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Annuities: When they're right, when they're not


Despite their popularity, these financial products remain controversial. Here are the pros and cons.


Annuities: When they're right, when they're not

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Choose article section... Carefully consider the many trade-offs The right investment in some situations

Despite their popularity, these financial products remain controversial. Here are the pros and cons.

By Dennis Murray
Senior Editor

The complexity of annuities can make an investor's eyes glaze over and attention wander. But with the stock market struggling, they're attracting a lot of media interest these days, making them much harder to ignore. Do they make sense for physicians, though?

To decide for yourself, you'll need to tune in long enough to grasp a few basics. Issued by banks, brokerage firms, and insurance companies, and usually sold on commission, annuities are designed to provide income in retirement. You can own as many as you like and contribute as much as you want to them, in a lump sum, periodically, or both. Tax on the earnings is deferred until you take distributions, which you can do monthly, quarterly, semiannually, or annually.

Traditional IRAs and 401(k) plans also allow you to defer taxes on earnings, but the law requires that distributions from them begin at age 701Ž2, at the latest. Annuities often have no such age requirements, so you can postpone withdrawals for many more years—as late as age 95, in some cases—by purchasing a "deferred" annuity. Or, payments can start right away, if you buy an aptly named "immediate" annuity.

Annuities come in two basic flavors: fixed and variable. With a fixed annuity, the amount of each distribution won't vary for as little as one year and as long as 10 years, after which the insurer can change your interest rate. Distributions are based on how much you invest and current interest rates, among other factors.

Variable annuities, on the other hand, pay a sum that fluctuates depending on the performance of the investments wrapped within the annuity, which are similar to stock and bond mutual funds. If the investments do well, the payment can be higher than it would be with a fixed annuity, which helps to offset inflation. Depending on how the annuity is structured, distributions from it can last for a specified number of years, your lifetime, or for as long as either you or your spouse remains alive. The latter arrangement is known as a "joint and survivor" option. (For more on variable annuities, see the US Security and Exchange Commission's publication, "Variable Annuities: What You Should Know," available at

You can get both types of annuities with a death benefit, which in most cases will at least equal your entire original investment. For a variable annuity, that means your heirs will receive that original amount no matter how poorly the investment accounts perform. In all cases, though, the death benefit is eliminated once distributions begin.

You may also qualify for a "step-up" benefit: If you die before receiving any payments from the annuity, your heirs will receive its highest value on a specified annual or monthly date during the time it was owned, regardless of how much it's worth at death. This benefit usually carries a fee, though, so ask.

Carefully consider the many trade-offs

These features don't come cheap, however. To cover the costs of the death benefit and brokers' commissions, annual expenses on an annuity are generally higher than those for mutual funds—as much as 3.5 percent vs 0.7 percent for a typical index fund. In fact, depending on the annuity, it can take from five to 15 years for the tax benefits to outweigh the fees, according to Mark D. Lowe, a financial adviser with Montauk Financial Group in Red Bank, NJ.

Moreover, if you cancel an annuity contract before a designated date—for instance, to roll the assets into an IRA or move them into another type of annuity—the issuer will levy a "surrender charge" that could total 8 percent or more of the annuity's value.

"The biggest problem I have with annuities is that they're often sold as a tax-deferred retirement vehicle inside a retirement vehicle—an annuity within an IRA, for example," says Craig Carnick, a financial planner with Carnick & Company in Colorado Springs. "If a customer questions that—and few of them do—a savvy broker will point to the annuity's death benefit. But unless you're uninsurable, you'll almost certainly get more coverage for less cost by buying life insurance separately."

At this point, you might be asking yourself why you shouldn't own stocks or no-load mutual funds instead of an annuity. Good question. You definitely should purchase stocks or funds if you don't think you're going to stick with the annuity for more than a few years.

However, it's difficult to say which path makes more sense over the long haul. Naysayers argue that because annuities have high fees and the income they throw off is taxed at ordinary income rates, physicians and other high-net-worth individuals are better off investing in securities. Those, they note, have lower annual expenses than annuities and are taxed at more favorable capital gains rates when they're sold (provided they're held longer than 12 months).

For their clients in high tax brackets, many financial planners recommend "tax managed" or "tax sensitive" mutual funds run by managers who limit capital gains by trading infrequently. A mutual fund's turnover ratio, which measures the percentage of change in the portfolio's holdings, can give you a rough idea of how long a manager typically hangs onto investments. The lower the number, the better. The Muhlenkamp Fund, which has a turnover ratio of 11 percent, is a good example of a fund that limits trading and, thus, the capital gains it passes to its shareholders.

Lewis J. Altfest, a New York City financial planner, recommends tax-free municipal bonds and municipal bond mutual funds as alternatives to fixed annuities for his conservative clients. The bonds' value will fluctuate as interest rates rise and fall, but if held to maturity, they'll almost always deliver the anticipated rate of return, Altfest says. And unlike interest income from annuities, interest on municipal bonds is free from federal taxes—and often from state and local taxes, too. In many cases, this gives the municipal bond or bond fund an advantage over an annuity that offers a higher initial rate of return.

The right investment in some situations

Because brokers make good money on annuities, you're bound to hear your share of pitches for them. Do they have a place in your portfolio? Probably not, particularly if you're young and have plenty of time to ride out the stock market's ups and downs; then it makes little sense to pay an annuity's high fees. You're better off funding to the maximum all other tax-deferred retirement vehicles available to you.

The case for annuities gets a bit more compelling as you near retirement, however. "If you've worked hard to build a sizable nest egg, wouldn't you want to protect it?" asks Robert M. Doran, a financial adviser in Wantage, NJ. "Yes, annuities cost more than other types of investments, but they offer security that others can't. If you're close to retirement, a fixed annuity—or a variable annuity that offers a fixed component, as some do—should definitely be part of your portfolio."

A fixed annuity can also make sense if you've received a lump sum and fear having to pay for costly services in the future, Craig Carnick says. "A few situations come to mind: an elderly person who sells his or her house to pay for a stay in a nursing home, or an accident victim who uses the proceeds of a settlement to pay for special needs care."

If you decide to invest in an annuity, read the terms carefully, and beware those that include enticing "teaser" or "bonus" rates for a year or so. When the period ends, you could be stuck with below-market rates.

Moreover, consider the issuer's financial strength. If it runs into trouble or declares bankruptcy, you may be forced to take smaller payments, the value of your annuity may shrink, or you could be locked out of your money for several years.

In other words, "guaranteed" payments are guaranteed only as long as the company stays in business. Check it out with a financial rating service such as Weiss Ratings ( ), A.M. Best ( ), or Standard & Poor's ( It's smart to choose a company that gets high marks from at least two of these sources.

For fixed annuities, your best bet may be a no-load product from Charles Schwab (888-311-4887), TIAA-CREF (800-842-2776), or The Vanguard Group (800-522-5555).

If you already own a high-cost annuity, don't despair. When the surrender period ends, roll the assets into a less-expensive annuity. You can do this tax-free, via a "1035" exchange. Be mindful, though, that the clock will start again on the new annuity's surrender terms. If you own a variable annuity and want to determine whether a swap will save you money, start with the calculator at


Dennis Murray. Annuities: When they're right, when they're not. Medical Economics Sep. 5, 2003;80:38.

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