Question:
My father will be retiring soon, and he will get a lump sum payment from his company's 401-K Plan. An insurance agent recently recommends that he put this money into a variable annuity. One of the reasons this agent cited is that an annuity will guarantee you won't lose any principal amount. How can we analyze this situation, and do you think rolling this money into an annuity is the right move?

Answer:

Before I explain to you about annuity, bear in mind the agent will IMMEDIATELY earn about 6% in commission. Guess why the insurance company pays such a high commission???

Annuity is an investment product that is "wrapped" in a life insurance package. The main advantage is the fact that earnings in an annuity is tax-deferred (like an IRA account). But when the annuity is withdrawn, the income portion (which is the portion that is first taken out in any withdrawal) is all taxable. And it is taxed at a person's ordinary income tax rate. But the biggest problem of an annuity is its very high cost (which answers why such huge commission). The 1.4% you pay each year is over and above the annual cost of the mutual funds, which will average another 1.5-1.8%. So these annuity is among the highest cost investment products in the market. On top of this, the money is locked up for quite a number of years because there are huge surrender charges (I hope the agent explained this to you, usually it is a declining charge schedule such as 7% fee if withdrawn in the first year, 6% in the second year.... ). And the "guaranteed amount" this agent talked about simply refers to the beneficiary (your mom) getting at least the amount that was invested. If it is invested over time, it is highly unlikely that the account will have a loss. So the value of this benefit is very limited. Most people do not buy annuity because of this little benefit (which you pay quite a big fee for).

Annuity is usually for people who :(a) are fairly young, like in their 40's, so they can keep it for many years -- because of the high costs, experts estimate that it will take 15-20 years for an annuity to perform better than funds outside of an annuity but invested similarly in a regular account; (b) are in a high tax bracket so the tax deferral feature is beneficial; (c) have used up all tax-deferred tools such as IRA, 401K, etc. Insurance agents like to sell annuity to old folks because they are easier targets. But usually it is a good deal for the agent, not for the customer.

In your dad's case, the money is already in a tax-deferred vehicle (rollover IRA) so there is no need to pay extra for this tax benefits. Besides, in an annuity you are limited to the mutual funds offered by the insurance company. You will not be able to choose the many other excellent funds in the market, particularly the very low cost index funds that I highly recommend. And if he needs to withdraw money from it before the surrender charge period, he can only take out a tiny bit (like 10% or something like that) without paying the surrender charge and taxes. I can't think of any good reason why your dad wants to lock up his money and pay these extra costs in an annuity.

Unless you can find a good reason to put this money into an annuity, I would recommend leaving it in a rollover IRA and simply self-direct the investment (meaning you pick the investment you want). Another reason for doing this, other than the much lower costs, is the fact that you can allocate a portion of it into CD or Treasury bonds which are low risk. You can't do this in a variable annuity, and even if you can the much lower return of these riskless investment will not justify the high cost you will have to pay the insurance company for these investments.

Even if you want to put all or some of the money in an annuity, there are ways to buy low-cost annuity with no surrender charges -- Schwab, Vanguard and other brokerage companies offer these annuity with much lower costs and much wider choices of mutual funds.