San Juan Mountains

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San Juan Mountains: Grenadier Range

Tuesday, December 15, 2015

Annuities Are Terrible Investments

I am routinely approached by insurance agents who want to sell me annuities.  Do you know what an annuity is?  Let me give you a brief lesson.  An annuity is basically a life insurance contract in reverse.  With a life insurance contract the insurance company charges you a premium and only pays you off if you die.  With an annuity contract the insurance company charges you a premium and stops paying you off when you die.
There are two types of annuities:  variable and fixed.  Variable annuities are essentially stock mutual funds placed inside an insurance "shell" in order to get tax qualification for the assets contained therein.  That means the assets within the annuity can accumulate tax deferred, although they are taxed as ordinary income when distributed to the annuity owner later in life.  Fixed annuities are essentially bond funds and they pay a fixed rate of interest, depending upon what current interest rates are in the bond market.
Insurance companies are not prone to tell potential investors in either fixed or variable annuities that they are essentially just purchasing a stock or bond mutual fund.  Look at the chart below.  The "General-account assets" are those assets held by the insurance company that are used to pay the fixed rate of interest in their fixed annuities.  The "Separate-account assets" are those assets held by the insurance company that are used to pay the variable rate of return on their variable annuities.  As you can clearly see, the great majority of the assets (76%) in fixed annuities are invested in bonds and an even greater percentage of the total assets (80%) are invested in the stock market for the variable annuity contracts. 

Annuity salesmen, or at least those I have had the misfortune of coming into contact with, tend to present their annuity contracts as a safer alternative to the stock or bond markets.  As you can see, that presentation is false and misleading at best.  Both fixed and variable annuities are subject to the same market risks associated with the stock and bond markets that stock and bond mutual funds experience.  If you are thinking about purchasing a variable annuity to avoid or mitigate the risks associated with your stock mutual fund you are making a big mistake.  The risks are the same with both.
Annuities, however, are not just mutual funds that have tax qualification privileges associated with them.  In order to get the government to grant those special tax qualification privileges the annuity has to present itself as some sort of insurance product.  Creating an insurance product costs money, sometimes a lot of money.  According to this website, here are the average fees associated with owning a variable annuity:

"Variable annuities are not insurance products, they are actually securities. Money invested in variable annuities is subject to market risks as well as fees and expenses.  If you decide to invest in a variable annuity, it is important to know and understand the fees you will be charged.
Let’s begin with the basic expense for the annuity itself.  The expense is known as the mortality and expense fee. (M%E)  This fee helps offset underwriting and policy costs.  The percentage can change depending on which contract you select, but the industry average is 1.25%.  That is 1.25% of the value of your variable annuity.  The 1.25% is charged each year you own the annuity.  The next basic fee is called the administration or expense fee, industry average is .25% of your entire account value.  This fee is also charged annually and is designed to cover costs associated with maintaining and servicing your annuity.  So the basic fee for variable annuities in our example is 1.50% of your annuity value.
To that percentage then add on the fees for the actual management of the funds held within the variable annuity. Investment options are actually a type of mutual fund called 'separate accounts'.  The categories can be stocks, bonds, US Treasuries, foreign assets, real estate trusts, almost anything that can be managed as an investment.  Many owners of variable annuities select several separate accounts to add diversification to their investment choices. Each choice will have their own fees associated with the individual separate account.  Most variable annuities will average 1.35%/year for invested assets but actual expense fees can be higher or lower."

Stock mutual funds also have costs associated with them.  The cost of running the fund, or fund operating expense, is the same as the management fee for running the separate accounts described above for the annuity.  In 2014 the average expense ratio for a domestic growth stock fund was 1.2%. The average expense ration for a domestic value stock fund was 1.1%.  In both cases the average cost associated with running a stock mutual fund is lower than the average cost associated with running a variable annuity.  The kicker on the variable annuity contract is the 1.5% you have to pay each year for the privilege of tax qualification.  That annual expense destroys the long term rate of total return and is reason alone to never purchase an annuity contract. 
All of this having been said, let me give you the main reasons I would never purchase a variable annuity.  (I would also never purchase a fixed annuity but these are my reasons against the variable version.)
  • Variable annuities are more expensive than stock mutual funds.  On average they cost 1.5%/year more in total fees.  The loss associated with the higher expenses is almost impossible to make up.
  • If you die during the accumulation phase of your variable annuity your beneficiary will usually only get the total value of the amount you have invested into the contract.  All increase in value within the contract is retained by the insurance company.  Over longer periods of time this can come to a tremendous amount of money lost to the beneficiary.  If you have invested $50,000 into your variable annuity and it is worth $150,000 when you die, your beneficiary will receive $50,000.  If you had placed that money into a stock mutual fund your beneficiary would get all $150,000
  • When you annuitize the contract (the point you stop putting money in and start taking money out) you commit yourself to a particular payment for the rest of your life.  Most of the time this monthly payment will be payable to you and a co-beneficiary and it is guaranteed to both of you for life.  If and when both you and the co-beneficiary die, the insurance company retains all of the assets in your account.  This can amount to a tremendous amount of money lost to your beneficiaries, especially if you die earlier than actuarial expectations would dictate.  Insurance companies justify this practice because they also have annuitants who live much longer than expected and they have to continue to pay a monthly benefit to those folks who have outlived their initial account value.  Why should you be forced to assume the risk of other people living longer than you?
  • In a stock mutual fund you are granted capital gains tax treatment on all sales of your shares after one year.  In a variable annuity all distributions are treated as ordinary income and subject to much higher rates of taxation.  Whatever benefit might have been realized from the tax qualification of the variable annuity is lost when the time to take money out comes.  This is especially true with growth stock mutual funds.   With growth stock mutual funds your taxable income is generally lower and that which is distributed to you is generally a tax-favored capital gain rather than a fully taxable as ordinary income dividend.
  • Some people are persuaded by immoral insurance agents to place annuities within their IRA accounts.  An IRA, as most of you know, is already tax qualified.  By placing an annuity within an IRA you are agreeing to pay the insurance company 1.5% of your total assets each year for absolutely nothing.  You do not need the tax qualification provided by the annuity because you already have it with your IRA, yet some folks blindly trust their insurance agents and make that foolish and costly decision.
Generally speaking I believe people purchase annuities because they are afraid of the stock market and they want someone to give them a guarantee.  Insurance companies are happy to come along and sell you a variable annuity and give you that monthly income guarantee you want, but at a very steep price.  I don't ever think it is worth the price but judging by how many variable annuities are sold to fearful investors, I find myself in the minority once again.  

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