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New Retirement Calculus Gives New Life to Tricky Annuities

Thursday, 1 Nov 2012 | 3:02 PM ET

For years, Americans found a lot to dislike about annuities. The product, which offers a guaranteed income stream for life, was either complicated, expensive or in some cases even dubious.

Jason York | E+ | Getty Images

Though some experts say not that much has changed about the insurance product, fundamental changes in the average American's financial outlook have given new life to annuities.

"In the last four to five years, it's really taken off," said financial planner Pete D'Arruda, president of the Capital Financial Advisory Group in Cary, NC. "People aren't saving as much as they should in their 401(k)s. Everyone I talk to these days wants to have some guaranteed income. It's the reason we offer an annuity." (Read more: Catching up on your retirement savings.)

D'Arruda recommends annuities to all of his 250 clients and that they account for 20-40 percent of their overall portfolio.

The growing interest in annuities, said experts, reflects two converging forces. One is an increasing risk-averse consumer who has suffered through two recessions and been burned by the stock market more than once the last decade. The other is growing concern that people will outlive their retirement savings and need a dependable second source of income to supplement their Social Security payments.

In fact, none other than the U.S. Government Accountability Office, whose mandate is to reduce wasteful government spending, recommended such an approach in a 2011 report.

The GAO report, "Ensuring Income throughout Retirement Requires Difficult Choices, advised middle-class retirees to delay taking Social Security benefits until the maximum age (70) and convert at least half of their retirement savings into an annuity.

"Clearly there is a stronger demand," said David Hefty, CFP, CEO of Hefty Wealth Partners in Auburn, Ind. "During times of economic uncertainty — where the stock market is down, household income is down, people's personal economy is down, and everything is worse off than a decade ago, you want to have some sort of floor on your savings and investments." (CNBC poll: Why don't you have an annuity?)

Industry-wide sales of fixed and variable annuities hit $231.1 billion in 2011, up from $214.6 billion in 2010, but down from the 2008 peak of $261.5 billion, according to the Insured Retirement Institute, IRI. Sales are down 6 percent year over year so far in 2012.

Assets of all fixed and variable annuities were $2.18 trillion at the end of 2011, the IRI said.

Some 30 percent of workers and 41 percent of retirees had made or were expected to make an active choice of some kind of annuity, according to a 2012 AARP Survey of Pension Plan and IRA Distribution Choices.

Fidelity Investments said annuities sales to its customers have doubled since 2006, but wouldn't disclose further details.

"For generations, retirees relied on pension plans," said Brett Wollam, an SVP with the company. "We believe annuities are part of a diversified portfolio" that addresses investors' risk tolerance. "The market declines of 2008-2009 had a lasting impact on investors' psyches," he added.

Companies seem to be responding to the sea change. More 401(k) plans are now offering annuity options.

At their heart, annuities aren't that complicated. Essentially, you loan an insurance company a lump sum of money, which it invests. In return, the firm agrees to pay you a sum — fixed, variable or otherwise — on an annual basis beginning at a specified date until your death, with the assumption it will earn more on the money than it pays out.

All annuities grow on a tax-deferred basis, regardless of whether they are in a retirement plan, and there is no ceiling on investment. All annuities have fees, which can include an upfront sales commission, insurance company management charges (known as mortality and expense fees), and manager fees for the mutual funds in the portfolio.

Variety and Complexity

To start, there are fixed and variable annuities.

Fixed annuities simply provide a fixed payment over time, based on market interest rates, with insurers paying you a premium. Variable annuities involve investments — mutual funds, for one — that you can control, which yield a payment that varies with investment performance.

The complication comes in the variations of the two main categories and the specific terms, which vary from product to product and company to company. Two good examples are death benefits and early withdrawals penalties.

The first subcategory is immediate and deferred. The former allows people to start taking payouts soon after signing the contract, while the latter accumulates money until a date in the future when withdrawals begin. What's more, some deferred contracts can be converted to immediate ones.

Another good example of the variation model is indexed annuities, whose returns are based on the performance of a specified equity index, such as the S&P 500.

Within that group is the subgroup known as an indexed annuity with an income rider, which guarantees a specified accumulation rate, usually 7 percent-8 percent, over the life of the contract, so that the account value increases at that rate every year. Your actual payout is smaller because of fees, and typically works out to 4.5 to 5.5 percent, depending on when you begin withdrawing funds.

"You want to lock in for the longest term possible, as long as you can flip the switch and get income at any time," said D'Arruda of Capital Financial, adding that 20 years is often a good duration for the contract.

D'Arruda said he likes annuities because of their "income promises" and uses them instead of bonds as "a safety investment."

Ebby May | Digital Vision | Getty Images

Yet for all the new attention and growing interest, annuities remain somewhat controversial and mystifying, even among financial advisers.

D'Arruda and Hefty of Cornerstone Wealth Management, for instance, have their individual preferences and are not about to make a sweeping endorsement of the financial product.

D'Arruda only uses an indexed annuity with an income rider. "It's the only reason we would offer an annuity today. We know with certainty what someone's money will grow to."

Hefty, meanwhile, said indexed annuities don't work. He prefers "the plain vanilla" fixed annuity, but allowed "some variable annuities can work."

Other advisers are lukewarm to cold on annuities.

"An annuity is not our first choice," said Phil Cook, CFP, founder of Cook & Associates. "It's primarily a cost factor. Say your gross return is 5 percent, but when you factor in the expense ratio of the underlying mutual funds, mortgage and expense charges by the insurance company, you're left with 3 percent."

Cook, whose firm is based in Manhattan Beach, Calif., said he could accomplish as much through a traditional investing approach.

Brian Fricke, president of Financial Management Concepts in Winter Springs, Fla., expressed mixed feelings about annuities.

Read the Fine Print

He said consumers need to look closely at the cost and such details as withdrawal penalties — should they need unexpected access to the money.

"Any time we look at an annuity a client brings to us we see little if any benefit," he said, adding that consumers continue to fall prey to sales and marketing efforts.

At the same time, Fricke said: "The only reason we are not recommending them in today's economy is the low-interest rate environment."

Another aspect of the annuities puzzle is that there any so many products and the terms are so complicated that even financial advisers have trouble understanding them, never mind recommending them.

"We have identified a few that make sense," said Capital Financial's D'Arruda.

"I can't look at an annuity and without an immense amount of homework say whether it is a good deal," added Ted Beck, executive director of the National Endowment for Financial Education. Beck added that shopping around for the right annuity takes a lot of work because it is hard to compare products.

At the same time, the industry's variations can serve more individual needs. For that reason, experts advise consumers to do their research to see if there is a product that meets their needs, and to drill down on the costs and terms within.

And make sure you go with a well-known company, said Beck. "It's important to remember that you are accepting credit risk on the provider," he explained. "Make sure the institution you buy from is very, very solid."

The annuities industry is aware of the issues, which — some 25 years after the product's introduction — remain a sales challenge.

"Annuities can be complex investments; they're not right for everyone," said Wollam of Fidelity. "We try to make them as simple as they can be and as value-oriented as can be."

Nevertheless, he added the "business has an opportunity for improvement."

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