Financial Abundance

With the stock market in turmoil and interest rates at all time lows, you might be tempted to purchase a deferred annuity. The deferred annuity sales person will tell you about the tax deferred benefits, the guaranteed return if you were to die and may even provide a product that gives you market related returns when the stock market is up, while guaranteeing that you will not have a loss in value during a down market. If this sounds too good to be true, it probably is.

Since the deferred annuity sales person will be paid a commission as high as 10% on your deferred annuity purchase, let’s take a closer look at what he/she is trying to sell you. Here are some areas that are not always well explained by the deferred annuity sales person.

1) Mortality and Expenses (M&E) Charges – All deferred annuities have M&E charges to pay for the life insurance guarantee, the sales person’s commissions and the administrative expenses of the contract. M&E charges are usually between 1% and 2% of the contract value, paid every year. If your deferred annuity has a value of $100,000, up to $2,000 annually will be used for M&E expenses. Even though you will likely never see these charges, they are being taken from your investment each year.

2) Surrender Charges – Virtually all deferred annuities that are sold through commissioned sales people will carry a surrender charge. Typically, these charges begin at 7% for the first year of the contract and decrease by 1% per year. Seven years after you purchase the contract, you may still have to pay 1% of its total value if you want to cash it in. Sometimes, you are allowed to withdraw up to10% of contract value yearly. However, the surrender charges assure that the insurance company will have your money long enough to pay for the high sales commissions required.

3) Management Fees – If you buy a variable annuity, the subaccounts are very similar to mutual funds. A typical subaccount will have a 1% or higher management fee. This expense is over and above the M&E fees that were previously discussed. While these fees are somewhat consistent with the fees charged for actively managed mutual funds, they are up to 5 times as high as the fees charged for indexed mutual funds and Exchange Traded Funds (ETFs). The subaccount returns will be net of the management fees, but they will not show the M&E fees that are assessed each year.

While it is true that a deferred annuity will be tax deferred until you cash it in or annuitize it, all gains of the deferred annuity will be taxed at your ordinary income rate when you receive your returns. Since the deferred annuity is typically held for 10+ years, this tax advantage may completely disappear when you cash it out.

If you believe that a deferred annuity is right for you, before you buy the product that your sales person is offering, contact Schwab, Fidelity, Vanguard or another discount brokerage house. They will likely have a similar deferred annuity product. Compare M&E expenses, surrender charges and management fees of the non-commissioned product with the one you are being sold. You will likely find that the non-commissioned product provides a better total return than the one that you are being sold.