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RETIREMENT AT RISK

Q&A: Annuities

Retirement At Risk

April 24, 2006|Josh Friedman

What is an annuity?

Annuities are insurance contracts. Buyers typically contribute a lump sum and pay no taxes on the investment gains or interest until they tap the money years later. The term traces its origin to ancient Rome, where citizens paid a lump sum for a contract that promised an annua, or yearly payment, for life.

What are the different kinds of annuities?

There are two main types: fixed and variable.

Fixed annuities are savings plans that pay interest at a guaranteed rate, adjusted periodically. A retiree who needs income can draw monthly interest and leave the principal intact, or pick from other payout options.

Variable annuities are investments linked to an underlying stock or bond mutual fund. They offer the potential for higher returns than a fixed annuity. But they can also lose money, unless the contracts contain guarantees.

What is an equity-index annuity?

A fixed annuity that pays interest linked to a stock market index, such as the Standard & Poor's 500. Unlike variable annuities, equity-index annuities cannot lose value. They typically offer a minimum guaranteed return, with additional interest based on how the index performs.

How do I invest in an annuity?

With a lump sum or through periodic investments. Most issuers require a minimum initial investment of $1,000 or more, but that may be waived if the investor agrees to make regular contributions. Insurance agents, banks, investment brokers and financial planners sell annuities. They can also be purchased directly from many insurance companies.

Are there fees?

Yes. With variable annuities, they are deducted from the investment. Variable annuities charge 2.3% of assets per year on average, compared with 1.4% for mutual funds, according to Morningstar Inc. The difference reflects the cost of insurance features included in variable annuities, such as death benefits for the investor's heirs.

Fixed annuities carry no stated expenses, but because insurance companies pay commissions to the agents who sell them, they may impose "surrender" charges as high as 25% on withdrawals during the early years. Those charges deter savers from tapping the accounts quickly, allowing the insurance firms to invest the money and earn enough to pay commissions and ultimately pay off the investor while making a profit.

What are the advantages of an annuity?

In an era of longer life spans and dwindling pensions, annuities provide the security of monthly checks for life. Some contracts continue payments for the rest of a surviving spouse's life.

There is no limit on how much money can be placed in annuities, so they can make sense for investors who want to shield their nest eggs from taxes and have already contributed the maximum to tax-deferred vehicles such as 401(k)s and individual retirement accounts. Unlike IRAs, annuities are not subject to mandatory withdrawals at age 70 1/2 .

Annuities also offer a death benefit. If an annuity holder dies before the insurer has started making payments, the beneficiary is guaranteed a specified amount -- typically at least the money invested.

What are the drawbacks?

Most annuities restrict people from withdrawing more than 10% of their account value each year for a certain number of years. People who need their money for an emergency -- or simply want to change investments -- may have to pay surrender fees.

Although annuities often include principal guarantees, critics say these are not worth the expense because the stock market usually provides solid returns over long stretches.

Equity-index annuities can be oversimplified in the sales pitch. Because of contract restrictions, in an extreme example such an annuity might pay zero interest in a year in which the related stock index gained 10%. Unlike index mutual funds, they typically offer no dividend payments.

Where can I learn more about annuities?

Try the North American Securities Administrators Assn. at www.nasaa.org; the NASD (formerly the National Assn. of Securities Dealers) at www.nasd.com; the National Assn. of Insurance Commissioners at www.naic.org; and the Securities and Exchange Commission at www.sec.gov. Click on the investor or consumer tabs at these websites.

-- Josh Friedman

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