There are many different kinds of annuities. I am going to describe the two most popular ones: deferred variable annuities and equity-indexed annuities -- and one that isn't popular but should be: fixed immediate annuities.
Deferred Variable Annuities
With deferred variable annuities, you pay the insurance company a lump sum. Your money is invested based upon your selection of the investment options provided by the insurance company. The invested funds grow tax-deferred until you start taking distributions. You cannot access your funds without a tax penalty before the age of 59½ .
Sales people gush about the "death benefit," which is guaranteed to be at least the total of the amount contributed, less any withdrawals. However, these are long-term investments. It is highly unlikely that when the insured dies, the account will be underwater.
Expenses for variable annuities are high, averaging over 2% a year.
The tax-deferral benefits are over-hyped. You are trading capital gains rates for ordinary income tax rates at the time of withdrawal. No one can predict what those will be.
Your heirs get stuck with this tax disadvantage. They will have to pay taxes on any profit your annuity generates.
Variable annuities are not suitable for most investors. They are aggressively sold, however, because the commissions are irresistible.
Equity-indexed annuities are complex -- but their pitch is simple: You give the insurance company your money. You get a "guaranteed" minimum return, plus a kicker based on changes in an index, like the S&P 500. The salesman will say you get the best of both worlds: You participate in the increase of a rising stock market, but you get downside protection.
It would take an actuary to understand the true costs and risks of these policies. Here are some of them:
- You can lose money if you need to cancel your policy early;
- You can lose money if your guarantee is based on an amount that's less than the full amount of your purchase payments;
- It can take several years before the minimum guarantee will break-even;
- You will not get the full amount of the increase in the stock market index;
- There are high, hidden costs in these products; these costs fund big commissions, which is why these products are aggressively sold.
Fixed Immediate Annuities
Finally, an insurance product I like!
Fixed immediate annuities are simple products. You give the insurance company a lump sum. It gives you fixed, periodic payments for the rest of your life, or for a stated period of time after your death (or after the death of your spouse).
The chance of running out of money is significantly reduced if you purchase an immediate annuity in an amount sufficient to fund monthly expenses not covered by other sources of income.
There are some downsides, however. Unless you buy an inflation-indexed annuity, the fixed payment may not be sufficient to cover your future expenses. And the commitment is irrevocable. You can't get your lump sum back if you change your mind or your circumstances change.
Consider using several insurance companies to diversify your risk. Also, in this low-interest rate environment, it might make sense to buy immediate annuities in stages.
The industry leaders in low-cost immediate annuities are Vanguard and TIAA-CREF.
Dan Solin is the author of The Smartest Retirement Book You'll Ever Read (Perigee Books, 2009). His other books include the New York Times bestsellers The Smartest Investment Book You'll Ever Read and The Smartest 401(k) Book You'll Ever Read. See SmartestInvestmentBook.com.