Annuity Fatuity

Every newspaper I read seems to have "financial advisor" advertisements for free lunches where they will concisely explain how to invest and retire. But is it really a free lunch? Many times, the financial "advice" received at these free lunches are sales pitches for insurance products called annuities. There are many flavors of annuities but the main pitch and feature of them is that they are to provide a steady stream of income in retirement. I suppose people like the "guaranteed" nature of the income. Another popular sales pitch of annuities is that you can receive tax deferred status from them so that any of the gains you make on them are not taxed until a payout is received by the investor/annuitant.

A good place to look for general info on annuities is here.

I do not quite understand the popularity of annuities. There usually is no reason to purchase them, and the disadvantages can be significant.

1. Regular IRA's, Roth IRA's, or 401(k)'s all have the tax deferrment advantage. Financial advisors sometimes counsel or allow clients to purchase an annuity with their IRA or 401(k), but when this happens there is no additional benefit of tax deferrment.

2. If you change your mind and want to cash in an annuity be prepared to pay. And I mean pay. Surrender charges for annuities can be very steep, and you typically must hold an annuity for a significant amount of time before you can cash out without a penalty.

3. Trying to find an investment that will beat inflation is always a challenge. You have no better chance of beating inflation in an annuity than you do in any other investment such as bonds or mutual funds or stocks or real estate. In fact, annuities will take your money and invest their funds in these same investments and charge you administration fees to do it!

4. For estate planning purposes, annuities are not an advantage at all. The IRS takes the present value of the future stream of income payments from an annuity and makes that value a part of the gross estate. For estates the values of which are below the IRS applicable exclusion amount, there is not a great concern. But for those estates which may be greater in value than the applicable exclusion amount, the estate will have an imputed value for any annuity payments going to beneficiaries. For example, if a decedent has several annuities which payments are payable to beneficiaries for their life, the IRS has a formula which will calculate a value of those payments based on the life of the beneficiary. Such value is a part of the gross estate and taxable (if the value of the gross estate is above the applicable exclusion amount). So potentially, the estate could have taxes on, say, a $100,000 imputed value and have $0 present from the annuity assets to pay those taxes (because the cash from the annuity is a FUTURE stream of money). The estate would then have to sell or use other estate property to pay the taxes resulting from the annuities.

5. I've always thought it would be interesting to show up at the free lunches and ask a pointed question to the financial advisors about how much commission they receive from selling their annuity products. The fact is that commissions from annuities are some of the highest in the industry. Everyone needs to make a living, but keeping their compensation secret or misrepresenting their compensation, makes me think annuity salesman have a reason to hide it. Sales commissions don't come out of thin air, they are built into the price and structure of the annuity. In other words, the investor pays for them, and that directly cuts into your rate of return. Perhaps the popularity of annuities comes not from their excellence for planning and investment, but from the outstanding commissions being made from them.

There may be some situations where annuities would have some advantage. I cannot think of any, however, I would leave the door open for complex estate planning and investment strategies. The key word is "complex". Annuities are complex and probably not for the average investor or retiree. When investing in them, study thoroughly the prospectus and rely not on salesmen's representations.