In general, you cannot purchase an annuity without the involvement of an insurance agent. Insurance agents make their living by selling insurance products for a commission.

Every sale that is compensated by a commission has a built in conflict of interest. So, the logical question is, “Can you trust the advice of a salesperson to be in your best interest as a consumer?” Sadly, following my two decades in the financial services world, I would have to say your chances of getting advice in your best interest are quite slim.

The more informed you are, the better your odds are of purchasing the right investment product. I know this article will make a lot of insurance salesman angry with me. I don’t mean to say that all insurance salesmen are evil. They are not all evil, even if some insurance salesmen are. There are many extremely ethical and honest insurance salesmen in the industry that do an excellent job for their customers.

But my question still needs to be answered. With an inherent conflict-of-interest, will the recommendation you receive be in your best interest? That is, will the insurance salesman act as a fiduciary when advising you on whether or not to purchase an annuity and if so which one? This points to why your education is critical.

An annuity agent is not a fiduciary to his customers and is not held to a fiduciary standard by the insurance department of his State and, at present any way, even if he is a CERTIFIED FINANCIAL PLANNER practitioner, he is not held to a fiduciary standard by the CFP Board of Standards when engaging in a sales process as opposed to a financial planning process.

Insurance salesmen are held to a suitability standard, not a fiduciary standard. If you want to be sure the recommendation is in your best interest, cough up a few bucks to a Fee-Only Financial Advisor to evaluate the situation for you before you make any purchase.

To identify a Fee-Only fiduciary advisor, go to www.napfa.org, the National Association of Personal Financial Advisors (NAPFA). NAPFA Registered Advisors are required to annually sign a fiduciary oath. They get no compensation from product that is sold, that is, no commissions to be a conflict of interest. Be sure to ask if the NAPFA Advisor has the expertise to evaluate an annuity. Not all do since many of them have not come out of the insurance business.

Again, I know annuity agents will deeply dislike this article because even if their advice is good and proper, it will slow down their sale and their pay day. I understand, but I am not writing this to support annuity agents, I am writing to protect the general public through greater understanding and through knowledge of how to act rather than being acted upon. My intent is to put you, their customer, in control of the process instead of the sales person.

The Most Important Question

Before taking any action, you should ask yourself one simple question and be sure you have a complete answer to it, “Why are you considering the purchase of an annuity?” or, in another form, “What are you trying to accomplish with this money?” If you don’t take the time to accurately answer this question, then you are leaving yourself open to “suggestion” by some annuity sales person’s presentation.

A good salesman will introduce all sorts of bells and whistles and convince you that you can’t live without them. Actually, all the bells and whistles may have little, if anything, to do with the real reason you would be considering investing in an annuity…if you stopped and took the time to carefully think about it. This is the most important question! As a general rule, you waste money when you buy bells and whistles. When it comes to saving and investing, wasting money is the last thing you want to do.

Costs Always Impact Performance

There really is no such thing as a free lunch and there is no such thing as a financial product, annuity or otherwise, without some costs to produce and provide that product to you, the consumer. The question is, What is the affect of that cost and what is a reasonable cost to bear?

What are the costs associated with a fixed annuity? There are some who will try to tell you that you dont bear any costs with a fixed annuity, the insurance company pays the agents commissions and any costs related to bringing this wonderful annuity contract to you. While it may be true that the insurance company bears those costs, the insurance company gets the money with which to bear those costs from you. So, you really do have some costs that you should be aware of. This doesnt mean you wont buy that annuity, it just means you will know what the costs are that you are bearing in order to buy the insurance companys guarantees.

Fixed annuities don’t have explicit fees, like variable annuities, but they do have implicit fees, which the industry refers to as “spreads.”

Consider a worker nearing retirement earning 2.5% in a fixed annuity during a period when short term interest rates are 5%. That worker would not be getting a good deal since there is an implicit fee (i.e., the difference between the 5% interest rate and the 2.5% annuity rate) of 2.5%. I think that any economist worth his salt would call that (i.e., the spread of 2% to 2.5%) a “cost,” and so would any investor if it were disclosed to the investor in an understandable way.

As for the seeming lack of an up-front commission sales charge, do you seriously believe that a fixed annuity is sold without the insurance company paying the agent who sold it? In fact, the insurance industry recovers those “phantom” commissions via the series of surrender charges imposed by a fixed annuity. The idea that an investor “technically” doesn’t pay up-front commissions in a fixed annuity is merely a distinction without a difference.

So, what good does this information do you? If you are considering buying a fixed annuity, compare the current interest rate paid by the annuity company to the interest rate of the short term bonds. Are you really going to get a good return after taxes or are the costs of the annuity eating up your returns?

Variable Annuity Costs

Explicit Costs

The explicit costs include: 1. Mortality and expense fees (M&E) of 1.25%-1.45% of the value of the annuity annually (this is the industry average)… it is claimed that M&E covers mortality and expense, but it mostly covers profit. This becomes clear once you realize that the insurance company actuaries all use the same numbers for mortality. The high cost insurance companies charge 1.25%-1.45% for M&E while the low costs providers charge about .25%-.30%.

