How to Decide if an Annuity Is Right for Your Client: Morningstar's Benz

Annuities have grown in popularity, largely due to their promise of a guaranteed income stream until a client's death. They can help investors strengthen retirement plans, defer taxes and some can protect against stock market losses, but there are caveats, says Christine Benz, Morningstar's director of personal finance.

The questions advisors must answer: Is an annuity right for a client? If so, what kind?

In her first of a series looking at how to evaluate annuities, Benz provides an overview of how to answer these questions.

Advisors and clients first must understand the wide variations in types of annuities. Some are simple fixed annuities while others, she says, are complex, and have "opacity of fees, high commissions and advisor incentives" that can make it difficult for clients to evaluate.

Lifetime Income, but…

Guaranteed lifetime income, similar to Social Security, is better than an investment portfolio that can run out of money, Benz notes. By pooling risk with other annuity buyers, those who die early help pay for the others.

Yet an annuity's "return" isn't that of an investment, but rather a client's own capital. Further, it's not like an investment that can be sold, whereas with an investment, upon sale you at least get part of your original money back.

"Nevertheless, the combination of lifetime income plus a higher payout means that basic income annuities can be a sensible additions to retirees' tool kits," Benz writes. This is especially true today considering low yields on safe investments, erosion of pension funds and longer life expectancies. She adds that for married couples, especially those with high incomes, there's at least a one in four chance that one spouse will make it to 95 years old.

There are other pluses to annuities, such as protection against stock market losses, typically with equity indexed annuities. Using options, these products protect the downside, but also cap the upside, Benz writes. "That means that returns on equity indexed annuities tend to fall between stocks and high-quality bonds. The products can also be incredibly complicated."

If growth is a key object, Benz says, variable annuities might be the ticket. These are designed by having subaccounts that are investing in safe investments and higher-risk ones, she notes. The problem is these annuities can cost as much as 2.5%, and there can be a cap on gains.

Taxing Issue

Like 401(k)s and IRAs, these products have tax benefits; that is, they are tax deferred if they stay in the "annuity wrapper."

If the annuity is purchased with pretax dollars, Benz notes, payouts are taxed as ordinary income.

However, if it is purchased with after-tax funds, the payouts aren't subject to taxes on funds already taxed.

Other rubs: if a client outlives their life expectancy, any payments after that age are taxed as ordinary income, Benz says. "That opportunity for tax deferral means that annuities have some tax benefits relative to saving in a plain-vanilla brokerage account, but they're not necessarily better," she writes.

Why? Because appreciation on assets in a taxable account is taxed at a capital gains rate, which is lower than the ordinary income tax rate.

Another factor to keep in mind, Benz points out, is when a client will need their money. Rules differ, but typically there is a carry charge if they need funds in the first several years of the annuity purchase. This varies with the type of annuity. There also could be a tax penalty on withdrawals, similar to IRAs.

For all these reasons, Benz recommends that if advisors recommend annuities to clients, the portfolio also should hold non-annuity investments "to further diversify and to meet liquidity needs as they arise." — Related on ThinkAdvisor: