By Steven Joshua Samuel JD, MBA, AIF® (April 2012)

Annuities are getting a great deal of attention in the media, especially with baby boomers who are retired or nearing retirement and seeking guaranteed investments. While annuities can be appropriate for some investors, some annuities involve complex limitations that can harm a retiree and should be examined with the assistance of a trusted financial professional before investing. Practical consumer information about these investments is scarce, as insurance industry materials are often and unfortunately too biased to offer a balanced view regarding whom and when annuities are a good choice. To make it more confusing, the materials that are available to the consumers consist mainly of warnings about high costs and misleading sales tactics.

Immediate annuities are the simpler of the two main types available. An investor makes a one-time payment to an insurance company in exchange for a monthly payment based on life expectancy, beginning immediately and guaranteed by the insurance company to continue until the investor’s death. Tax deferred annuities, the second kind of annuity, allow tax deferrals of the investment until money is withdrawn. Within the tax deferred annuity category, investors can choose either fixed annuities, which offer fixed interest rate investment accounts, or variable annuities, which offer a range of investment options. Variable annuities are long-term, tax deferred investment vehicles designed for retirement purposes.

Variable annuities allow a range of investment options and involve risk. The insurance industry has developed variable annuities that address risk with “living benefits,” which guarantee lifetime income and/or principal even if the investments lose money. Here are five facts you should know about annuities, focused mainly on “living benefit guarantees.”

1. Risk Tolerance

Some investors think annuity guarantees are a license to invest more aggressively and are entirely without risk. It’s important to understand that living benefit guarantees do not refer to or protect the value of the investment account. The guarantees refer only to calculations on a hypothetical account, called a “benefit base.”

The “benefit base” account is not real money. The guaranteed amounts refer to annual withdrawals calculated on the “benefit base” account. It takes a long time just to get your own money back, even at the 5 or 6 percent guaranteed annual withdrawal or growth rates now offered. For example, a 60 year old investing $100,000 today will likely be in her 80’s before she gets back the $100,000 she invested, at today’s guaranteed rates; and, guaranteed principal generally is a benefit only for her heirs after her lifetime.

The investment risk assumed by the investor remains very real. The only actual large lump sum of money an investor in a guaranteed annuity can freely withdraw is in the cash account, and that is subject to surrender charges. This may well be less than the original amount invested, depending on how the actual investments perform, notwithstanding the guarantees.

All guarantees are based on the claims paying ability of the issuer.

2. Complexity

The sales pitch for variable annuities with living guarantees is often oversimplified to: “You get to invest in the stock market with no risk because the insurance company guarantees your ability to withdraw a stable amount or have stable income growth every year no matter how your investments perform.” That’s true, but it’s not the whole truth, and it’s important to fully understand what this means.

Insurance companies accept some risk and offer some guarantees, but even with specific, written income guarantees as high as 5 or 6 percent per year, an investor still has to ask, “What can I realistically expect for income and are there any limitations or exceptions on the guarantees?”

All guarantees are based on the claims paying ability of the issuer.

Here’s why:

Annuities with living benefits can limit (hedge) the company’s risk by requiring 50 percent or more of the invested money to be in low or no-risk fixed income investments. Hedging can prevent stock market losses, but also limit gains when the stock is performing well. In addition, insurance company guarantees of income or principle protection are almost always subject to a bewildering array of conditions on the amount and timing of withdrawals, the performance of the actual investments and other considerations. Make sure you understand them with explanations from sources not selling the annuity.

3. Cost

With rare exception, the cost of the living benefit guarantees is charged against the above referenced hypothetical “benefit base.” This creates a predictable revenue stream for the insurance company, but it also creates a rising cost to the investor if the actual cash balance account declines. A charge of 1.25 percent per year on a $100,000 investment is $1,250 for the first year. If,10 years later the actual investment account value has dropped to $50,000, that same $1,250 fee represents 2.5 percent, double the rate. Guaranteed annuities also have the standard annuity fees for mortality, administrative and underlying fund management expenses; therefore, the total cost to an investor can be over 4 percent per year. Once withdrawals begin, the cost burdening these contracts can exceed 8 percent.

4. Liquidity

Once an investor begins withdrawals, there is a limit on the amount that can be taken each year without serious consequences. Taking a withdrawal in excess of the amount guaranteed may be permissible, but this “excess” withdrawal can sharply reduce future withdrawal amounts, even for those which appear to have been guaranteed. An investor opting for an annuity with living benefits must be sure to have other investments outside the annuity to supplement income and for emergencies. Also, investors should be mindful of surrender charges and consider the IRS 10 percent penalty for pre-age 59 1/2 distributions from any annuity in addition to any gain taxed as ordinary income.

5. Don’t Pay For Insurance You Will Never Use

Income guarantees are available to investors up to age 85. But are they worth buying? Even with a guaranteed withdrawal rate as high as 7 percent per year, an investor in her late 70’s or 80’s is very unlikely to spend down to zero during her lifetime. Remember, until you’ve withdrawn the entire amount you invested and recovered the fees for the guarantee, you have not received a nickel in investment gain from the insurance company. Make sure that if you are paying for any insurance that you’re transferring real risk. Buying a lifetime income guarantee if you are in your 70’s or 80’s and your name isn’t Yoda is like paying for insurance on a mountain top retreat to protect against a flood.

Investors who feel they must have guarantees and are willing to pay for them should get help from their trusted financial advisor in order to understand their choices and focus on:

* annuities from the most reputable company that offers a decent cost and benefit value proposition

* mitigating costs by utilizing low-cost investment options within the annuities and learning the difference between A, B and other annuity share costs

* avoiding paying for insurance that isn’t likely to be used

* fully understanding how guarantees work and how they are limited

* making certain you leave money outside the annuity in case you need additional income

Variable annuities are sold by prospectus. You should consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity, or from your financial professional. You should read the prospectus carefully before you invest.

Samuel Financial, Inc. is located at 858 Washington St. Dedham, MA 02026 and can be reached at (781)461-6886. Securities and advisory services offered through Commonwealth Financial Network, member FINRA/SIPC, a registered investment adviser. www.samuelfinancial.com