Is your annuity safe?

Question: I have $100,000 in an annuity with AIG that my mom and I depend on for income to live. Should I cash it out even though I would suffer a loss, or do you think I should hold onto it? It’s so hard to know what to do. —Kitty Schwartz, Plano, Texas

Answer: Most people buy an annuity at least in part because they see it as a refuge, an investment they can count even if the financial markets are spiraling downward. But that faith has been tested in recent weeks.

The government needed to step in to cover the debts of AIG, the nation’s largest insurer, and the health of many other major insurers has been called into question.

So it’s no surprise that I have been inundated with questions from people worried about the security of money they have in annuities.

I would love to be able to give a simple reassurance.

But annuities are often complicated products. I’ll try to lay out the most important issues surrounding that choice as best I can.

To do that, however, you first must understand the safety mechanisms that are in place for annuities so you can better gauge the risk you actually face (which for many people will be a lot less than they fear). And you must also understand the possible consequences of withdrawing your money from an annuity.

3 lines of defense

Basically, there are three lines of defense that protect the money you have in an annuity.

The first is oversight. Insurance companies are regulated at the state level, and the main job of each state’s insurance commissioner is to assure that the companies headquartered in that state have enough reserves, or capital, to meet their obligations to annuity owners and other policy holders.

The second line of defense becomes a factor when insurers run into trouble despite the oversight. Specifically, the state insurance commissioner steps in, do anything from arranging for a takeover of the ailing insurer to transferring annuities and other policies to a healthy insurer.

The third line of defense is the network of state guaranty funds, a factor if a failed insurer doesn’t have enough in assets to cover obligations annuity holders. Most states cover up to $300,000 for life insurance death benefits, $100,000 in cash surrender values for life insurance and $100,000 in withdrawal and cash value for annuities, although some states have higher limits.

This coverage is per person per insurance company. So if the state limit for annuities is $100,000 and you have a $100,000 annuity with one insurer and another $100,000 with a different insurer, you would receive $100,000 of coverage for each annuity.

A quick note about variable annuities. Most people who own variable annuities have their money invested in one or more “subaccounts,” or mutual fund-like stock or bond funds. The money in these subaccounts is segregated from the insurer’s assets and cannot be tapped by the insurer or its creditors. So while the market value of your variable annuity may decline, the money you’ve invested in a variable annuity would be safe should the insurer fail. (If you have invested in the variable annuity’s “fixed” account, that money is part of the insurer’s assets and would be covered by the guaranty fund.)

So if your annuity’s value is within your state guaranty fund’s coverage limit, you don’t need to bail out to protect yourself from a loss. That’s not to say you might not want to get out at some point in the future for peace of mind or if you decide annuities aren’t for you. But you don’t have to exit in a rush, which might trigger taxes and penalties. Your money is secure.

What if the value of your annuity exceeds these limits? In that case, you’ve got a few factors to consider.

Consider your insurer’s financial strength

Assessing the financial strength of your insurer is difficult if you’re not an insurance analyst. But you can get a feel for it by checking how highly your insurer is rated by ratings companies like A.M. Best, Standard & Poor’s and Moody’s. (It’s important that you have the exact name of your insurer, as there may be multiple subsidiaries with similar-sounding names, each of which is rated separately. The name of the insurer that issued your annuity should be on your contract.)

Granted, these ratings are hardly foolproof. Rating agencies can get it wrong. And rapidly deteriorating markets can make what was a sound company weeks ago vulnerable today.

It’s hard to draw a dividing line between what rating represents an acceptable level of safety and what rating doesn’t. But I think it’s reasonable that someone relying on an annuity for security would want to see a rating of A or better. (The rating scales vary somewhat between companies, but A is usually the third highest rating, after AAA and AA.).

Weigh the taxes and penalties

You’ve also got to consider withdrawal penalties. Most annuities carry surrender charges that typically start at 7% or so and decline gradually each year until they disappear after seven years. In some cases, however, surrender charges can run as high as 20% and last 20 years. If you pull money out early, you could take a sizeable hit.

There is a bit of a loophole here, though. Most insurers allow you to withdraw a small amount – usually 10% of your balance – free of surrender charges each year.

Taxes are another consideration. If you withdraw money from an annuity, you’ll owe tax at ordinary income tax rates on any gains (and on your original investment if your annuity is held within an IRA account funded with tax-deductible or pre-tax dollars.) If you’re under age 59 ½, you’ll pay an additional 10% early withdrawal tax.

There is a way around the tax hit. Instead of just pulling your money out of the annuity, you can do what’s called a 1035 exchange into another annuity. In fact, you can do a 1035 exchange and split your money among two or more insurers with good ratings to diversify your exposure. You’ll still be in an annuity, of course. So if your goal is to exit the annuity altogether, this tactic wouldn’t help. A 1035 exchange also doesn’t exempt you from any surrender charges that may apply. And, indeed, by moving to a new annuity, you would likely start the clock again on a new set of surrender fees, which could make a future exit more costly than getting out today.

Bottom line: If your annuity’s value is over your state’s guaranty fund limit, you’ve essentially got to weigh the cost of getting out vs. the risk of staying in.

If you have an annuity with a highly rated insurer and the surrender charges are still quite high, you might prefer to just hold on at least for now, especially if your annuity’s value isn’t that far above the guaranty fund’s limit. You can always pull money out later on or move it to another insurer via a 1035 exchange after the surrender charge has fallen.

You could even reduce your exposure above the guaranty limit gradually by taking advantage of the annual surrender-free withdrawal provision.

If, on the other hand, the insurer has a low rating or you’re really worried about a loss and the surrender penalty isn’t too severe, you might want to switch via a 1035 exchange to an annuity with a highly-rated insurer, especially if the annuity’s value is well above the guaranty coverage.

If the insurer’s rating is low and the surrender penalty is still high, you could also consider doing a partial 1035 exchange – that is, move enough of your current annuity to an annuity with one or more highly rated insurers so that each annuity falls within or at least not too far above your state’s guaranty fund limits. You would still have to pay a surrender charge, but at least it would be on only a portion of your annuity’s value.

All this comes down to a personal judgment. But I think that ultimately, if you’re going to own annuities, you want to have your money spread among two or more insurers and, to the extent possible, below the guaranty fund limit for your state. You don’t have to get to this position overnight. But the weaker your current insurer is and the higher above the guaranty limits you are, then it seems to me the sooner you want to do this.

Are annuities for you?

One final note: I think this is a good time for people who own an annuity – or are considering buying one – to ask themselves whether they really ought to be in an annuity at all. I’ve long recommended a particular type of annuity – an immediate annuity – as a way to convert a portion of your savings to a lifetime income once you’ve retired.

But immediate annuities represent a very small portion of annuity sales. Most of the annuities that are sold fall into two categories: fixed deferred annuities, which are sold to older investors, most of whom I think would likely be better off in bank CDs and bonds; and variable annuities, which are touted as mutual funds that can shelter their gains from taxes and often sold (usually inappropriately in my opinion) as investments for IRAs and 401(k) rollover money to people who are still years away from retirement.

If nothing else, I hope the attention that insurers and annuities are getting will lead investors to re-assess (ideally with the help of a financial adviser who doesn’t depend primarily on annuity sales for his or her livelihood) whether they really belong in annuities.

As I said at the beginning of this column, annuities can be complicated. But there’s one aspect of them that’s become painfully obvious: Getting into them is a lot easier than getting out.

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