Default Risk Among the Many Concerns with Annuities

The recent turmoil in the equity and credit markets has created angst and panic among investors. Emotionally charged investment decisions are being made without consideration to the long-term consequences.

The insurance industry thrives in this type of environment. They offer neatly packaged products with bells and whistles that befuddle even the most experienced investors. The opportunities offered appear too good to be true and they are.

A popular product with investors is variable annuities because they offer guarantees. The truth is, they are expensive and are anything but risk free. Here’s what you need to know:

  1. The fact is insurance companies charge an average of 2.44% on assets per year in variable annuities.
  2. The pressure from salesmen is enormous considering they can make as much as 15% in commissions per sale (paid by the insurance company). And watch out if they have your phone number. They may never stop calling you.
  3. And by the way, don’t get sick in the early years of ownership. If variable annuity money is needed in an emergency, there are penalties during the first years of purchase called surrender fees. The maximum surrender fee averages 5.94% and lasts an average of 5 years from purchase.
  4. Annuities are tax deferred. Money withdrawn is taxed at your income rate. IRAs are tax deferred too and withdrawals are also taxed at your income rate. There is no tax benefit to owning an annuity in an IRA, yet tax deferred money continues to pour into annuities.
  5. In taxable accounts long term gains are taxed at 15%. Cashing out a hypothetical $1 million investment that grew to $2 million would cost you $150,000 in taxes. Cashing out a hypothetical $1 million annuity investment that grew to $2 million would cost you $600,000 at a 30% income tax rate.
  6. In addition, when you die, the cost basis in your taxable account is stepped up for your heirs. Not so in an annuity.
  7. Your money invested in an annuity is only as good as the insurance company you bought it from. An insurance company could default. This is not common and the salesman will emphasize this to you, but by law they cannot guarantee the insurer will not go out of business. Let’s say there’s a 1% probability of an insurance company default or bankruptcy. Compounded over 30 years, there’s a 26% cumulative probability of default (meaning at some point during that period).

Your best investment approach is to create a diversified portfolio of bonds, stocks, ETFs and mutual funds concentrated on value and compound interest and then to be patient.

E.J. Smith is Managing Director of Richard C. Young & Co., Ltd. an investment advisory firm managing portfolios for investors with over $1,000,000 in investable assets.