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20 questions, No. 4: Annuities offer security, risks

Updated: May 3, 2013 12:14PM



What is an annuity -- and is it right for me? A. Annuities are one of the most misunderstood -- and frequently misused -- financial products. So here's "Annuities 101" -- and a warning that you should investigate the costs, surrender charges and restrictions before making a purchase.

An annuity is basically an insurance company contract. Annuity accounts are not federally insured -- something that is now a great concern for many savers. There is a state-by-state program that would "assess" other insurance companies, up to a limited amount of cash value in a contract, in case of an insurance company failure.

However, the federal government has given every indication, through its reluctant support of AIG, that it will not let a major insurer fail and default on this type of contract. Also, many large, global insurers are well-capitalized and highly rated.

IMMEDIATE ANNUITY: This type of contract is used to ensure monthly payments for life -- no matter how long you live! The lifetime payments start the year you deposit your money with the insurer. They look at the amount you've invested, and your age and gender, to determine how much they can pay you every month until your death.

Caution: Once you start receiving these monthly checks, you cannot break the contract to get your remaining money back. If you die, the insurance company keeps the balance -- unless your contract says it will continue to pay your beneficiary for either his or her life, or a certain number of years.

Another caution: That fixed monthly amount might look generous now but could be decimated by future inflation. For planning purposes, you would not want to put all of your money into an immediate annuity, which gives a fixed monthly check.

To get an idea of how much money you could receive every month, go to www .immediateannuities.com and use the calculator to compare offerings.

TAX-DEFERRED ANNUITY: These contracts take advantage of a law that allows cash to grow tax-deferred inside insurance company contracts. These contracts typically have steep penalties for withdrawal of your money for a number of years -- surrender charges. (It is these "surrender charges" that help fund large commissions for the salesperson!) These can be a bad deal for seniors, who might need their cash in the near future for living expenses.

Tax-deferred annuities allow you to continue to grow your assets at a fixed rate or at a variable rate that is determined by investment performance, until some time in the future. At that point -- once past surrender charges -- you can withdraw the money, paying ordinary income taxes. If you die before withdrawing the balance, you can leave any balance to a named beneficiary -- unless you had chosen to annuitize.

There are two types:

**Fixed-rate tax-deferred annuities: These contracts promise a fixed rate for a certain number of years. For instance, today you can get a 4.25 percent rate for five years guaranteed from a major insurance company. You should never sign a contract that has surrender charges lasting longer than the rate guarantee -- or you could be stuck for years with below-market rates!

**Variable tax-deferred annuities: These contracts give you a choice of investment sub-accounts, much like mutual funds. Your choice of investments determines the growth of your account. Ask about the mutual fund management fees, which may be significant, as well as annuity fees and surrender charges.

Beware: Some annuities are "linked" to the performance of an index. But most of those products don't give you the full benefit of gains or dividends over the years and tend to be a costly mistake.

The most exciting new annuity policies may even offer a "high-water mark" guarantee -- a promise that you can withdraw over your lifetime, based on the highest value of your investment account, even though it has dropped in value since that time. These products are so interesting and complex that I'll write a separate column about them soon.

In the meantime, remember that the tax- deferred growth or lifetime income promises of annuities can be enticing, but they come at a cost that is not always obvious. That's The Savage Truth.



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