3 retirement deals you can do without
Chances are, one of these days someone is going to urge you to buy a retirement investment that sounds too good to be true. If the word annuity comes up, be wary of the deal.
By Walter Updegrave, Money Magazine senior editor

(Money Magazine) -- Last December, Tom Donofrio decided it was time to get serious about retirement. So with the help of a financial adviser affiliated with MetLife, the 39-year-old father of two transferred money that had been sitting in a 401(k) at a previous job into an IRA rollover account invested in mutual funds.

Or so he thought. Donofrio didn't understand that the bulk of his retirement savings - some $22,000 - had actually ended up in a variable annuity, an insurance product that puts your money into a fund-like portfolio but typically carries fees that are much higher than those of funds. In Donofrio's case, those charges can run as high as 2.8 percent a year, at least double what he could be paying for a portfolio of funds.

Deal Breakers
Keep these problems in mind before moving ahead on annuities.
Annuity type The problem
Equity-indexed High price to get out, bewildering return formulas and caps on how much you can earn
IRA rollover The guaranteed protection referred to is expensive and almost certainly unnecessary.
Annuity swap You may face withdrawal penalties and higher fees; new surrender charges kick in.
Securing your future
Don't worry about picking hot stocks and funds or brilliant market forecasting. Money Magazine's Penelope Wang offers the only five rules that matter. (more)
Don't wait another minute. Start a savings plan now. (more)

What's more, he's effectively locked in for the foreseeable future because bailing out within the first seven years would trigger early-withdrawal penalties of as much as 7 percent.

"I suppose I should have done a better job researching this," says Donofrio, "but basically you trust the adviser's expertise." (While not commenting on the specifics of Donofrio's experience, MetLife told Money Magazine its representatives take great care to ensure that clients understand the products.)

Every year thousands of people like Donofrio are steered into high-cost annuities, often without knowing exactly what they're buying. What draws people in are sales pitches that portray annuities as the ideal solution to every fear.

Worried you won't have enough to retire? An annuity can boost the size of your nest egg by sheltering your returns from taxes.

Anxious about a market meltdown? An annuity will protect your capital.

Afraid you'll run out of money? Relax. Annuities will guarantee you income for life.

How annuities really work But annuities are hardly a simple solution to these all-too-common concerns. Simple, in fact, is the last word that springs to mind. For starters, annuities come in more than one flavor.

A fixed annuity pays you a guaranteed interest rate, much like a bank CD.

A variable annuity, on the other hand, lets you invest in mutual-fund-like portfolios known as subaccounts.

A third variety, an equity-indexed annuity, is a hybrid: It usually pays a minimum rate of interest but also gives you the chance to share in the gains of the stock market.

Adding to the confusion is the fact that you can use annuities in two ways - to accumulate assets for retirement, or to convert assets into a monthly income.

Given the hype and misunderstanding surrounding these investments, it's no surprise that annuity sales tactics have long topped securities regulators' lists of scams and scandals. Just last May, representatives from the National Association of Securities Dealers and the Securities and Exchange Commission, along with state regulators and consumer watchdog groups, convened in Washington, D.C. to talk about better consumer protections.

Until those protections appear, if they ever do, you have to remain on guard. With commissions that run as high as 10 percent of what you invest, the incentive for an adviser to push an annuity is strong. Sooner or later, you'll hear a pitch, most likely one of these three.

Sure, sometimes the case for an annuity holds water. But more often than not, the deal is an offer you should refuse.

Equity-indexed annuities. The pitch: Earn stock market returns without the risks

After attending a free lunch and financial planning seminar at a local Florida restaurant two years ago, 73-year-old Dorothy Eddy thought she'd found the perfect place for her retirement savings: an equity-indexed annuity (EIA).

As she says she understood it, it would pay her a sure 7 percent a year, protect her principal against losses and, most important because she needed cash for family and medical expenses, give her ready access to her money.

