The Pros and Cons of Annuities

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Index Annuities - Immediate Annuities

Life Insurance


Annuities are technically not investments

Annuities are classified as "insurance products". Annuity salesmen like to make you feel warm and fuzzy by labeling annuities as "income products". But how they want to classify annuities makes no difference! Annuities are still expensive, highly taxed, inferior performing products where people put their money. You need insurance for things like your car and your house, but not for your money.


cherryMassaging their own cherry picked studies

Annuity pushers are very adept at doctoring up their own studies in order to make annuities appear to outperform normal investments such as index funds. These studies are all flawed.


Just for starters I'd like to see a risk adjusted study that compensates for all of the many investors who paid contingent deferred sales charges (also known as early surrender penalties) and the nasty 10% federal tax withholding penalties plus additional state tax penalties!



Beware of "advisers" who claim annuities are safer than CD's

Annuities should never be compared to CD's because, for one thing they are not as safe as CD's. They will try to scare you by talking about how banks only keep $1.37 for every $100 on deposit. In reality no one has ever lost a dime of FDIC-insured deposits. Secondly, putting your money in a CD is not investing. One of the most basic principals of investing is to never bear too much risk or too little risk. Putting all of your money in a certificate of deposit is taking way too little risk. You won't even begin to keep pace with inflation. Of course if you have already reached your financial goals and have enough money to last your life expectancy, sitting on cash (certificates of deposit) might make sense for some. But for most people, if you wake up and decide to finally become an investor by taking some risk then there are much better alternatives to annuities that involve a simple diversification of stock and bond ETF's. Hire a fiduciary RIA if you can't figure out how to pick a simple portfolio for yourself.


Beware of "advisers" who use the words "safe" or "risk free" to describe annuities

The state of Colorado recognizes that words like "safe" give a false impression of life insurance and annuities. And the words "risk free" also give a false impression. In reality insurance companies can become insolvent, state guarantee funds can become tapped and this leaves annuitants hung out to dry. The Colorado Insurance Division has ruled that these words may not be used in advertisements due to the potential for misleading consumers.


Advisers use a false choice to serve as a selling point

The false choice used by advisers who push annuities is that you can either invest in a stock heavy portfolio or you can put your money in an annuity. They predictably compare conservative (an annuity) to risky (stocks or a stock heavy portfolio) during a bear stock market period. They completely discard the most appropriate option: a bond heavy portfolio.




When someone considers an annuity they have thrown in the towel and given up on the volatile stock market. But what would happen with a portfolio of 72% 10-year treasury bonds and 28% VOO the S & P 500 stock index during a minimum 10-year period (because annuities are a long-term commitment)? History has shown that there is no crazy volatility! Please note that there was deflation in the range of 9% to 10% from 1931 - 1932. A 1930's-like decline is also highly unlikely for many reasons.





DEBUNKING A MYTH: Afraid of a repeat of the 1929 crash and great depression? When accounting for the deflation which was occurring back then, a 75/25 portfolio actually never lost money!




Beware of "advisers" who compare annuities to stocks alone

An insurance company keeps releasing this graph that appears at first glance to show that their "reset design" greatly outperformed the S & P 500 index over a 14 year period from 9/30/1998 to 9/30/2013. See if you can figure out how this study is likely to fool naive investors...



1) DIVIDENDS THROWN OUT: For starters, if you didn't read the fine print associated with this study you would never know that they conveniently used the S & P "price return index" which excludes dividends. Yes their annuity is based on the price return index BUT for anyone who was using this chart to evaluate and compare investment options, it leaves a distorted impression. Investing 100% in the S & P 500 index is not a fair comparison to investing in an annuity. They are polar opposites on the risk / reward scale. Remember that annuities are sold to investors who are IGNORANT of how bonds protect against stock market volatility, and insurance companies and salesmen are well aware of this!


2) BONDS MITIGATE STOCK RISK: For anyone who might have been confused by this chart, it is completely ludicrous to compare index annuities with stocks alone! This is not an apples to apples comparison! The type of market fearing investor who might consider a conservative investment like an index annuity would never otherwise put 100% of their money in the S & P 500 index! A more realistic "apples to apples" comparison might be to compare index annuities with a conservative portfolio of 75% Barclays Aggregate Bond Market and 25% S & P 500 stocks. In this case, from January 1, 2000 until January 1, 2014 the total return of the 75/25 portfolio was $234,256. This compares with just a total return of $198,725.00 for their best index annuity when using 9/30/1999 as the starting point for the annuity. See the chart below.


NOTE: I have not factored in trading costs (which would only be about $14 to buy in with Scottrade and $14 to cash out) nor costs of owning bond and stock ETF's. For example VOO has an expense ratio of only .05% per year and SPY has an expense ratio of just .09% per year.

Performance return statistics were gathered from this site.


