If It Sounds Too Good To Be True . . .

by | Jan 30, 2009 | Cash Flow, Weekly Column | 3 comments

annuity.jpgA new client recently asked me, “Rick, you’re one of four financial planners we interviewed. Why are you the only one who didn’t tell us we needed an annuity?” Actually, this couple had really interviewed only one financial planner and three annuity salespeople.

Annuities are the hottest financial product in the market place these days. I rarely use them. There are some good things about annuities, especially the fact that earnings grow tax deferred until distributed. Their negative aspects, though, include their high fees and the high surrender charges one must pay for taking money out early.

A client recently had a chance to buy an annuity supposedly guaranteeing him, in his words, “the greater of a 6% return or whatever the stock market went up.” I told my client if this was true, I had $100 million of client closer-look.jpgmoney to put into that annuity. Of course, after several phone calls I found out “the rest of the story.”

First, the 6% guarantee was only for the first 10 years. From then on this “guaranteed” balance (I call it the funny money account for reasons to become obvious shortly) never would grow. You could elect to receive a 4% annual payout on that balance for life. If you ever wanted all your money, however, you could only withdraw the amount you would have had based on the market returns, less all of the 4% withdrawals.

Upon your death, your heirs wouldn’t get the “guaranteed” balance, either. They would receive the greater of your original investment or the amount it would have grown in the stock market, less any withdrawals.

For the privilege of basically receiving the same returns as if you had invested in the stock market, you would pay 3.25% a year in fees. Had you just bought an index fund from Vanguard, the annual fee would be 0.10%.

Let’s assume you invest $100,000 in this annuity and the stock market returns an average of 6% annually over the next 10 years, a reasonable assumption. Your investment will grow at only 2.75% (6% – 3.25%) and be worth $131,165 in 10 years. However, since that return is less than the guaranteed 6% rate, the funny money balance will be $179,084. The account will be frozen at that balance unless the return earned in the stock market finally exceeds it, which at a 2.75% return would happen in the 21st year.

If you invested the money in a retirement account instead, assuming again a 6% return, you would have $349,572 in 21 years, or $170,488 more than the guarantee.

If you chose to take the 4% withdrawal after 10 years, you would withdraw $5,426 a year, for life. If in the 21st year you either died or wanted your money, the payout would be $179,084, minus the sum of the 11 payments, or a total of $119,398.

If you put your money in a retirement account, withdrew the same amounts, and died or wanted your money in the 21st year, the payout would be $253,844, or $134,516 more than the guarantee.

free-lunch.jpgThis is another reminder that there is no free lunch. The annuity would cost investors $3,250 a year, for 10, 20 or 30 years. What would they get? Basically a meaningless promise, designed to make them feel better in the short run, that left them poorer at the end.

Most annuities are expensive investment vehicles that benefit the salesperson and the company far more than they benefit you. If you are thinking of buying one, make sure you get advice from someone other than the annuity salesperson before signing on the dotted line.

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