She decided to invest almost $156,000, a good portion of her retirement stash. "I was earning 3 percent, and this was promising me 7 percent," says Eddy. "There didn't seem to be any downside to it."

Before long, Eddy found out what thousands of other retirees and pre-retirees have discovered: Equity-indexed annuities are hardly the all-gain, no-pain opportunity they seem. While they can shield you from market setbacks, their hefty fees and many restrictions dramatically dampen their growth potential.

The steady 7 percent that Eddy expected? Well, that's hardly assured. EIA returns are based on a benchmark such as Standard & Poor's 500, but that doesn't mean you'll earn full market returns.

In addition to excluding dividends, most EIAs limit how much of the index's return you can collect - 70 percent, say - or simply cap your annual gains. With Eddy's annuity, that max is 7 percent, and the insurer has the right to reduce it to 4 percent. Even if the S&P 500 rises much more, she will get no more than a 7 percent gain.

At least a 7 percent cap is easy to grasp. In many other cases, insurers base your return on complicated systems that involve averaging the monthly closing price of the S&P 500. Although this protects you against falling stock prices, it also makes it exceedingly difficult for most people to figure out their return.

"You practically need a Ph.D. in finance just to understand how the return is calculated, let alone assess whether it's a good investment," says Craig McCann, president of Securities Litigation & Consulting Group, a firm that does research for lawsuits involving annuities.

Yet another drawback to an EIA is that you may have to pay steep fees to get at your money. The AmerUs Multi Choice annuity that Eddy owns, for example, levies surrender charges that start at 18 percent and last for 14 years, which means she won't have unfettered access to all her funds until she is almost 85 years old.

Eddy, who's now involved in a lawsuit against AmerUs, rues the day she signed up for that EIA. "I have grandchildren going to college who I'd like to help, but I don't dare tap into my money," she says. "I feel I was tricked."

Mark Heitz, AmerUs Annuity Group president and CEO, told Money Magazine the company doesn't comment on the facts of pending litigation but said, "We feel we have a very strong defense."

If you want to earn market returns but can't afford to put all your money at risk, a better strategy is to create a diversified portfolio of low-cost stock and bond funds. While this approach doesn't guarantee that you'll never lose money, it does give you the best combination of growth potential and risk reduction.

IRA rollover annuities. The pitch: Protect your IRA money from market downturns

When you roll over money from a 401(k) into an IRA, you may find yourself on the receiving end of an annuity sales spiel. The reason: With an estimated $1.7 trillion expected to flow into IRA rollovers between 2005 and 2010, according to research firm Cerulli Associates, this event is a commission honeypot.

It rarely makes sense to put your IRA rollover into an annuity if you're switching jobs or still investing for a retirement that's years away. After all, your gains are already sheltered from taxes in an IRA. But that doesn't stop insurers and advisers from touting annuities as an ideal rollover investment. Indeed, last year MassMutual launched an "IRA Annuity Rollover Campaign" that homes in on job changers.

Annuity issuers freely admit that an annuity's tax benefits are essentially worthless when it's held inside an IRA.

But, the pitch goes, it can still pay to buy a variable annuity within an IRA because of extras called living benefits.

One particularly alluring add-on is what's called the guaranteed minimum income benefit. This feature promises that if you hold your annuity for long enough (at least 10 years), you can count on collecting a certain retirement income, even if your annuity loses money.

The drawbacks As emotionally appealing as this assurance may be, its financial value is questionable.

First, there's the cost - usually 0.5 percent a year or more. Add that to the typical variable annuity's hefty expenses and then throw in one or two other bells and whistles, and you could end up paying upwards of 3 percent a year.

In the meantime, the income you're being guaranteed is underwhelming, to say the least, because insurers base it on ultralow payout rates designed more to protect them than to provide income to you.

