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By Jason Stipp | 05-24-2011 11:08 AM

Five Questions to Ask Before Purchasing an Annuity

Christine Benz says investors should consider the annuity type, other tax-sheltered vehicles, liquidity needs, and fees.

Jason Stipp: I am Jason Stipp for Morningstar. Its no wonder that investors are often puzzled over annuities. There are so many different types and varieties. So, if you are considering an annuity or if an advisor as recommended one, where should you start? Morningstar's Christine Benz has five questions that you should ask before purchasing an annuity. Thanks for joining me today, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, there would be many decisions involved in choosing an annuity. These five questions are meant to give you a start on that decision making process, a place to begin. The first one relates to what I mentioned in the intro that there are lots of different kinds of these things. The first one is just getting an handle on what type you are being recommended.

Benz: That's right, I often talk to people Jason, I am sure you do too, who when they are talking about their annuity, they are not really sure what they have. They are not even a 100% sure its an annuity until you poke around and ask a few more questions and determine that it is. So, this is obviously a key stumbling block, yet people still buy annuities without really understanding them. So, my advice is if someone is pitching you on annuity, ask, "Is this a variable annuity, or is it fixed annuity? Is it an immediate annuity or is it deferred? Or is it an equity indexed annuity?"

Ask for what flavor it is. Then go back and do your own research, and then you can come back ask some more informed questions. But really getting to the bottom of what this thing is that's being recommended to you is question number one.

I was talking to someone a few weeks ago, and he said, "Oh, my advisor always talks about these products; I don't understand."

And to me that says that person has the wrong advisor. If that person can't explain to you in plain English what it is that the advisor is recommending, you probably need to go somewhere else.

Stipp: So, first of all its important to know which type you might be considering. So, there is obviously choice among annuities, but there is also choice between annuities and putting your money somewhere else. And that relates to your second question.

Benz: "Am I taking maximum advantage of other opportunities for tax-deferred growth?"

So, annuities do offer an element of tax-deferred growth, and that can be very attractive for people who have already maxed out the cheaper ways to get tax-deferred growth. So, you have to ask yourself, "Are you already maxing out your IRA? Are you already maxing out your 401(k)?"

Those vehicles might be a cheaper way to achieve some compounding on a tax-deferred basis, which is the same thing that you get with many annuity products.

Stipp: So, annuities do offer that tax advantage as these other accounts do. One of the things that a simple annuity will offer is a guaranteed income stream which is something that you can't get necessarily with investments in an IRA or 401(k). So, how should you think about that guaranteed income aspect of that simple annuity as part of your decision-making process?

Benz: Well, that's a great question, Jason, and you are absolutely right. That's something that annuities give you that you do not get with these other products. So, you do want to think about that potential advantage. You also want to see how much extra you are getting in that vehicle via income payouts due to risk pooling, the longevity risk pooling, that goes on in that annuity versus just buying some of plain-vanilla savings vehicle. So, its definitely worth checking that out and recognizing that there are some features of annuities that are unavailable in plain-vanilla investment products.

Stipp: The third question to ask, Christine, relates to the fact that, when you have money in an annuity, its not as accessible to you as when you have money in other accounts like Roth IRA, for example. What should you be thinking about on that front?

Benz: That's a great question to ask: "What are my liquidity needs?" So ask yourself, "Will I have any near-term need of this money or even the possibility of needing this money?"

If so, an annuity is oftentimes going to be the wrong vehicle for you. You might be able to take a look at a product, buy it, and then undo it if only a short period of time has elapsed. That's called a free-look period; that's kind of escape hatch. Or you might be able to do some conversion into a similar product. Oftentimes transitioning out of some kind of annuity once you've purchased the contract is going to entail a pretty big surrender charge. So, you don't want to mess around with money that there is any possibility you will need in the near future.

Stipp: So typically when you are investing in annuities, you are turning over a lump sum of money. Are there any concerns with turning over all of that money to one company and right now at this point in time?

Benz: Well, there is, and so, you want to think about the timing. If you are buying that plain-vanilla fixed immediate annuity where you are getting a payout over the whole of your life, you want to think about the timing. And one idea, one thing we've talked about is possibly buying a number of annuities at several intervals. So right now, as we all know interest rates are really low. It's probably a bad idea to stake the whole amount that you might put in an annuity right now; you are better off thinking about doing it over a period of maybe five years. So, if you had planned to put $250,000 into a fixed immediate annuity, maybe think about putting $50,000 in over the space of five years, and that way you can also diversify your insurance company exposure. You are depending on the claims-paying ability of the insurer, so you maybe want to diversify that risk a little bit by purchasing several contracts from several different companies.

Stipp: Question number four, Christine, has to do with how much does this annuity cost. Why is this an important question, and how do you begin to get to the bottom of whether the cost is reasonable?

Benz: So these things, especially variable annuities, can be larded with different costs. So there are the investment expenses. There are mortality expenses. There are also surrender charges that might kick in if you need to get out of one. So, I think its perfectly fair questions to ask a broker are: "How are you getting paid? Are you getting paid to sell me this thing, and how much?  And what will my total expense load look like in dollars and cents? So, if I am going to put $200,000 into this contract, how much should I expect to pay in year one for this product?"

So, really get to the bottom of the dollars and cents of the cost that you are paying because these products can very costly.

Stipp: I know with variable annuities there is also a lot of riders that you can also add on which will also increase your cost or it will affect your payout in some way.

Benz: So, one typical rule of thumb to keep in mind, if you are navigating the annuity universes, the more protections you add on for yourself as the investor in an annuity contract, the more it's going to cost you. So, if you add on a rider that adds inflation protection, that will be an extra cost, or if you add on some flexibility that lets you use this product for long-term-care insurance if you need that first. Those kinds of features, while very attractive in that they will give you some flexibility, will also cost you.

Stipp: Lastly Christine, these are offered by insurance companies. These are corporations so, it's a little bit different than investing in mutual fund for example. What should you think about the strength of that insurance company that's offering this annuity? How do you assess that?

Benz: So, you want to ask your advisor what due diligence he or she has done on this front. "How is this insurer rated by the big rating agencies?" So examples are AM Best, S&P, Moody's, and Fitch. You want to look for a variety of different ratings; these firms all use different systems. But you want your insurer to be very highly rated. And one protection of that, as I mentioned, would be laddering the annuity and not staking your whole annuity contract with a single firm, but rather spreading it out across several firms to mitigate the risk of tying yourself to single insurer.

Stipp: All right, Christine, well, lots of questions related to annuities, but these five are a great place to start. Thanks for joining me today.

Benz: Thank you, Jason.

Stipp: From Morningstar, I am Jason Stipp. Thanks for watching.

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