- February 10, 2012
- Posted by: Parker Evans, CFA, CFP, CMT
- Category: Annuities
Are annuities a good investment? The short answer is probably not. Annuities are insurance contracts based on life expectancy tables. A simple, traditional annuity provides the buyer with a fixed monthly stream of income for life. Unfortunately, the insurance industry has made great strides in making the simple complex. For example, annuities can be immediate or deferred, and fixed, variable or equity linked. Today, new-fangled annuities outsell traditional immediate fixed annuities by a wide margin. There are at least four potential problems with investing in a deferred annuity:
1. Tax Disadvantages
2. Mind-boggling Complexity
3. High Costs and Illiquidity
4. Concentrated Credit Risk
Consider this hypothetical example. A fifty-two-year-old investor purchases a $100,000 equity index deferred annuity. The annuity is linked to the S&P 500 Index, has a seven-year surrender term, a 60% participation rate, and a 6% annual cap. Keep in mind this investor could easily invest in an ultra-low cost, tax efficient ETF that will reliably replicate the return on the S&P 500 Index. Also, currently the ETF pays a tax-advantaged dividend of approximately 2% annualized which can increase over time. The annuity investor will not receive any return linked to dividends, a fact disclosed in the fine print of the contract. Now, assume the S&P 500 appreciates 60% over the 7-year term of the annuity term. The $100,000 invested in the ETF is now worth $160,000 and considerably more with the dividends reinvested. The $100,000 invested in the annuity is worth at most $136,00 and probably less, possibly a lot less. It gets worse. When the investor surrenders his annuity, he pays taxes on any gain at his highest marginal tax rate. In contrast, the ETF investor, if he sells his shares, may enjoy lower long-term capital gains tax rates. Better yet, the ETF investor may never owe taxes on his gain if he is in a low marginal tax bracket at the time of sale or if he qualifies for a step up in basis at death.
In the event the investor needs to surrender his annuity before seven years, the insurance company will charge hefty surrender fees and a market value adjustment. The IRS may assess a tax penalty as well. In contrast, the ETF investor will incur only a relatively small commission to sell his shares. And unlike the annuity investor, the ETF investor could easily borrow money at very low cost using his ETF as collateral without triggering a taxable event.
Now it is possible, but historically unlikely, that the S&P 500 will be lower after seven years. In that scenario, the annuity investment might actually outperform the ETF, assuming the annuity carrier does not go bust. In the aftermath of the 2008-2009 market crash, many annuity issuers were in such dire financial straits that they required TARP capital injections from the US Treasury.
Don’t be a fooled. Annuities can be unsuitable investments with complex riders and features designed to promote sales and protect the insurance company, not the investor.