Insurance Annuities Are Worth Checking Out
Insurance annuities have become the investment of choice for many Americans who want to save for retirement.
In the past few years, the annuity business has been growing at double-digit rates. Other types of life insurance products have also grown, but not as fast as annuities, industry experts say.
There are a number of explanations for this sudden burst of popularity. Some note that Americans have become increasingly skeptical of banks and thrifts following the $500-billion savings and loan bailout and reports about troubles at big banks. Insurers might seem like a safer option.
Others believe that aging baby boomers are now starting to plan for retirement, boosting annuities, 401(k) plans and other long-term savings plans.
But the answer may really lie in economics. Many insurance companies pay generous guaranteed rates--much more than you could generally get on a certificate of deposit. Although these rates are guaranteed only for limited periods, companies will usually provide histories to show how their rates have compared to market rates in the past. Moreover, some insurers allow their annuitants to bail out without penalties if their rates fall below set levels.
It should be noted too, that money can accrue in these accounts tax-free until it is withdrawn at retirement. And that makes the returns even richer.
Just how good are these returns? Consider two individuals who are both in the 33% tax bracket and who both earn 8% on a $100,000 investment. One investment is currently taxable, the other--the annuity--is tax-deferred.
Because of the power of tax-free compounding, the annuitant’s nest egg is worth about $800,000 in 27 years, while the other investor ends up with half that amount, or $400,000.
The annuitant must pay tax on interest earnings of $700,000 when the money is withdrawn. But assuming the same 33% tax rate, this individual would still end up with $169,000 more at the end of the period than the person whose investment was taxed annually.
It is important to note that an 8% rate is not too hard to come by in an insurance annuity, even in these days of 6% and 7% rates of interest.
Independent Advantage Financial, a Los Angeles brokerage that specializes in these contracts, published a six-company “honor roll” of highly-rated insurers that offer good rates and good terms. Honor roll insurers are currently offering rates as high as 8.6%, according to Independent.
What do you get with that extra percentage point or two? More risk, of course.
The risks come in several areas. First and foremost, when you buy an insurance annuity, you are essentially marrying your insurer for the term of the contract. You find you’re incompatible and want a divorce? It’s possible, but it will cost you.
In most cases, insurers charge hefty “surrender” fees for those who opt out in the first six to 10 years of the contract. Those fees vary company to company, but generally amount to between 7% and 9% of the account balance during the early years.
In addition, if you had deferred tax payments on interest accrued in the account, you will also need to pay a 10% excise tax to the Internal Revenue Service--just as you would on an early withdrawal from an individual retirement account or 401(k) plan.
In other words, you could lose some of your principal and virtually all of your interest if you bail out early.
There are a myriad of financial reasons why investors might need to bail out--such as unexpected expenses--but there are also other concerns.
Ask policyholders of Executive Life Insurance Co. of California. On Thursday, Executive Life, which has been struggling with severe investment losses for two years, was taken over by state regulators. Regulators are trying to rehabilitate the company, but in the meantime, they have placed a ban on surrenders and policy loans. Policyholders are concerned that they will lose substantial sums if the company cannot be saved.
This does not mean you should forget annuities altogether. You just need to shop carefully to make sure you buy from a very healthy company.
You can do that by checking the issuing company’s rating with several services: A. M. Best & Co., Moody’s Investors Service, Duff & Phelps, Standard & Poor’s and Weiss Research.
There are limitations on these ratings since they generally score the company’s financial status rather than its long-term prospects. The one exception is Palm Beach, Fla.-based Weiss Research, which rates companies on how they would survive a severe economic downturn.
Find out how long the company has been in business and how big it is. Although there are always exceptions to the rule, usually the bigger and older the firm, the better.
Examine the terms of the company’s contract. Does it allow you to bail out penalty-free if the interest goes below a certain level, or if you have some economic hardship? Although many insurers reduce the surrender fees in the later years, others will charge hefty amounts until the very end of the contract term.
