If there's one investment vehicle that causes more controversy than any other, it has to be the annuity. Opinions among financial professionals are usually divided along the lines of compensation model. Commission-based brokers and insurance salespeople tend to think more highly of annuities, and to recommend them more frequently, than Fee-Only financial planners. There's no mystery to this relationship: annuities typically pay out some of the largest commissions of all financial products.
The majority of our clients are still accumulating investment assets rather than drawing down on them. So, I haven't yet encountered a client situation in which I thought that annuities would help achieve their financial objectives better than other investment vehicles. The tax deferral and downside protection frequently used to justify the recommendation of an annuity in a taxable account can often be replicated at lower cost. And the negatives of annuities (poor tax treatment on withdrawal, higher expenses, and loss of liquidity) usually overwhelm the positives. Using annuities in tax-deferred accounts before retirement is just plain silly.
But having said all this, I also fully expect in the future to be confronted with client circumstances in which annuities will fill the bill nicely. After all, annuities are unique among investment vehicles in offering a stream of cash flow guaranteed to last a lifetime. With traditional pensions on the decline, the Social Security program looking wobbly, and life expectancies rising, this feature is becoming more scarce and valuable.
So it's when you're starting to think about the distribution phase of your financial life rather than the accumulation phase that annuities may have a role to play. And when I say annuities here, I mean immediate annuities, in which you pay a lump sum in return for a lifetime stream of income starting immediately (as opposed to deferred annuities). There are some academic studies that suggest that new retirees stand a better chance of successfully funding their retirements by allocating 25-50% of their nest egg to an immediate annuity.
As with any financial product, there are well-designed, cost-effective annuities available and there are really expensive, inflexible, and overly complicated annuities out there. Unfortunately, the general investing public gets a lot more exposure to the latter since again that's where commissions are the fattest. To make matters worse, many financial salespeople don't have a very good understanding themselves of the annuities they're pushing. The good news is that there are cost- and tax-efficient ways to extricate investors from inappropriate or sub-optimal annuities.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.