Are annuities a good deal or not?

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(MoneyWatch) Should you consider buying an annuity? You'll hear lots of passionate opinions on both sides of this debate, each with valid points. Let's cut through some of the confusion to help you decide if an annuity might be a good investment for you.

First, understand that there are good annuities and bad annuities, just like any other product or service that you might buy. When I hear someone say they'd never buy another annuity because of the poor performance or high fees they experienced with the annuity they had purchased, I have the same reaction I'd have if I heard someone say they'd never buy a car because they had a bad experience with a lemon they'd previously owned.

Second, it's important that you distinguish between deferred variable annuities and immediate annuities. These products are as different as a Hummer is from a Prius. Would you decide to never purchase a Prius because you experienced bad gas mileage and expensive repairs with your Hummer? Of course not.

Deferred variable annuities are used to accumulate savings for retirement on a tax-advantaged basis, and they often come with high fees and poor performance. In my opinion, the best deferred variable annuities -- meaning low cost and good performance -- are offered by mutual fund companies such as Vanguard or Fidelity. You initiate the purchase of this type of products by contacting these institutions. If a broker or advisor is trying to sell you a deferred variable annuity, chances are good these products will come with high commissions and fees that drain your savings. This leads me to an important recommendation: Go shopping, and don't be sold!

In fact, you should never purchase a deferred annuity until you've maxed out on your 401(k) or IRA contributions -- these two investment vehicles usually offer lower costs and better tax advantages. Even then, as an alternative to a low-cost deferred annuity, you should probably consider other ordinary investments, such as index funds and municipal bonds that have special tax advantages, before purchasing a deferred annuity.

On the other hand, immediate annuities are used to generate reliable income during your retirement and aren't usually used to accumulate savings for retirement -- that's the big difference between an immediate annuity and a deferred variable annuity. Think of an immediate annuity as a do-it-yourself pension. The most straightforward immediate annuities are quite simple: You give your money to the insurance company, and they promise to pay you a monthly pension, no matter how long you live and no matter what happens in the economy. You can also opt to continue the monthly pension to your spouse or partner after your death. Retirees who bought an immediate annuity just before the Great Recession are a lot happier than their friends who remained invested and saw their nest egg crack open.

Many immediate annuities are fixed in their dollar amount, but some are indexed for inflation or increase at a fixed rate, say 3 percent per year. As with deferred variable annuities, you can buy low or high-cost immediate annuities. Both Vanguard and Fidelity offer annuity bidding services so you can shop your annuity among a number of well-rated insurance companies; the transaction charges are low and transparent. You can find other effective annuity shopping services at Income Solutions and ImmediateAnnuities.com.

Annuity salespeople don't like me
Create a do-it-yourself pension
What happens if your insurance company fails?

Individual investors and advisors often worry about insurance company bankruptcies -- they point to AIG as the latest example of why you shouldn't buy an annuity. But no AIG annuity policyholder suffered any losses, and there are good reasons for this. First, the life insurance subsidiary of AIG remained healthy throughout the crisis, and creditors of the AIG parent company could not touch the assets of their life insurance subsidiary. Even if the life insurance subsidiary of AIG became insolvent, most insurance policies are protected by state guaranty associations.

Because insurance companies are highly regulated and very conservatively managed, there have been very few insurance company bankruptcies, unlike bank bankruptcies, which happen much more frequently. In the few instances of insurance company insolvencies, benefits have been protected by the state guaranty association, or another insurance company has stepped in and taken over the policies. As a result, there have been very few instances where policyholders have lost money when an insurance company goes bankrupt. For an excellent article that describes the low risk of insurance company bankruptcy, read How Safe Are Annuities? by Joe Tomlinson.

Here's the bottom line: Annuities can be the Rodney Dangerfield of financial products. But they deserve your respect and consideration. And as with any important product or service that you'd buy, you need to do your homework to make sure you're getting the best deal.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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