Annuities vs. Other Investment Opportunities

Annuities can play a prominent role in your overall wealth management strategy. As a means for guaranteeing income in the future, they can be an integral part of your retirement strategy.

Annuities are a relatively safe investment, and therefore are often compared to other low risk instruments such as CD’s and bonds. Annuities have features investors find attractive, such as tax efficiency and liquidity that CD’s and bonds do not offer. Annuities may carry a higher expense structure than CD’s and bonds, but may offer slightly higher returns overall.

You should consider the lost opportunity costs involved with tying your money up in an annuity. Many people want to know what their returns would be if their money was invested in stocks rather than annuities. Annuities offer stability that stocks cannot offer, but the trade-off is in the returns. Generally speaking, stocks will outperform annuities over the long run. In addition, the tax structure is different. Annuity growth is taxed at ordinary income rates, while stock growth is taxed at the lower capital gains rate.

Annuities are not for investors with short-time horizons. They are not usually the best option if you need your money returned within five years, or you will not attain age 59 ½ in that time period.

Before investing, it is important to weigh the various advantages and disadvantages associated in annuities, and to determine the specific role you wish for it to play in your overall portfolio. Annuities come in many shapes and sizes, and therefore you may be able to find a choice that meets all of your needs. One word of caution, however: the promise to provide lifetime income is only as reliable as the insurer who issues the annuity. Make sure you research the financial strength of the insurance company that you choose as issuer.

Annuities Compared with CD’s

Annuities often get compared to CD’s (bank certificates of deposit) because they have the following similar features:

• Safety
• Security
• Investments with guaranteed rates of returns based on interest rates
• Issued by large financial institutions (CD’s by banks and annuities are offered by insurance companies).
  

There are, however, significant differences in the two instruments in a few key areas. Let's look at annuities compared with CD’s. The following describes areas where they diverge.

Safety and Security: Banks issue CD’s and insurance companies issue annuities. CD’s have Federal Deposit Insurance Corp. (FDIC) protection to guard against the bank or banking industry failure. Unlike banks, insurance companies are regulated by the states. All 50 states have industry-funded protection for policyholders if there insurance company fails. Typically, annuities are covered up to $100,000 by the states. States require insurance companies to have reserves pools in place to pay their obligations. Insurance companies are also vetted for financial strength by objective rating firms -- Standard & Poor's, Moody's, A.M. Best and Duff & Phelps. If you are considering an annuity, it is advisable to research the issuer’s rating with these agencies. The higher the rating, the more financially secure the insurer.

• Returns: The returns on both annuities and CD’s are linked to interest rates. Annuities typically have guaranteed minimum interest rates. This provides a level of protection that your investment will never dip below the stated rate during times of falling interest. CD’s do not offer that level of protection.
• Tax-Deferral: Annuities offer tax deferral, CD’s do not. With a CD you pay annual taxes on the amount of interest earned. While you are paying taxes, you might not yet have access to your money. You cannot withdraw your funds until the term of the CD expires. Put another way, you cannot get your money back until the CD matures. With annuities, there is also a set term, but you are not taxed on the earnings. Your tax obligation commences once money is withdrawn or distributed from your annuity. This allows you to enjoy the power of compounded investment growth because your original investment and the interest it has generated accumulate tax-free until withdrawn.
• Liquidity: Money cannot be withdrawn from a CD until the term expires. CD’s are inflexible in this regard. Annuities, however allow for easier access to your funds. Annuities typically include contract language allowing you to access a minimal percentage (usually 10%) of your account value each year without incurring surrender charges. Some annuity contracts allow the earned interest to be removed on a monthly basis. Some contracts have provisions, which allow funds to be accessed in times of hardship. Hardships are usually defined as things such as hospitalization, life- threatening illnesses, permanent or extended nursing home stays, or other major calamities that have significant economic impact.
• Investment Time Horizon: CD’s are generally more appropriate for people who will need access to their money within a year or two. Because of the set up and administrative fees as well as surrender clauses inherent in most annuity contracts, annuities are not suitable for short-term investors. If you have a longer-term investment perspective, like more than five years, an annuity will outperform a CD, even if you withdraw all the money from the annuity at the end of the term.
  

