Are Annuities Suitable Investments for You? Depends, Say the Experts

Wondering whether annuities would be good investments for you? A growing number of Americans are embracing the products as a way to supplement retirement savings and shelter investment gains from taxes, but experts warn that annuities may not be right for everyone.

Despite these warnings, variable annuity sales are surging, according to the most recent quarterly data available. The products experienced double-digit growth in the third quarter of 2011 – the sixth consecutive quarter of positive growth, according to LIMRA, a marketing research firm that serves the insurance industry. Sales rose to $40.2 billion, a 16 percent increase from the third quarter of 2010.

MetLife, the largest seller of variable annuities in the third quarter, sold $8.56 billion of the products, compared to $4.66 billion in the same quarter of the previous year. Prudential sold $4.48 billion in Q3 2011.

Annuities are a type of insurance product designed to help investors save for retirement or other long-term goals. Annuities can be structured in a variety of ways, but products known as deferred annuities allow investors to defer taxes on earnings until they are withdrawn, typically in retirement. A variable deferred annuity is generally invested in a combination of stocks, bonds and money markets, which are subject to investment risk, while a fixed annuity yields a guaranteed fixed interest rate over a period of time.

“As its name implies, a variable annuity’s rate of return is not stable, but varies with the stock, bond and money market subaccounts that you choose as investment options,” said the Financial Industry Regulatory Agency in report designed to help you determine whether annuities would be good investments for you. “There is no guarantee that you will earn any return on your investment and there is a risk that you will lose money.”

Risk-adverse investor seeking exposure to the stock market can secure variable annuities with guaranteed minimum income and withdrawal benefits, known as GMIB and GMWB. The insurance riders can be expensive, but may be worth the price to investors unwilling to risk their retirement income stream.

The products also have relatively high fees and tie up money for the long-term. What’s more, the tax advantages tend to be overblown, said FINRA. “While earnings in a variable annuity accrue on a tax-deferred basis – typically a big selling point – they do not provide all the tax advantages of 401(k)s and before-tax retirement plans.”

According to experts at Vanguard, a leading mutual fund company, “Financial advisors usually recommend that you consider a deferred annuity only after you’ve contributed the maximum to other tax-favored retirement accounts, such as 401(k)s and IRAs.”

Deferred annuities offer the greatest benefit to investors in higher tax brackets who invest in longer-term annuity products, said Vanguard. High net worth investors may also benefit from IRS rules that allow unlimited contributions to a tax-deferred annuity and impose no mandatory withdrawal requirements on the investments.

Tax-deferral allows investments gains to grow tax free, potentially enabling investors to build a bigger nest egg, but when earnings are withdrawn, they are taxed as ordinary income – a rate that may be higher than capital gains taxes. A 10 percent penalty tax can be levied on withdrawals taken before the age of 59 ½.

Deferred annuities can also include a death benefit payable directly to a beneficiary, said Vanguard, which allows investors to transfer wealth outside costly and time-consuming probate proceedings. Some annuities offer a stepped up death benefit, a percentage of earnings over the life of the annuity. Individuals who have difficulty obtaining life insurance can use the stepped up benefit to better provide for beneficiaries. Annuities may be moved to another company tax-free, but may be subject to surrender charges.

If you’re a high net worth individual, you’re more likely to conclude that tax-deferred annuities are suitable investments for you, according to a fourth quarter wealth study by Millionaire Corner. The products are preferred by wealthier Americans, who have investable assets of $5 million to $25 million. Thirty percent of this well-heeled group own variable annuities for an average balance of $491,000, and 25 percent own fixed annuities for an average balance of $472,000.

Millionaires with $1 million to $5 million own annuities to a lesser extent. Twenty-three percent own variable annuities and 27 percent owned fixed annuities. Less than 20 percent of investors with investable assets between $100,000 and $1 million own annuity products, indicating lower net worth individuals are least likely to conclude “annuities are good investments for you.”