3) HIGHER ORDINARY INCOME TAX RATE: And while this study does not factor in annuity savings from tax deferral, it also doesn't factor the tax savings when considering that the 75 /25 portfolio is not subjected to the higher ordinary income taxes. According to Wealth Manager's article "Photo Finish" regarding annuity tax deferral in general, when all said and done, it does not favor the annuity.


4) CHERRY PICKED TIME PERIOD: They picked a mostly bearish time period that would make the S & P 500 index look bad.


5) ONE SINGLE CHERRY PICKED CONTRACT: The "Index-5" green line is actually supposed to be based on an actual consumer's annuity. Notice how from Sept 30, 2010 to Sept 30, 2011 the S&P 500 index dropped slightly, yet the "Index-5" account value went up from $160,747 to $171,388. How on earth did that happen if the S&P 500 index was the crediting method? This is because the annuitant just happened to in fact switch crediting methods at just the right time to a "mixed allocation". So this chart does not show a strict adhering to the S&P 500 index as a crediting method. In other words the insurance company may have cherry picked this contract in order to put their best foot forward. If they showed a simple ongoing use of the S&P 500 index as the crediting method then the ending value on September 30, 2013 may have been less than $198,725.


6) REBALANCING: In addition to not comparing their annuity to a low risk stock / bond portfolio, this study also never examined the positive effects of rebalancing. Stock / bond rebalancing is a basic strategy that increases returns. According to Vanguard, simple rebalancing can add up to 0.35% per year to a portfolio value. An index annuity cannot be rebalanced.


7) WHAT IS MY CASH SURRENDER VALUE? Last and most importantly, the green "annual monthly average Annuity-5" line is a meaningless value if it is not the cash surrender value. You can read the brochure for this annuity if you like. It is unclear if the green line value is also the cash surrender value which would ultimately determine annualized return on investment. If the contract holder wanted to cash out in 2013 would they actually get $198,725? If they indeed were able to cash out with $198,725 then their annualized return on investment after 15 years was only 4.68%. This does not factor in surrender penalties. Unfortunately I do not have Barclay's US aggregate total return index data using September 30th as the calendar year start date. So I instead calculated 25/75 investment returns beginning 3 months later on January 1st of each year because this total return data is easily accessible. It's not a perfect comparison but it's bound to be generally close.


Most investors fear stock market crashes. The "lost decade" began in 2000. So let's instead see how the annuity did from 9/30/1999 to 9/30/2013. It provided a 3.975% annualized ROI -- Again this is assuming that 'Index-5' actually represents cash surrender value. By comparison, with 25% in the S&P 500 total return index and 75% in the US Barclay's aggregate index from 1/1/2000 to 1/1/2014 you still came out the winner with a 4.18% annualized ROI. And you were $35,531 richer, again not counting less than $20 in trading costs to buy 2 index funds like SPY and AGG and not counting the miniscule index fund expense ratios and turnover costs. Again, this is during the worst of times for traditional investments, the year 2000 onward!!! Also keep in mind that index funds are 100% liquid. Cash out at any time for any reason, without penalty! All in all this makes traditional investing the superior choice.


BELOW: The performance chart that the insurance industry doesn't want you to see. Notice how bonds smooth out stock market volatility.


Annuities are sold based on unrealistic fear of loss of principal

And so annuities are sold based on investor ignorance of how diversification (into bonds) protects against stock market volatility. When stocks fall, money runs to the safety of bonds. Bonds provide the consistent slow growth that conservative investors want. And while stocks have historically been the best performing asset class, stocks are much more volatile than bonds and nobody who is considering an annuity would otherwise invest 100% of their money in stocks (or a stock ETF). A conservative senior citizen investor cannot wait 10 years for recovery from a bear stock market, such as the one from 2000 to 2009. A conservative investor who is actually considering an annuity is not looking to take much risk. Therefore a bond heavy portfolio makes sense -- Perhaps somewhere between 50% stocks / 50% bonds or 75% stocks / 25% stocks.


Unfortunately many investors still have an irrational fear that even with a bond heavy portfolio they may lose a lot of money or run out of money while withdrawing perhaps 4% per year. History has shown that just hasn't been happening. The only thing these investors are doing by putting their money in annuities is giving money to insurance companies and sales agents disguised as "financial advice givers", increasing their taxes, sacrificing their liquidity, risking having to pay a surrender penalty, and screwing over their heirs.


Finally, ask yourself how do you think insurance companies are able to make the promises and guarantees that they make through thick and thin, still earn a profit, and still pay your "adviser" his lavish commission?! The answer is that they are fully aware of how the markets work. They stack the deck in their favor so that they are virtually guaranteed to come out a winner. Then they take your money and do what you should have done. They invest it in bonds and stocks!


How would a 75/25 portfolio hold up after the 1929 market crash?

