A couple months ago, I wrote a column about a good friend who’d plunked a substantial part of his life savings into an expensive and unnecessary whole life policy. I explained why this is almost always a terrible investment.

But my friend’s insurance agent is back at it, pitching him now on annuities. “It’s like an IRA, offering tax-deferred compounding but with no investment limit,” the salesman gushed.

[ad#Google Adsense 336×280-IA]“And you are guaranteed a lifetime of minimum withdrawals, no matter how long you live or how poorly the stock or bond markets perform. No other investment product offers this combination of benefits.”

Wow. Sounds enticing. Who could argue against these great benefits?

Only those who know the facts. For starters, you really shouldn’t be buying broker-sold investment products.

These are ideal for only one kind of person: salesmen.

They offer the highest commissions in the industry – and believe it or not the SEC doesn’t even require them to be disclosed in the prospectus.

Know the Drawbacks

Annuities are generally used to achieve either tax-deferred growth or lifetime income. My friend’s agent did a fine job of summing up the potential positives. But, in my experience, most agents either ignore or don’t know all the negatives. So let’s consider them here:

  1. Annuities are not FDIC-insured.
  2. Withdrawals prior to age 59 1/2 are generally subject to a 10% IRS penalty.
  3. Annuities are the highest-cost investment products in the financial industry. Average annual expenses are up to three times higher than a typical mutual fund’s expenses and up to 30 times higher than a typical Vanguard index fund’s. This, of course, sharply reduces your future investment returns.
  4. If you cash in a variable annuity, your gain (if any) will be hammered at your income tax rate, not the lower capital gains tax rate. If it’s any consolation – and it’s not – your tax burden may actually be less because the high annual fees will dramatically lower your investment returns.
  5. You can get most of the same tax-deferral benefits (at one-thirtieth of the cost) by simply buying and holding Vanguard equity and/or municipal bond index funds. Or by buying and holding individual stocks, and holding companies like Berkshire Hathaway or Biglari Holdings. (So much for the big “tax advantage.”)
  6. If inflation heats up, your fixed annuity payments will lose their purchasing power. (Insurance agents will counter that some products allow policyholders to raise their annual payouts by 1% to 3% a year. But that means you have to start with lower payments. There’s no free lunch.)
  7. Oh… and about that principal guarantee. Your contract – contained in a prospectus up to 3 inches thick – will require you to hold the annuity for many years to realize that guarantee. If you cash it in sooner for some reason, you will be hit with an additional fee – called a surrender penalty – equal to up to 10% of your investment.
  8. Even if you hang in there for years or decades, a guarantee is only as good as the issuer. Understand that you are surrendering your principal to the insurance company immediately. And while your agent may brag about his company’s high rating from A.M. Best, remember that the world’s biggest insurance company, AIG, imploded in the financial crisis and had to be bailed out by Uncle Sam. How confident are you that this won’t happen again in the future? Yes, there are state industry-backed guaranty associations, but they have limits. In a major crisis, they may not cover your insurer’s insolvency. (To find your state’s limit, visit www.nolhga.com.)

Pros and Cons

So, yes, annuities do offer certain advantages. But, in most cases, they are swamped by all the drawbacks. You are free to make up your own mind, of course. But you can make an informed decision only if you are aware of both the pros and the cons.

If you’ve plunked a substantial sum into an annuity, I’m sure you were told of the potential benefits. The question is whether the negatives were explained. In my experience, the ultra-high fees and commissions cause most agents to ignore or gloss over them.

So think long and hard before you buy one of these. Annuities are expensive to get out of; once you’re in, you’re generally stuck.

It may not be the worst investment you can make, but it ranks up there.

Good investing,

Alex

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Source: Investment U