Think of it this way: For the guarantee feature to be a good deal, one or more improbable things would have to happen. Your investment returns would have to be abysmal - say, 1 pecent a year for a decade - or years from now insurers would have to slash payout rates so severely that your guarantee is better, which is likely only if interest rates drop to below 1 percent or if life expectancy rates rise dramatically (thanks to a cure for cancer, perhaps).

You want to shell out 3 percent a year for those slim odds?

Annuity swaps. The pitch: Trade in your old annuity for a brand-new model

Say you already have an annuity. A salesman - maybe the same one who sold the annuity to you - comes to you explaining that it's outdated. Ah, but not to worry. He can exchange it for a new model that has better investment options and other up-to-date benefits. He might even throw in a bonus to sweeten the pot: an extra 1 percent to 5 percent of the amount you invest.

As enticing as this deal may sound, it's almost always one you should pass on. The new and improved annuity will likely have higher annual charges, especially if it's a bonus annuity. (The only way the insurer can afford to pay the bonus is to collect higher fees.)

And if you've owned your annuity for only a few years, surrender charges probably still apply. Earlier this year in Missouri, for example, regulators issued a cease-and-desist order against an adviser who allegedly switched clients in and out of several annuities, in one case generating surrender charges of more than $24,000.

Finally, whether you get hit with surrender charges or not, switching your money to a new annuity starts the clock on a whole new set of surrender charges, tying up your money for years again.

What's driving the volume of switching - which accounts for an estimated 40 percent or more of all variable-annuity sales - is that current annuity holders are excellent sales prospects. You've got money, and you've already shown that you're willing to buy an annuity. Persuading you to shift from one annuity to another may be the easiest way for a salesperson to generate new business.

Regulators have attempted to crack down. Last year the advisory firm Waddell & Reed agreed to pay $7 million in fines and up to $11million in restitution to customers to settle charges that it had engaged in a switching campaign. But enough swapping still takes place that the NASD issued an investor alert about the practice in March.

Switching typically makes sense only if you won't have to pay onerous surrender charges and you're moving into an annuity with lower expenses. Of course, you don't have to worry about being swapped from one annuity to another if you don't buy one in the first place. That strategy may be the wisest of all.

When annuities make sense

One kind of annuity can be useful in your retirement planning: a lifetime income annuity, also known as a payout or immediate annuity.

By investing, say, $100,000 when you retire at 65, you can create an income that's guaranteed to last as long as you live. You'll find two types of income annuities.

A fixed-income annuity You turn over a lump sum to an insurer who agrees to pay you a set amount each month. The older you are and the higher interest rates are, the higher your payment.

The pro: Certainty. You know how much you'll receive each month, which makes for easier budgeting and greater peace of mind.

The con: No inflation protection. As prices rise, the purchasing power of your monthly payment drops.

How to buy: It's wise to compare quotes from several insurers at immediateannuities .com, since payments can vary by 10 percent or more among insurers.

Monthly payment in year 1 for a 65 year old with $100,000: $717. In year 30: $717.

A variable-income annuity You invest a lump sum in mutual-fundlike portfolios called subaccounts. The size of your first check is based on your life expectancy and an assumed interest rate. After that what matters is how well your subaccounts do.

The pro: Growth potential. If your subaccounts perform well, your payments will get bigger, protecting you from inflation.

The con: Uncertainty. Although you're assured of receiving payments for life, you don't know from month to month exactly how much they will be. If the markets head south, your income will drop.

How to buy: Payments are based on returns after expenses, so pick an annuity with low annual fees. Issuers that keep expenses low include Vanguard (800-522- 5555), T. Rowe Price (800-469-5304) and Fidelity (800-493-3004).

Monthly payment in year 1 for a 65 year old with $100,000: $686. In year 30: $1,218.

_________________________

Ask the Expert, by Walter Updegrave:

Don't treat your 401(k) like a piggy-bank

Thinking twice about variable universal life

Annuities don't guarantee peace of mind

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.