Annuities Are Not Silver Bullets

03/11/2013 9:00 am EST

Focus: INCOME

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Dan Wiener of the Independent Adviser explains why investors need to read the fine print on annuities.

Annuities often sound like a retirement investment silver bullet: Tax deferred growth potential and guaranteed income for life.

I’m not a fan.

Here’s how annuities are supposed to work. After maxing out other retirement or tax deferred investment options, you purchase a variable annuity—and the amount you can purchase is almost without limit. Your money grows in the investments you’ve selected without the drag of taxes. Then, in retirement, your annuity provides a steady, and in some cases guaranteed, stream of income regardless of what the market does. And as a cherry on top, annuities have a “death benefit” to protect your loved ones when you pass.

That all sounds great on paper, but reality has a way of tarnishing this image.

Generally speaking, annuity expenses are outlandish, with salesmen regularly earning 5% or more in fees. True to form, Vanguard’s annuities are among the cheapest around. But compared to a Vanguard mutual fund, they are still astronomically priced.

Additionally, you could be hit with a penalty for early withdrawals. No such penalty exists with a regular mutual fund (other than the tax you may pay if you have a gain when you sell).

And possibly my biggest concern about Vanguard’s annuities is that there are only a couple of great investment options available.

Even the issue of growing your money in a tax-deferred manner isn’t cut-and-dried. I love tax-deferred investing. Every dollar you invest and every dollar earned in additional gains just keeps on compounding until you take your money out.

So what’s the catch? First, it can take a long time for the benefits of tax deferral to compensate annuity buyers for higher expenses. Another wrinkle is that every dollar you take out of your annuity is taxed as income, whether earned through dividends or capital gains. (If you fund your annuity with after-tax dollars, only the profits you withdraw are taxed as income.)

Considering the higher expenses and the tax consequences (particularly given the new, higher income tax rates we’re all paying) you need to hold an annuity for decades to make it worthwhile.

Now, what about this death benefit? Vanguard complicates matters by offering investors the choice of two death benefits. With the Accumulated Value death benefit, if the markets went up while you were putting money in, your beneficiaries get the contributions you made, plus the gains you earned. If the markets declined, however, they may end up getting less than your contributions. It’s no different than what would happen in a regular investment account. You put money in and whatever happens, happens.

The Return of Premium option is more expensive, at 0.395%, but offers protection on the contributions. Beneficiaries are entitled to either the annuity’s accumulated value or the sum of the contributions less any withdrawals and premium taxes, whichever is greater. That sounds great, but if you invest in an annuity for a long time, hopefully your account value will far outpace your contributions. In that case, you are essentially paying up for nothing—the accumulated value should be higher than the value of your contributions alone.

One final gripe with the death benefit: There’s no step-up in cost basis, so your heirs will owe taxes on the full amount.

The final piece of the story is the guaranteed income. Vanguard offers an optional Guaranteed Lifetime Withdrawal Benefit (GLWB ) rider on three annuities: Balanced Annuity, Moderate Allocation Annuity, and Conservative Allocation Annuity. It’s meant to provide a specific income, set at the time of the purchase of the rider and dependent on when you begin taking withdrawals, regardless of what the market does, for the lifetime of the annuity.

This is not a free service, however. The cost of the GLWB rider is 0.95%, and it appears that papers have been filed to increase it to 1.20% for purchases made on or after May 1, 2013. Vanguard has the flexibility to increase it to as much as 2.0% in the future. There are also plans to reduce the maximum annual withdrawal percentage down by 0.5% for purchases made after May 1.

At this point, I’ve hopefully convinced you that annuities are not all they are cracked up to be. Annuities are far from the perfect investment. That said, there’s little question that Vanguard’s annuity program is one of the best in the industry.

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