Bao An Gongsi

Many investors have little understanding of annuities or variable annuities but I hope to change that today. I’m not offering investment advice or recommendations rather my goal is to educate you on the pros and cons of variable annuities so you can make a more informed decision.

Annuities are meant to be long term investments so if you need to access the money in a few years they are probably not for you. There are many companies that offer variable annuities and they all have different features. Some offer guaranteed future income and others guarantee the initial investment. You must read the prospectus to fully understand what each annuity provides or consult a financial advisor.

I like to think positively so let’s start with the pros of variable annuities. Remember each company may offer slightly different features but you can expect most of these will be included.

Pros

Death benefit can ensure your family receives a portion of the account balance Ability to guarantee income until you die, also called annuitizing Deferred taxes until withdraws are made No contribution limits like 401ks or IRAs Take a loan against the value of the annuity for a fee Investments may increase over time outpacing the rate of inflation
Cons

Commissions on variable annuities can be 4 percent to 8 percent Administrative and insurance fees average 2.2 percent of the assets each year Gains taxed as regular income not as capital gains which have a lower rate Surrender fees can be significant if you close the account within 7 years If you withdraw prior to age 59

Are annuities safe? Well, that is a question that deserves great attention.

First of all, it is important to know what type of annuity you are dealing with. Fixed annuities are safe from stock market fluctuations while variable annuities aren’t. Immediate annuities are pretty much encompassed by a set of terms that are predetermined but it doesn’t mean that they are safe. And while fixed annuities are safe from market fluctuations, they can be subject to lack of safety due to the nature of the insurance company providing it.

Safe is a relative term. It is a term that can be used in many different contexts. When I am asked if an annuity is safe, the answer is, ‘it depends’. First of all, is it safe from what? The market? From a downturn in the economy? From the standpoint of our economic system failing?

Furthermore, the type of annuity determines it’s degree of safety. Again, a variable annuity is subject to market risk although the death benefit (depending on the annuity) may be guaranteed never to be lower than your initial investment. Fixed annuities insulate themselves from the stock market but is it a safe investment if you own a 3% annuity and inflation drives rates up to 20%.

One needs to consider that there are so many factors to consider when buying an annuity. Just because your annuity agent tells you it’s safe, you have to take that with a grain of salt. You must determined that quality of the insurance company (RATINGS AREN’T ALWAYS THE BEST DETERMINANT NEITHER), the quality of the investment, the type of the investment and most importantly, your financial goals. If you can’t afford to lose money, a variable annuity is not safe. If you can’t afford not to make a reasonable ‘stock market type return’ than a fixed annuity may not be safe.

Know what you need going in. Consider ALL the factors and consider the market environment. And also, consider the fact that no one cares about your money more than you do….not your agent or the insurance companies. Sad but true. And if you go in with this notion, you’ll likely come out ahead.

Ignorance is not Bliss!

Your net worth is the amount of your current liabilities subtracted from the value of your current assets (you gross value). One aspect of calculating your net worth that leads to a lot of confusion relates to insurance policies and annuities. Do these represent assets? Do they represent liabilities? What value should be used?

Assuming you have a cash-value life insurance policy, such as indexed universal life insurance, then your insurance goes into both your gross value calculation as well as your liability calculation. If you do not have a cash-value insurance policy then it is just a liability and should be considered with your other regular expenses. Cash-value policies – which are often touted as useful investment tools for tax purposes – on the other hand, do have a transferable cash-value that should be considered an asset.

The actual cash value of a cash-value life insurance policy is basically a liquid asset that can be bought and sold, merged into other investment vehicles (for example, a viatical), and borrowed against. As such the actual cash value of the policy – not the face value, or coverage value – should be added into your gross value assessment. People frequently use these policies as an investment tool because interest and other amounts realized and credited to the cash value are not usually taxable as income and because loans taken against the cash value are treated as debts as opposed to taxable distributions by the Internal Revenue service (IRS).

At the same time, insurance policies always mandate regular payments and these should be considered liabilities for the purposes of calculating your net worth. Your regular insurance premiums, plus any additional amounts owed to the policy due to loans or penalties are all regular expenses that have to be considered liabilities. Failure to pay your premium usually results in your policy being terminated, so this is not really a discretionary expense and should be viewed as a regular liability, such as your mortgage or car payment.

Another tricky investment vehicle usually related to insurance and insurance companies is the annuity. Annuities are retirement planning contracts that involve two distinct phases: the accumulation period and the annuitization phase. In the first part, the owner of the annuity invests money in the plan and in the second phase the money invested in – plus any additional amounts earned through its investment by the annuity administrators are paid out. There is a wide range of annuities available that operate on different terms, but for the purposes of calculating your net worth the main thing to consider is the surrender value if you are in the accumulation phase or the cash value if you are in the annuitization phase.

The surrender value is the amount that you can sell your annuity contract for before you begin receiving payments from the contract. In general your annuity provider should give you regular updates about the surrender value of your annuity and this should be added into your gross value calculation. If in the accumulation phase and you contribute regularly to the annuity (not always the case), then this expense should be added into your expenses.

If you are in the annuitization phase, then you should not be paying into the annuity any longer and you should have a fairly solid cash value for the contract. However, it is important to note that annuities are tax-deferred, which means you should be paying taxes on your payouts and this may significantly change your overall tax liability.