By Dan Barney
Last week we reviewed some of the features of an annuity including some of the advantages of an annuity. This week we will discuss some of the features that can also create disadvantages.
As noted last week, a basic simple annuity is simply an investment in which another party promises to pay a fixed amount to the investor for the balance of his life.
Built upon this basic concept, however, are all of the “bells and whistles” that can add significant expense to the investment and therefore result in a very low return.
High expense and low return become the primary negatives with an annuity. Often this disadvantage is effectively hidden by the “hype” associated with advantages such as the following:
1. In some cases the return may be variable, if so a “guaranteed” minimum on return may be included in the terms to provide that the annuity will pay a minimum of two percent (2%), for example.
However, in response there may also be a “cap” imposed to limit the return to a maximum amount.
Such a cap can be statistically selected so that the issuing company will expect to “win” over the long haul.
The effect is to “rake off” the high returns, thus greatly reducing the return to you. Often the security offered outweighs the loss in return, at least in the minds of the buyer.
2. Annuities can also offer a “guaranteed payout” so that the invested amount will be guaranteed to be paid back either through the annual annuity payments or through a guaranteed “death benefit” if you fail to live long enough to recoup your investment.
Again, from a financial standpoint, the terms can be carefully constructed by the company to insure that they “win” financially, but the guarantee is a sufficient motivator to prompt the buyer to invest in this case.
You transfer much of the risk to the issuing company but in return they can reap the rewards of taking that risk.
3. Our discussion, thus far, has assumed payouts and returns that are fixed and within reason predetermined.
Another special feature that has been very popular is the “variable annuity.” Such a plan does not provide a fixed return but provides you the opportunity to select investment options such as mutual funds or stock funds to provide potentially higher returns.
These can be advantageous but can be subject to high fees, fees that can be both direct in your annuity or included in fees imposed by the manager of the funds.
Again, a minimum guaranteed return can be included but also a restrictive maximum cap can also be included to restrict the benefits.
4. Participation Rate. Some annuities may also include a “cut” for the issuer; i.e. if the fund earns ten percent (10%) in a given year, the issuer may credit you with only eight percent (8%), for example, an eight percent (8%) participation rate. This can obviously be a significant penalty.
The conclusion – there is no absolute answer as to the desirability of an annuity in your situation. Selection and purchase is dependent upon your personal objectives.
The analysis requires a balance of your objectives for growth and risk versus the goal of security.
It is a fact though, that if you want guarantees from an annuity, there will be a cost associated with that goal.