Annuities Unraveled (SCMBX)

Annuity salespeople commonly boast about a guaranteed return, safety into retirement, and deferred tax benefits of the products they peddle. Annuities can be complicated products and require careful consideration of the prospectus and alternatives before integrating them into your portfolio.

A fixed annuity is when the annuitant pays a lump sum or installment payments to the insurance company in exchange for a stream of fixed payments, either immediately or deferred, for a certain period of time or for the lifetime of the annuitant(s). A fixed annuity provides certain advantages; most notably, it caps risk. In times of market volatility, it grants security from these economic downturns, it also can provide a constant income which cannot be outlived. Annuities are generally illiquid investment products; usually carrying severe penalties if the annuitant attempts to withdraw money early. Furthermore, fixed annuities do not always adjust for inflation which is likely to reduce the real return over time.

An indexed annuity is similar to a fixed annuity in that it provides a minimum rate of return in the case of market downturns, but yields are usually capped. For example, if the index being tracked is the S&P 500 and it experienced a very bullish year of 15% growth, but management fees are 0.5% and the cap is set at 10%, the annuitant's return is only 9.5%. The risk of indexed annuities is the opportunity cost investors face because they will not realize the full benefit of the market due to the capped return. So while they miss out on very bullish market activity, the risk is limited. Another bonus is indexed annuities offer a minimum rate of return even during bear markets. Another downside is that the annuitant misses out on dividends to which shareholders of the particular stocks within the index are privy.

A variable annuity would be considered the riskiest of annuity products because while the annuitant receives periodic payments, they are tied to investment performance. As a result, payments will fluctuate. The annuitant may also designate the investment allocations and select from a list of specified funds, (i.e. 60% in a bond fund and 40% in an equity fund). It is possible to lose principal in this type of annuity, but growth is usually uncapped.

Tax-deferral is a key selling point for annuities, which may be more of a negative than a positive considering the current state of the economy. With the current national debt over $14 trillion, and the Bush tax cuts extended for the next two years, it is possible that the government will need to raise taxes upon expiration. Investors may prefer to be taxed at current rates than wait until being taxed on the periodic payments sometime in the future. However, using the concept of present value, investors may prefer to pay higher tax when they receive payments rather than give up the money now. Those who prefer the former may be attracted to Roth IRAs are or this reason. Roth IRAs are taxed up front and not when you begin making withdrawals.

While annuity salespeople might target those who fear market volatility, there are alternatives to annuities that are considered fairly safe as well, and provide increased liquidity and tax advantages. Consider municipal bond funds, such as DWS Managed Municipal Bonds (NASDAQ: SCMBX), which experienced a 4.35% annualized return for the past ten years. A minuscule percentage of municipalities have defaulted in the past, and investing in a municipal bond fund diversifies this risk further. In addition, the interest accumulated is federal tax-exempt. If you hold a state municipal bond fund and reside in the same state, it is also state tax-exempt. The tax benefit is more profound for a person in a higher tax bracket, but they provide advantages even for those who fall in the lower brackets as well. More liquidity, good potential returns and superior tax advantages than an annuity can offer. Another consideration are simple Treasury notes, or Treasury Inflation Protected Securities (TIPS), which pay a fixed interest rate on an inflation-adjusted principal, without high fees and commissions that annuities require.

It is important to discuss your options with a financial advisor to be made more fully aware of the implications of potential investment decisions. Neither Benzinga nor its staff recommends that you buy, sell, or hold any security. We do not offer investment advice, personalized or otherwise. Benzinga recommends that you conduct your own due diligence and consult a certified financial professional for personalized advice about your financial situation.