Tax-deferred annuities offer generous rewards, but you need to heed warnings
TERRY SAVAGE firstname.lastname@example.org Apr 27, 2009
Updated: May 3, 2013 12:14PM
Writing about tax-deferred annuities creates tremendous possibilities for misunderstandings and misleading uses of the information.
So let me start with a series of warnings. Much like the label on your prescription medicine, these warnings inform you that the product within is designed to be a benefit -- but only if you take it as directed, and avoid using it under the wrong conditions!
Here's the warning label for these tax-deferred, variable annuities:
**Purchase only through a reputable dealer, with expertise in these products.
**Purchase only from an insurance company with a strong financial balance sheet.
**Understand that there is no official federal bailout fund for insurance companies -- only state funds that may "assess" other insurers in case of a company failure.
**Get a written explanation of all fees and charges.
**Use only if you understand "surrender charge period" -- and are sure you will not need access to all of your money before that period of time expires.
**Understand the risk of loss, as well as what is -- and isn't -- covered by guarantees.
**Understand the difference between "withdrawals" and taking an "annuitized" stream of income.
**Understand what happens to the balance of your account if you die before taking out all your money.
Now, having read the warning label on the package, there are some very interesting annuity products available. And some of the most generous ones are starting to disappear, as insurance companies reassess their ability to provide the returns they have been promising.
Guaranteed minimum income
A tax-deferred variable annuity is a contract with an insurance company that lets you invest money for tax-deferred growth in a choice of mutual fund-type sub-accounts, which carry certain additional fees.
The value of your tax-deferred account depends on your fund investment choices within the annuity. The risk is that you make a wrong choice and lose money.
That's why the industry has come up with some enticing new products called guaranteed minimum income (and withdrawal) benefits. They protect your retirement income from bad investment decisions -- at a cost, and with some strings attached.
Guaranteed minimum income benefits provide, at a slight additional cost, protection against a market decline in the cash value of the variable annuity. That is, the insurance company guarantees a growth rate of 5 percent or 6 percent annually on the amount from which you will be able to withdraw income in the future. That "protected withdrawal value" is guaranteed -- no matter what the investment performance of your fund sub-accounts.
For example, to use some big round numbers: If you invest $100,000 in this type of annuity, you could get a guaranteed 6 percent rate of growth on your "protected withdrawal base." At the end of one year, that base would be $106,000 -- even if your stock market investment choices fell to be worth only $80,000. Next year, you're guaranteed to earn 6 percent on that base of $106,000.
On the upside, you get a chance to make significant gains. If your stock market investments are successful, your investment account could be worth more than that guaranteed withdrawal base.
You have access to that actual market value at any time, assuming you're past the period of surrender charges. But the best use of these products is to take a withdrawal of no more than 6 percent a year (or whatever the guaranteed rate), thus preserving that protected withdrawal value.
You have access to all of your cash at any time, once past surrender charges. But the idea is to keep it growing at this minimum guaranteed rate and hope your investments someday total more than that guarantee. Really, it's a win-win situation for the investor.
And that's what has the insurance companies a little worried these days. Many insurers are reducing the guaranteed rate to 5 percent or even 4 percent -- and increasing the annual costs and fees.
Each company's product has its own wrinkles. Some register your annual "high-water" mark -- the value of your investment for withdrawal purposes -- only on the anniversary of the purchase of the product. Others lock in that mark at the highest point during the year. Some create additional "riders" guaranteeing a regular monthly income payment for your lifetime, even if your investment account balance goes to zero!
Quite honestly, these products are so complicated that I have to re-learn the basics every time I write about them. (And I actually own some of them!) So I highly recommend that you use a trusted and experienced adviser -- not just the salesman that tempts you by offering 6 percent rates when your bank is paying less than 1 percent. Remember, the sales commissions are substantial -- and hidden -- when you purchase these products.
Jeffrey Oster of Raymond James (888-655-1035, ext. 801, or www .JeffreyOster.com) is my own expert on the subject.
As with all investments, you must never be blinded by the obvious rewards without understanding the costs and the risks. Tax-deferred annuities are NOT "chicken money" investments because of their costs, complexity, lack of immediate liquidity, and lack of outright federal guarantees of insurance products.
But they are worth a second look for investment capital, before some of the best deals disappear. And that's The Savage Truth.
Terry Savage is a registered investment adviser. Distributed by Creators Syndicate.