Should you join the people who hate annuities?

I constantly bump into people who say they hate annuities. I bet you have, too. You may have even noticed ads and stories by people who slam annuities.

So, should you consider annuities for your retirement investments or not?

From my perspective, the answer is "It depends on your situation and the type of annuity you plan to purchase." Like almost any other product or service you might buy, you'll find both good and not-so-good annuities. The fact is, annuities aren't for everybody.

Annuities are financial instruments that have many variations and go by many names, and each variation has its corresponding pros and cons, limitations and advantages. To determine if an annuity is a good fit for your retirement needs, you have to look beyond the general term "annuity" and learn about the specific features of various types of annuities.

But before we dive deeper into the taxonomy of annuities, let's consider an analogy. Suppose you heard someone say "I hate trucks." Suppose further that when you asked the person for his reasons, he said trucks are big and noisy, cause pollution, get poor gas mileage and can mangle regular cars in accidents.

While you might agree with those observations, nevertheless, you might remember that trucks come in many varieties, from small pickups to giant freight trucks that haul goods across the country. A truck may not be right for you, but in many situations the right kind of truck has its place.

It's the same with annuities. Certain types can be great tools for some people, while other types might be lousy deals. And some people might never need an annuity. You need to determine if there's a type of annuity that can help improve your security in retirement.

Many annuities are sold as investment vehicles for retirement savings, and their focus is on accumulating wealth. These annuities are often purchased many years before retirement, without focusing on exactly how you'll use your assets in retirement. One common type is called a "deferred variable annuity," and you'll find a variety of stock and bond investments that underlie this annuity contract.

Deferred variable annuities are typically sold with one or two angles:

  • Your principal is guaranteed not to drop, but you can participate in upside potential if markets do well. In other words, you can have your cake and eat it, too.
  • You can take advantage of a special tax advantage: You don't pay income taxes on investment earnings until you withdraw any money from the annuity for retirement. Unlike deductible IRAs or 401(k) accounts, however, contributions to deferred variable annuities are usually not tax-deductible in the year you contribute.

Many deferred variable annuities have high commissions, high expenses and poor performance. The contract features that provide floors on your investment losses also impose caps on your returns when markets do well, and the terms of these features can be quite complex.

They can have high surrender charges if you want to withdraw your money soon after you invest in the annuity. Often you must meet certain requirements to receive the investment returns that you thought you'd receive from the marketing materials.

And they're often pitched by insurance salespeople who make high commissions on the sale of the annuity. It turns out that these are the types of annuities that many people say they hate.

To protect yourself against purchasing this type of annuity, do the same thing you'd do if you were buying a car or a camera: Research your options to understand the different types of annuities, how they operate and when they're appropriate. Ask salespeople about the charges for insurance and investment expenses, and how much they'll be paid if you buy an annuity from them. If you don't get a satisfactory answer that you understand, go elsewhere.

This leads me to important advice: Go shopping, don't be sold. Think about the investing goals that are important to you, learn the types of investments that can meet your goals and then go shopping for these investments, looking for the best-performing vehicles. Don't be swayed by a salesperson with a persuasive pitch for a specific product.

Another part of the "go shopping" advice means learning about the alternatives to deferred variable annuities when saving for your retirement. It turns out that some investing strategies use conventional stocks, bonds and mutual funds, and balance protection against losses while giving you upside potential. In addition, other retirement saving vehicles with tax advantages are better than deferred variable annuities.

After considering the alternatives, if you still really like the idea of using deferred variable annuities, consider low-cost annuities from Fidelity Investments or Vanguard that don't have the expensive and complex features that so many people hate.

It's a completely different situation when you're approaching retirement and looking to generate reliable lifetime income. In this case, some annuities might meet your needs and are completely different animals from deferred variable annuities. They can go by the names "immediate fixed annuity," "single premium immediate annuity," "longevity insurance," "guaranteed lifetime withdrawal benefit," or "immediate variable annuity."

These can be excellent tools for generating a guaranteed source of lifetime retirement income, although once again you'll have to sort through competitively priced and expensive versions of each one. Your job is to determine if any one is appropriate for you and to find the best way of buying such an annuity. Don't be deterred from considering these annuities by the bad rap on deferred variable annuities and by the people who say they hate annuities.

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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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