First of all, what is an annuity? Traditionally, an annuity is purchased from an insurance company and offers a stream of income paid over someone's lifetime. In traditional annuities, buyers give up access to their principle for that guaranteed income.
A more modern annuity is a deferred annuity, which is an investment product used to defer tax, offer an income guarantee, provide a death benefit, or some combination of the three. Most people opt for deferred annuities because they don't lock up an investor's principle like traditional annuities.
Let's talk about the three main benefits of an annuity:
Annuities get attractive tax treatment. The gain is not taxed until withdrawals are taken. The withdrawals are taken out on a LIFO (last in, first out) basis, meaning that gains are taken out first and are taxable at ordinary income rates. Returns taken out prior to age 59½ are usually penalized by the IRS at 10 percent.
All annuities have a death benefit equal to the original investment amount. If you invest $100,000 into an annuity and the market value falls to $50,000 when you die, your beneficiary gets the $100,000. Often this guarantee can be 'enhanced' to allow for either annual 'step-ups' in the death benefit or something called the highest contract anniversary value, meaning the death benefit increases over time based on a certain rate or based on the yearly increases in value. Each year, the death benefit would lock in on one of these values. So now if this same annuity buyer purchased the investment with $100,000, and the product increased over a few years to $300,000, that would be the new death benefit. If the value then decreased and the policy owner died, the beneficiary would now receive $300,000.
Many annuities contain an income guarantee. This means that if you put $100,000 into a contract, it will usually guarantee some certain amount of income. For example, it could guarantee 6 percent of the contract value for life. And each year the contract increases in value, this guaranteed income would typically go up as well. So in 2008, your account value went down, but you could still take an amount of income based on the highest account value. So as you can see, annuities can offer some great benefits, especially in a declining market.
Now you've seen the good, let's look at the bad.
Most annuities are expensive. Their internal expenses are more costly than using a standard portfolio. As a matter of fact, their cost could be as much as two times higher.
Many annuities carry a big commission. A broker can make some significant cash selling annuities. To make it worse, many unscrupulous brokers put their client's entire portfolio into an annuity. Still further, those same brokers often get paid and then disappear. They don't choose a good portfolio, they don't monitor the portfolio's progress, and they don't review your accounts with you. They are obviously just trying to line their pockets.
Most annuities have a long surrender period. It usually extends either seven or 10 years. So investors are stuck in the investment unless you pay a hefty penalty.
See if you need tax deferral or guarantees on part of your portfolio. If you do, an annuity could be a great investment for you. Make sure you know how much the annuity costs, how much your broker is making, and whether or not he will stay in touch. Also, ask for the ones with a shorter lock in period.
Good luck and happy investing.
Kelly Campbell , CFP® and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Alexandria, Va. Campbell is also the author of Fire Your Broker , a controversial look at the broker industry written as an empathetic response to the trials and tribulations many investors have faced as the stock market cratered and their advisers abandoned their responsibilities to help them weather the storm.