One of the difficulties in working with annuities is the persistent mythology connected with them. Much of the “conventional wisdom” regarding these contracts is not “wise” at all, but is often mistaken, confused, or downright wrong. Here are five of my favorite “myths”:
1) “Annuities are…” Any sentence that starts this way will be misleading at best. Why? Because all annuities are not the same. Indeed, a true statement about deferred annuities is likely to be partly or wholly untrue when applied to immediate annuities, and vice versa. Just as a true statement about fixed annuities will probably be false (at least to some extent) if applied to variable ones (and vice versa).
How to dispel this myth: Specify what kind of annuity you’re referring to.
2) “Variable annuities are too expensive”. My favorite response to this one is: “Compared to what?” The “fees and charges” that so irk many annuity critics are not investment costs, but insurance (risk transfer) costs. “Mortality and Expense charges” are assessed for the transfer of certain risks from the buyer to the insurer. So, too, are the charges for “riders”, such as a Guaranteed Lifetime Withdrawal Benefit.
How to dispel this myth: Make sure that you distinguish between investment features and costs and charges for risk transfer. If a variable annuity offers a guaranteed annuity payout and a mutual fund does not, it makes no sense to say that the VA is “more expensive” without addressing the fact that the additional “expense” buys an additional benefit”.
3) “Annuitization is a Sucker Bet”. I hear this one a lot. It usually comes along with “you’re locking in today’s interest rates”. Yes, you are. But is rate of return why someone annuitizes? No. You annuitize because you want an absolute guarantee of a minimum income for a known period (which may be “as long as you live”). It’s that assurance of a certain income that’s the essence of an annuity payout, not some calculated rate of return which that income is supposed to represent.
How to dispel this myth: Keep always in mind that a “payout annuity” (either an immediate annuity or an annuitized deferred one) is all about certain income, not about imputed return. (It’s worth noting that the Internal Rate of Return on a life annuity cannot be calculated unless you know when the annuitant will die).
4) “Never put an annuity in your IRA!” This conclusion is usually supported by either or both of two reasons. “You’re paying for tax deferral you’re not getting” or “You’re wasting the tax deferral of the annuity”. The first one is simply false. No annuity imposes a charge for tax deferral. There are charges in some deferred annuities (all variable annuities and fixed index annuities) that include a “living benefit rider”. Fixed deferred annuities that do not include such a rider generally do not. Neither do fixed immediate annuities. But none of those charges is for tax deferral, which is granted, not by the insurance company, but by the Internal Revenue Code. The second reason is just as false. The tax deferral that is enjoyed by “non-qualified” deferred annuities (that is, deferred annuities purchased outside of IRAs or employer-sponsored pension or profit sharing plans) applies only to such contracts. It does not apply to annuities held in IRAs or “qualified” retirement plans. An IRA annuity gets tax deferral because it’s in an IRA. So, there’s no “wasted” benefit. Another way to understand the foolishness of that second argument is to use what mathematicians call “substitution”. If the argument is that the tax treatment that would apply to a deferred annuity if it were held outside an IRA is “wasted” when it’s inside an IRA, let’s see if that argument holds water if we substitute another investment vehicle for the annuity. Let’s use “small company stock”. If you buy a stock in small company (that often pays no dividends) and you hold that stock for more than one year and then sell it for a profit, how will that profit be taxed? Answer: That profit will be taxed as “Long Term Capital Gains”, at a lower rate than the tax on “ordinary income”. But if you buy that same small company stock inside your traditional (non-Roth) IRA, how will all profit be taxed (no matter how long you hold the stock)? As “ordinary income”. You’ll pay tax on that profit at a higher rate than would have applied if you’d bought the stock in a taxable account. So, by the reasoning that says that the preferential tax treatment (tax deferral) of an annuity is “wasted” when it’s held in an IRA, one would have to conclude that one should never buy small company stock in one’s IRA. But that’s absurd, isn’t it? And the reason it’s absurd is this: The tax treatment that applies to any type of investment if it’s held outside an IRA is totally irrelevant when it’s held inside an IRA. An annuity may or may not be suitable to own in your IRA; the potential profit, guarantee of principal and minimum interest (if it’s a fixed annuity) may be more or less attractive than the rewards and risks of some other investment. But the tax treatment will have nothing to do with that conclusion, because all IRA investments are taxed the same.
How to dispel this myth: Don’t confuse tax treatment of IRAs with the treatment that the investment would get if it weren’t in an IRA. Some investments are suitable for your IRA; some are not, but tax treatment has nothing to do with it.
5) “Index Annuities cheat the buyer because you don’t get the dividends on the stocks in the index you’ve chosen.” This one’s just as bad as the others. Yes, if you buy an index annuity, you’ll get interest based on the growth in the value of the equity index (or indices) you select. (Often, that’s the S&P 500). Yes, you won’t get the dividends on those 500 stocks. But that’s OK. You didn’t pay for them, and neither did the insurance company! The insurer typically buys “call options” on the index, and if the value of that index increases, it will exercise the options or sell them, collect the profit, and pay you interest on some of that growth (limited by “participation rates” and/or “cap rates”). The insurer will not receive any dividends because it didn’t buy the stocks; it bought options. And the holder of any option doesn’t get the dividends on the underlying stock. You don’t get what you didn’t pay for.
How to dispel this myth: Recognize that the buyer of an index annuity pays only for interest linked to the growth of the index (or indices) chosen. An index annuity is a fixed annuity, with a guarantee of principal (except to the extent that surrender charges may invade that principal if you cash out early). It’s not an investment in the index itself.
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