Annuities Are Confusing

I’m a firm believer in the KISS principle – Keep It Simple, Stupid. This is even more true when it comes to financial accounts. No one should ever invest in anything they don’t fully understand. If an investment is too complex for you to understand, it’s likely there are some fees you don’t know you are paying that will cost you a lot of money in the long term (and possibly even the short term too).

Annuities are complex financial instruments. In simple terms, an annuity is an investment that will provide payments over a period of time in exchange for premiums paid either in one lump sum or also over time. For instance, you might make a one-time $10,000 payment to purchase an annuity that will provide you with $1,000 a month income when you turn 65. Or instead of a $10,000 lump sum, you might pay $100 a month for 10 years to get the same payment at age 65.

There are many kinds of annuities – deferred, immediate, fixed, variable. If you think annuities sound similar to insurance, you’re right. They are. Whereas life insurance, such as term life insurance, will pay a fixed amount of money in a lump sum when someone dies, annuities pay a recurring amount of money when someone reaches a certain age, when someone dies, after some number of years, or after some other event, usually far in the future, happens.

Some annuities offer you a choice of investments within the annuity. Just like a 401(k) or IRA offers you differing investments within them (usually mutual funds), so too do some annuities allow you to select from a range of investments (again, often mutual funds).

Annuities can also be used as part of a tax planning strategy because the investment gains within an annuity are not taxed until the annuity makes payments.

Have your eyes glazed over yet? Yeah, mine too. This is the opposite of simple.

So why am I writing about them? Because I had one. Or rather, my daughter had one.

Thanks, I Think.

Eight years ago, my parents wanted to do something for my daughter that would help her financially in the future. (Aren’t grandparents awesome?) Some people buy stocks for their grandkids, some people buy bonds. At the instruction of their financial adviser, my parents purchased an annuity for my daughter. The annuity was funded with a $12,000 lump sum payment and was designed to give my daughter monthly payments once I died. The annuity would continue for 99 years from the date it was opened. So if I lived for 60 years after the annuity started, she would have 39 years of recurring payments. The payments were not fixed and the amount she receives would be based on the performance of the investments within the annuity.

Doesn’t that sound a little strange to you?  I mean, what’s the point? If the payments aren’t a guaranteed amount and instead depend on the performance of the securities within the annuity, how is this any different than just investing the money in the stock market outside an annuity?

Well, there are two differences. First, any gains would be tax deferred until the annuity starts paying out. Second, no payments would be made until after I die. Compare this to investing in a regular brokerage account I might set up for my daughter: 1) Gains, in the form of dividends and or proceeds from stock sales, would be taxed in the year they occur and 2) Once my daughter turns 18, that money is hers to do with a she pleases. I will have no control over it.

I’m not concerned about issue 2. I’m raising my daughter to be financially literate and responsible, so I’m pretty confident she won’t go wild and buy a Mercedes when she turns 18. (And really, in the case of the annuity, once I’m dead I’m not going to have control over how she spends the money anyway.) As for issue 1, I’m not sure that’s as big of a deal as it seems, especially for this small amount of money. She’s going to be in a low tax bracket probably at least until she graduates from college. After that, if I’ve taught her well, she’ll leave the investment in a low cost, tax efficient mutual fund that pays qualified dividends – meaning the dividends are taxed at a lower interest rate than regular income – and there won’t be much capital gains to pay taxes on due to low stock turnover within the fund. (See my post about this here.)

But you know what the annuity does give her? Fees. Lots and lots of fees.

Come back next week to see why I decided to get out of this investment.