Annuities Compared With Stocks

Annuities and stocks have more differences than they do similarities. They also serve different purposes in a portfolio. The following discusses some of the key differences between the two:

• The Nature of the Instrument: Stocks are shares of ownership in a company. You typically buy a stock that you believe will appreciate in value, generate capital gains and provide minor income disbursements in the form of dividends. An annuity is an income investment. They provide reliable streams of income in the future. With the potential exception of variable annuities, they do not enjoy capital growth.
• Safety and Security: Fixed annuities provide guaranteed performance and consistent monthly income. All 50 states have industry-funded protection for policyholders if their insurance company fails. Typically, annuities are covered up to $100,000 by the states. States require insurance companies to have reserves pools in place to pay their obligations. Insurance companies are also vetted for financial strength by objective rating firms -- Standard & Poor's, Moody's, A.M. Best and Duff & Phelps. There are no guarantees with respect to the value of the stock, or whether dividends will be paid. Stock prices fluctuate daily, and therefore are far riskier than annuities.
• Tax Treatment: A glaring difference between stocks and annuities is their tax treatment. The growth in an annuity is tax-deferred. You do not pay taxes until you receive income from the annuity. At that time, you are taxed at an ordinary income level, not at a capital gains rate. So, if you were to purchase a $50,000 annuity that pays out a total of $62,000 in monthly payments, you would owe ordinary income taxes on the $12,000 “profit.” In 2010, personal income tax rates go as high as 35%. If you were in the highest tax bracket, the tax obligation in this scenario would be $4,200. Conversely, a $50,000 purchase of stock that rises to $62,000 in value would create the same taxable income • $12,000 • but would generate a considerably smaller tax burden. The long-term capital gains tax is just 15%, making the tax obligation in the stock purchase scenario only $1,800.
• Returns: Another key difference between stocks and annuities is the performance you can expect to receive from your investment. The trade-off that you make by gaining safety with an annuity is a lost opportunity cost. The money you put into an annuity is side lined; it is not being invested in the stock market where it could potentially earn you more. Despite recent market performance, the U.S. stock markets have historically gained 10.5% per year. Annuities, on the other hand, perform slightly over the current triple-AAA rated bond yields, which is nearly 50% less than stock performance.
• Income Stream: Some investors purchase dividend-paying stocks to establish an income stream at retirement. Dividend yields and schedules, however, are not guaranteed. Stocks typically pay dividends quarterly. The dividend yield is not guaranteed and will change when the price fluctuates. Annuities, however, offer a predictable monthly stream of income. With fixed annuities, the amount is set. Variable annuity payment amounts may fluctuate based on the performance of the funds, but you will reliably receive income. The bottom line is that you can count on annuity income, but not stock dividends.
  

Annuities Compared with Bonds

Annuities often get compared with bonds because they are similar when it comes to their safety and their returns. Annuities and bonds are both long-term strategies typically implemented as retirement nears.

• The Nature of the Instruments: The issuers of bonds and annuities differ. Annuities can be described as a bet you make with an insurance company. You are assuming you will live long enough to collect more in monthly payouts than you paid for the policy. The insurance company assumes you (or enough people in their annuity pool), won’t. Conversely, bonds are an investment in the debt of a business. When you buy a bond, you are buying a promise from a company (or government) to pay you back a certain amount of money plus interest.
• Safety and Security: Both annuities and bonds offer a level of protection for your money. Insurance companies, the issuers of annuities are regulated by the states. All 50 states have industry-funded protection for policyholders if their insurance company fails. Typically, annuities are covered up to $100,000 by the states. States require insurance companies to have reserves in place to pay their obligations. Insurance companies are also vetted for financial strength by objective rating firms -- Standard & Poor's, Moody's, A.M. Best and Duff & Phelps. Likewise, there are bond issuers who have long-standing and well-earned reputations for making payment on their bonds. Those issuers include the United States government, governmental agencies, and financially strong corporations.
  