First of all, a 90% drop in the stock market is highly unlikely considering how very different the stock market is today compared to what it was back then. Before 1929 there was no Securities and Exchange Commission to protect investors against fraud, there was no FDIC insuring bank deposits, there was not Glass-Steagall Act, there was no 401K and pension money entrenched in the market, and no money managers whose job is to invest, not sit on the sidelines in cash. Click here to read about some of the steps that have been taken to prevent irrational market crashes.


From 1929 to 1946 your money was never in danger of running down to zero. The lowest the 75/25 portfolio dropped to was $85,524 at the end of 1932, however when adjusting for deflation you were actually EVEN at that point in time! Not bad considering that you were 3 years into the great depression!


jailYour money unnecessarily locked in prison without cause!!! Found guilty by a heartless one-man jury: Your broker! Earliest date eligible for parole: Age 59 1/2 or later

ANNUITY LIQUIDITY RISK is the risk that you may have to pay penalties (and greater taxes) in case you need your money. You never want to be "trapped" in investments that penalize you for early withdrawal with "surrender fees" yet you are just that with annuities until age 59 1/2 or later. In this day and age there is no need to lock your money away for any length of time in order to achieve higher returns or to protect against market volatility. The complete opposite is true. Anyone who tells you that you need to lock your money in prison is probably an insurance agent, bank employee, broker or a broker going by any number of alternate titles such as "investment adviser". They have a vested interest in selling you annuities, actively managed mutual funds, non-traded REIT's, limited partnerships, etc. Putting 25%, 50% or more of your investment money in illiquid investments like annuities is just plain insane. Putting less than 25% makes no sense. Years of history says that principal loss should not be a concern over long time periods of 10 to 20 years. It's flawed logic to presume that you are likely to lose money with an everyday defensive portfolio of high dividend stocks (or ETF's), bonds (or bond ETF's), CD's and other asset classes such as gold, publicly traded REITS (not non-traded REITS). This is a critical issue to note because annuities are in fact long-term investments so it makes perfect sense that we ignore short term stock market dips that investors fear when they are led astray by brokers who push annuities. In fact even T. Rowe Price has stated that the average investor needs to remain invested in a variable annuity for 10 to 20 years in order to justify the high fees. Keep in mind that T. Rowe Price sells annuities! So just for starters, if you don't plan on staying the course for 10 to 20 years then don't even think about investing in an annuity.


Insurance salesmen like to point out that there is an exception for medical bill hardship. You can withdraw money early to pay for medical bills. But what they aren't telling you is that you can't elect to withdraw money from your annuity before your other separate non-retirement investments (like ETF's, stocks, bonds and gold). Once you drain your liquid investments first, then suddenly you are really behind the 8 ball! You don't qualify for "medical hardship" until you are truly broke! Just one more reason to avoid annuities.


Insurance salesmen also never discuss with you that if you withdraw all or a lot of your annuity, you will be hammered by ordinary income taxes (not the capital gains tax rate). These high taxes are unavoidable even if you are given an exception for medical hardship. If you were under the impression that you could just pull all or a lot of you money out of an annuity once you turn age 59 1/2 or once the insurance company surrender period expires, think again. If you want to limit these escalating taxes then you will have to stagger withdrawals over several years. In essence this makes an annuity an ever longer term investment!


An annuity is not part of a diversified portfolio either

A common annuity salesman talking point is to say that an annuity is a bread and butter part of a diversified portfolio, which is like saying that every football team needs a bad player.


Understand that bonds and stocks tend to balance each other out. An old adage says that when stocks fall, money runs to the safety of bonds. Yet there are "advisers" out there who may try to convince you to replace all or part of the bond portion of your bond/stock portfolio with an annuity. This "strategy" defeats the purpose of a bond/stock portfolio. A 75/25 portfolio actually gained value during stock market declines from 2000 to 2002 and and 2007 to 2009, while index annuities gain nothing. From 1970 to 2010 the lowest risk portfolio was 28% stocks and 72% bonds.



Index annuities exposed by various respected experts!

A professor at Baylor University and expert witness on annuity products, William Reichenstein says that over the long term, simply investing in a conservative portfolio (conservative stocks and bonds or the equivalent ETF's) easily beats an index annuity. According to Reichenstein, over the last 44 years, the average index annuity would have under performed a very ultra-conservative portfolio consisting of 85% one-month T-bills, and 15% large-cap stocks by nearly two percent per year, on average! He identified only two rolling 10-year periods in which the most popular index annuities would have beaten the conservative 85/15 portfolio. Also according to Reichenstein, since 1957 there has never even been a 3 year period in which the 85/15 portfolio of T-bills and S&P 500 index stocks has lost money. Keep in mind that this study was done for demonstration purposes to show how easily an index annuity is beaten. Don't run out and and copy this portfolio. Meet with a fee-only fiduciary RIAA. They will likely get you invested mainly in bond and stock ETF's.


