B) account(s) over
to an individual retirement account (IRA).
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, March, 2008,
All About Annuities - Part III
By David and Erin Patterson