Think Twice About Buying That Annuity

Here’s some more investment advice: Most annuities are a bad deal. First, what are annuities? They are an investment that you make in which your gains (interest and appreciation), if you have any, aren’t taxed until you withdraw them.

In the case of variable annuities, which are the most commonly bought, you are investing in underlying mutual funds, usually stocks and bonds. The beauty of an annuity is when you retire, and “annuitize” your annuity, you get a guaranteed stream of income for life, if you so choose. Outside of Social Security and a traditional company pension, which few people have these days, only annuities can provide that guaranteed income.

Here’s the downside—cost. Variable annuities are not cheap. To get that tax-deferred benefit and guaranteed income, you have to pay for the risk that the annuity seller is taking to guarantee your money. Depending on the variable annuity you buy, that annual fee could be 3% or more—and that’s on top of the fee you are paying on the mutual funds in your annuity.

Bottom line, you could end up paying anywhere from 4% to 8% or more in fees for your annuity, which means your investments must make at least that amount each year to break even and start earning investment returns. I think that’s a pretty steep price to pay for a little added security. Most people are better off just investing in low-expense index funds and setting up a withdrawal plan at retirement.

There is one kind of annuity I do believe in—it’s called an immediate annuity. Companies don’t publicize them that much because they’re not big money makers for them like variable annuities. With an immediate annuity, you deposit a lump sum of money with the provider, usually an insurance company, and they pay you a set stream of income for life.

The interest rate on a immediate annuity is based on prevailing interest rates plus an amount based on your life expectancy—the shorter your life expectancy, the higher the interest rate, since the annuity provider won't have to provide income for as long. The big benefit is you get a guaranteed stream of money at a higher rate than if you had invested in a bond at the prevailing interest rates. The downside is you lose access to the principal that you invested, but heck you won’t need that money when you’re dead!

Let me know if you’re interested in the best way to set up a retirement withdrawal strategy.