In a study conducted by Dr. Craig McCann of UCLA and Dr. Dengpan Luo of Yale University, they discovered that investors would be better off in a simple portfolio of U.S. Treasury bonds and large cap stocks – a whopping 97% of the time. Other studies have suggested that when someone buys an annuity this typically results in a wealth transfer of as much as 15% to 20% from the investor to the insurance companies and the sales agents. Insurance companies know it. This is why they love to sell annuities. The deck is stacked in their favor. Source


The problem with index annuities is that they have high fees, they give up too much of the up side potential ("performance caps") that you would otherwise enjoy from a combination of bond and stock ETF's, you pay much higher taxes, and the market crash that your so-called "adviser" is warning you about is not likely to be sustained over 5 years or more (or whatever the surrender period of the index annuity is). Insurance companies know this. That's why they are able to make what appears to be a too good to be true offer. It is not. If you still are ever tempted to lock your money up in an index annuity, at the very least be sure to get an expert second opinion from a fee-only fiduciary registered investment adviser.


The deck is stacked in their favor!

Ask yourself how in the world is it that an insurance company is able to confidently and comfortably pay you a specific rate of return on a fixed type of annuity and at the same time 1) pay a lavish commission to the salesman who pushes their annuity product on you, 2) pay for underwriting costs, mortality fees, administrative expenses, including high paid CPA's and lawyers, litigation costs, accountants, trained phone support reps, office space rent, website costs, advertising costs, political lobbying costs, etc, and 3) be sure that they are earning a profit for the company? The answer is that they take your money and do what you should be doing with your money. They turn around and invest it in bonds and stocks and still manage to make a profit! That should tell you that you are cutting yourself short by not investing in bond and stock index fund ETF's like everybody else is doing.


With fixed types of annuities the insurance company offers you a guarantee that you won't lose money in any given year but at the same time they limit both your participation rate and they place caps on returns in such a way that they are low enough to very comfortably assure that the deck is stacked very much in their favor. In essence they offer no down side risk but they take away too much upside. Behind closed doors they understand that an annuity is a long-term financial product and that over long time periods the stock market goes up -- not down, and thus any short-term volatility that might occur will get smoothed out in the end. Then they win and you miss out because of your fixation on short-term market volatility (even though an annuity is long-term) and your lack of understanding about how diversification into not just stocks, but bonds, protects you from market volatility, especially long-term.


Beware of Advisers Who Cite Rosy Past Annuity Performance

Aside from trying to confuse interest rate or "income base" with return on investment, advisers may try to cite handsome annuity performance dating back to the 90's. That was then, this is now. Back in the 90's, insurance companies over promised with their benefits. Since the 2000 bear market, insurance companies were forced to rethink the returns and benefits that were promised in their contracts. So the only thing that matters moving forward is anticipated future return on investment. Story


Critical strategy of rebalancing is not an option with most types of annuities

Fixed types of annuities like index annuities are a doubled edged sword. After the market collapses, as it did in 2008, you are stuck in that ultra conservative investment while the smart investors are taking advantage of the fire sale buying opportunity in stocks. After market crashes you want to rebalance by taking on more risk. You sell some your bond ETF's in favor of stock ETF's. You sell some of your conservative stock ETF's in favor of growth stock ETF's.


Assuming you purchased an index annuity right before a market collapse, your only option to rebalance (perhaps a year later and after the market bottomed out) would be to pay a nasty insurance company contingent deferred sales charge of perhaps 4 to 6% in order to do a 1035 exchange to an annuity that allows you to take on more risk such as a variable annuity. All of a sudden that index annuity wasn't such a great choice after all.


diversificationUse diversification to protect against loss of principal -- NOT an annuity!

The time tested standard method to protect against market volatility is diversification -- not annuities! Simply pick a mix of stock and bond ETF's, and cash investments, gold, and perhaps TIP's and publicly traded REITS, all based on your goals and appetite for risk. There is no need to lock your money in prison for 10 to 20 years while subjecting your gains to the higher ordinary income taxation and wiping out your beneficiary's stepped up cost basis.


Do you fear loss of your investment money? Then avoid annuities!
High annuity management fees = Gradual loss of money that adds up!!!

Insurance companies are for-profit corporations. They skim money off of your investment. And annuity pushers earn huge sales commissions. They earn 5 - 14%. And you indirectly pay for all of it through drastically higher than normal fees of about 3 - 4% per year! It all gets shaved off of your annuity investment year after year after year in the form of high fees (described further down this page) that . These high fees are exactly what you fear the most... loss of your money!!! You're "guaranteed" to pay high fees for 10 to 20 years or however long you lock your money up in the annuity prison for. With an annuity you are assuring that you will UNDER perform the market.


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