Financial Literacy - Retirement Income Planning
retirement
Pros and cons of annuities

Contrast that with other investments, such as stocks and bonds.

"When I die, those assets get a step up in basis; the annuity does not," says LaSpisa.

That means that if you inherit a mutual fund that your Uncle Fred bought for $100,000 five years ago and it has since appreciated to $200,000 on the day he died, his cost basis was $100,000. But your cost basis is now $200,000, and you're taxed based on your cost basis if you decide to sell it.

Fees and expenses

The more complicated the annuity, the more expensive it's going to be. A straight fixed payout annuity with no riders will be less expensive than a variable annuity with any guarantee.

Longevity insurance -- a single-premium annuity purchased at age 65 with payouts beginning at age 80 or 85 -- may make the most sense, though it's not an inheritable asset. It's cheap relative to other annuities.

"If you have a variable annuity, there are mutual fund fees on top, commissions, monthly fee, annual contract fees. There are a lot of costs at the end of the day that average consumers have no idea that they are paying," says LaSpisa.

Restrictions and loss of liquidity

Annuities come with what is known as a surrender period.

After buying an annuity, that money is locked in for a certain period of time, typically between six and eight years, according to the SEC. You can take the money out, but you pay a certain percentage in surrender charges for access to your money. That fee typically decreases by 1 percentage point each year until it disappears. You may also pay penalties if you withdraw before age 59½, plus taxes.

After annuitizing the account, your money is basically gone. You've given the account to the insurance company in exchange for a regular income.

"The problem is that most people don't realize when they annuitize, they give up the account," says LaSpisa.

"When you lock in these strategies, you don't have an escape hatch," he says.

The guarantors

The income that annuities guarantee is backed up only by the insurance company, and to a certain extent, the state. Every state has a guarantee association that each insurance company doing business in the state has to pay into, which guarantees a certain level of protection for policyholders. In general, the amount protected varies between $150,000 and $300,000, depending on the state.

But there is no FDIC to ride in and give you your money back if the company fails.

If the insurance company fails, "it falls to the assets of the corporation or the insurance company. If we were sitting here a year ago, no one would have said there is anything wrong with AIG," says LaSpisa.

"They would have said they're the biggest (insurance company) and have a AAA rating," he says.

When you purchase an annuity, you become a creditor of the insurance company, so it's likely that you will get money that is owed to you for a couple of reasons.

"That book of annuity business was probably built on actuarially sound principles. The insurance company that is out of business would probably be able to sell that to somebody else, so you as a contract holder would not even see any disruption -- the checks would just start coming from somewhere else," says Craig Hemke, president and founder of Buyapension.com.

The risk to your money from an insurance company going belly up may be slight, but more cautious annuity investors may want to employ a diversification strategy.

"If you want to buy $1 million of annuities, you want to spread them around enough companies so that the guarantee is there. Because who knows what can happen to a company over 20 or 30 years," says Swedroe.

Further you should only buy from highly rated companies.

"You want to make sure that the credit risk is very low. You shouldn't necessarily buy the one with the highest interest rate -- stick to the companies with the highest rating," says Swedroe.

Annuities are a tool, and they can be very useful in the right circumstances. Prospective annuity buyers should make sure they understand all the benefits and drawbacks before jumping in.

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