Quality, investment grade bonds are typically considered safe investments because the risk of loss is minimal.

• Income Stream: Both bonds and annuities offer reliable income. Bonds provide consistent income because they make periodic coupon payments. Bond issuers have a contractual obligation to pay bondholders. Failure to make bond payments jeopardizes future efforts to raise capital via bond issuance. Unpaid bondholders can, in many cases, force the issuer into bankruptcy. The bond issuer’s future viability rests on its ability to make bond payments, and therefore the obligation is a high priority. Annuities typically pay income on a monthly basis. In the instance of fixed annuities, payment amounts are the same each month. Variable annuity payments fluctuate, but they will continue to be paid per the contractual schedule.
• What Happens at Death: With bonds, you (or your estate) will get your money back even if you die. Uninsured annuities stop payment upon death. So, if you bought an annuity this week, and died next, your money would be gone.
• Expenses: You are likely to pay more in annual expenses on an annuity than you would a corporate bond mutual fund.
• Returns: Annuities historically perform slightly over the current triple-AAA rated bond yields.
  

  Annuities Compared with Life Insurance

  Life insurance and annuities make up two sides of a coin for many insurance companies. Here is why. Consider term life insurance quotes. When issuing life insurance, the insurance company profits more if you live longer because they collect more in premiums. While the premium is collected, it is invested by the insurance company and enjoys compound growth. The insurance company is betting that the total premiums paid by you, and the investment growth they enjoy on those premiums , will exceed the amount paid out in death benefit.

  To counteract the risk of you living a long, long time, they make the opposite bet with an annuity. With annuity offerings, the insurance company is betting that you will die soon. Insurance companies’ profits increase when lifetime annuity policyholders die young because annuity payments generally cease at death. The shorter your life, the less monthly income payments they have to pay. Ultimately, the insurance company is betting on the fact that the individuals in its annuity pool of business will receive payouts in a much smaller denomination than the collective face values of their policies. There are other ways the insurance companies make money on annuities too. They benefit largely from the fees charged and the ability to invest money for a higher rate of return than what they pay out.

  There are three commonalities among life insurance and annuities:

  1. Protection against loss of income: Life insurance gives protection against loss of income resulting from premature death. Annuities provide income protection arising out living too long.
  2. Pooling technique. Both life insurance and annuities require the art of pooling. By combining multiple policies, the life insurance company can spread its risk and ensure that they are not too heavily concentrated in any one area. For example, a life insurance company would not want to have a pool of life insurance policyholders who all lived and worked in a concentrated area. If a natural disaster struck that particular region, it would be catastrophic to the insurer. With life insurance, all policyholders in the pool contribute premium so that when someone from the pool dies, benefits can be paid. Annuity pooling is where those who die prematurely contribute to the pool to give the insurer the funds necessary to make distributions to annuitants who live beyond their life expectancy.
  3. Calculated Risks. The contributions for both life insurance and annuities are based on the probabilities you will live, or you will die. They involve a calculation based on the age you were when you bought the product, which is known, and your attained age at death.

  Of course, no one knows when you will die. The insurance companies have sophisticated actuarial tables, called mortality tables, that attempt to predict how long you will live based on your demographic information.

  The main differences between annuities and life insurance are the type of benefits paid, and when they are paid. Life insurance is typically paid in a lump sum, when you die, and it is paid to your beneficiaries. The benefit is not for you per se, it is for your beneficiaries. The amount your beneficiaries are paid can be many multiple times higher than the premiums you invested, depending upon the timing of your death.

  With annuities, the payment made to you is in the form of future income. It is intended to benefit you while you are alive.

  Life insurance is something people generally think of when they are younger. For example, if you are young and have a family that is dependent upon your ability to earn an income, life insurance is a necessity. The good news is that the younger (and healthier) you are, the cheaper it is to buy life insurance.

  Annuities are a financial strategy usually considered as you approach retirement.