The trouble with annuities

(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.

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 59½. 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.

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."

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 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 immediateannuities.com, 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.