The trouble with annuities

Fixed annuities promise tax-deferred growth at guaranteed rates. But the shelter they offer can end up a trap.

EMAIL  |   PRINT  |   SHARE  |   RSS
google my aol my msn my yahoo! netvibes
Paste this link into your favorite RSS desktop reader
See all RSS FEEDS (close)
By Lisa Gibbs, Money Magazine

(Money Magazine) -- With the uncertainty of the market these days, a lot of investors are running for cover with their retirement funds. No wonder sales of fixed annuities surged 74% for the first three months of 2009, according to research association LIMRA.

These insurance products provide tax-deferred growth at a fixed rate - higher than that of CDs now - with the option to later turn the money into guaranteed income for life. It's a compelling pitch. But there's a costly catch. Getting into a fixed annuity today may force you to miss better opportunities tomorrow.

Know what's being sold

First, a clarification - because the world of annuities is anything but clear. The term "fixed annuity" typically refers to a deferred annuity. That's different from an immediate annuity, for which you turn over a lump sum to an insurer and start getting regular payments within a year. Deferred annuities are more like CDs; in fact, insurers often promote them as a higher-yielding alternative.

Aimed at retirees and pre-retirees, deferred annuities may promise a high teaser rate - based on prevailing interest rates - in year one, then readjust yearly based on market conditions, with a guaranteed minimum. Or they may offer a more modest fixed rate for longer. For example: In May, Mutual of Omaha offered 4.65% the first year for contracts of $100,000 or more, with 3.65% in years two through five. (That's compared with an average of 2.19% on a five-year CD at the time.)

While there's no term on either type of contract, you're hemmed in for five to seven years by surrender fees, often around 7% initially. (Some do allow yearly fee-free withdrawals of up to 10% of the account value, however.)

Unlike in a CD, money in a fixed annuity grows tax-deferred. But you'll pay a 10% tax penalty if you take it out before age 59. You'll also pay ordinary income tax on interest when you withdraw.

Usually you have the option to annuitize - turn the balance into lifetime payments - anytime after the first year. But many people choose not to, instead using the product as a way to achieve tax-deferred growth.

Know the downsides

The major disadvantage of fixed annuities is opportunity cost. With such high exit fees, it's prohibitively expensive to back out of a contract. So you could miss the rise in interest rates and improvement in market conditions that many experts are predicting.

Worst case: Your money ends up lagging behind price increases. "In an inflationary period, having 4% fixed in long-term money could be devastating," says Salt Lake City financial planner Ray LeVitre, author of "The Retiring Boomer's Financial Handbook."

Know your alternatives

If safe growth is your objective, consider short- to intermediate-term high-quality corporate and municipal bonds instead. These have been offering yields higher than CDs and have fewer restrictions than fixed annuities. Plus, with muni bonds, the interest is tax-free - a benefit that will be especially valuable if tax rates go up in coming years. Sometimes it pays to keep it simple.

If you want to guarantee income

If what has attracted you to a fixed annuity is the paycheck for life, consider instead an immediate annuity, which starts paying right away. You don't have to lock into an investment option first - and you can get a bigger monthly payout than you would by annuitizing a deferred annuity, says Mark Maurer of Low Load Insurance Services. To get the best deal, follow these tips:

1. Wait till you really need the income. The older you are when you sign up, the bigger your payment will be. (Recently a $100,000 contract for a 75-year-old man paid about $880 a month, vs. $680 for a 65-year-old.) Interest rates are an even bigger factor, so if you need income now, consider annuitizing some money today and some later, when rates may be higher.

2. Don't commit all of your portfolio. Just annuitize enough to create the income you need. That way you'll have the flexibility to take advantage of a market recovery with the rest of your assets.

3. Get multiple quotes. Talk to at least three brokers or shop online at a site like, and compare the offerings with low-load options from companies like Vanguard.

4. Vet the insurer. Look for at least an AA rating from firms like Standard & Poor's and A.M. Best. And ask your state insurance regulator what complaints have been filed against the insurer.  To top of page

Send feedback to Money Magazine
They're hiring!These Fortune 100 employers have at least 350 openings each. What are they looking for in a new hire? More
If the Fortune 500 were a country...It would be the world's second-biggest economy. See how big companies' sales stack up against GDP over the past decade. More
Sponsored By:
More Galleries
17 cool gadgets that tease the future Smart telescopes, surveillance for dogs, an electric roadster and more from CES 2018. More
These 12 airplane beds let you really sleep on a flight For the price of a premium class ticket, you may just get a space that's comfortable, private, and quiet enough to ensure a good rest. More
CES 2018 kicks off with oddball gadgets The biggest tech show of the year opened with a collection of quirky gadgets. More
Worry about the hackers you don't know 
Crime syndicates and government organizations pose a much greater cyber threat than renegade hacker groups like Anonymous. Play
GE CEO: Bringing jobs back to the U.S. 
Jeff Immelt says the U.S. is a cost competitive market for advanced manufacturing and that GE is bringing jobs back from Mexico. Play
Hamster wheel and wedgie-powered transit 
Red Bull Creation challenges hackers and engineers to invent new modes of transportation. Play