Explicit costs also include 2. A mutual fund annual expense ratio of about 1.50% (this is the cost of the average mutual fund; it includes, for example, investment management fees and 12-b(1) fees). The explicit costs associated with a variable annuity on the low side are, therefore, 2.50% (the M&E fee of 1.00% plus the fund annual expense ratio of 1.50%). The high side is 3.35% (the M&E fee of 1.85% plus the fund annual expense ratio of 1.50%). Both the low side and high side of explicit costs can increase if riders for living benefits are elected–which is being done more and more now. And that is a good subject for another article – too much to include here.

Implicit Costs

Implicit costs include:

1. Internal brokerage commissions paid on transactions of .45%. This cost is not included in a fund’s annual expense ratio but instead in a separate, obscure document called a “Statement of Additional Information.” Implicit costs also include,

2. Bid-ask spread costs (these costs provide a “market maker” with a profit for providing liquidity in a market) of .40% (for the most liquid stocks) to 10.00% (for the least liquid stocks), and

3. Market impact costs of .40% (these costs are caused by the impact on the market price of a stock when it is bought or sold). The implicit costs associated with a variable annuity on the low side are therefore 1.25% but can all the way up to more than 10.00%. Don’t forget that many of the mutual funds used in annuities are actively-managed and, therefore, have much higher costs than passively managed mutual funds (i.e., index funds and asset class funds).

The Bottom Line

The total is: Explicit costs of 2.50%-3.35% plus implicit costs of 1.25% (I’ll ignore the 10.00%, since that’s just too scary) for a grand total of 3.75%-4.60%. Oh by the way, did I mention the

1. Cost of surrender charges,

2. The cost of additional investment advisory services that are included in many arrangements,

3. Commissions received for selling to retail buyers (which being explicit costs are different than the implicit brokerage commissions earned on transactions internal to a mutual fund), or

4. The cost of the increasingly negative compounding effect caused by lost money?

Since some people will claim these costs are exaggerated, therefore let me quote from a randomly selected company, directly from the prospectus of Ohio National Variable Account A of the Ohio National Life Insurance Company ONcore Series of Variable Annuities Supplement to the Prospectuses dated May 1, 2009 in which, on page 8, Summary of Maximum Contract Expenses the Maximum Possible Total Separate Account Expense is listed as 5.45%. This does not include any of the implicit costs referred to above. It also does not include the fund operating expenses listed on page 9 with a range without waivers of .35% to 26.26%!

When you consider that the long term stock market returns are approximately 10.5%, how can you really do well in a variable annuity with these high costs dragging down any possible market returns? Income tax deferral won’t make up the difference in lost earnings for many many years and maybe never.

Savings for retirement in a 401K plan is a very smart idea and you should begin making contributions as soon as possible. 401K retirement contributions are made through your employer so if you are self employed you should start an IRA or Individual Retirement Account. Employees make contributions directly from their salary and this money is not taxed. Make sure you follow all IRA rules and 401k rules, as they have some variances. The IRS actually came up with the name 401K as it was from the code that originally created the retirement funds.

Some of the advantages to having a 401K include the following, your company may match the amount your put into the 401K, you can make a lot of money if you invest for the long term for 20 to 30 years, you reduce the amount of taxes you have to pay based on your salary and all contributes are tax deferred unless they are withdrawn prior to age 59 and 1/2.

Most employers will match their employee’s contributions though there are 401k rules to follow. These retirement accounts are protected by pension laws, as they are a form of personal investment.

A few of the disadvantages are that you cannot access the money in your 401K until you are 59 1/2. If your employer does contribute to your 401K then only your contributions will be going towards your investment, like is the case with IRA accounts. Also a 401K is not insured by the Pension benefit guaranty corporation. Like is often the case with a fixed annuity.

It is possible to investment in a variety of ways in your 401K. Your money can go towards money market funds, maturities, bonds, stock funds and other avenues. You are allowed to chose how you want to invest and can make changes when additional funds are deposited into the retirement fund. Most financial experts say that most individuals are not aggressive enough with their investments as stocks that are held for a long time do very well. Towards the end of the 401K period, when you may want to take money out you can switch to more conservative funds.

There are rules for a 401K and they differ depending on your pay bracket. 401k rules state that you can make both before tax contributions and after tax contributions. There is a maximum before tax 401k limits and the money needs to be deposited in a specific amount of time, usually 7 days before the end of the month.

After tax contributions are easier to access as it is possible to take a 401k loan out from yourself from your after tax contributions. These do have some drawbacks; so make sure you understand the 401k rules. The 401K retirement account was designed to benefit the majority of workers, but also benefits the individuals that run the companies. As they are able to provide a great benefit to their employees. Much like 401k’s there are IRA rules if you’re considering those retirement accounts.

With 401k and IRA accounts you take title as an individual. Make sure when buying property in the from of joint ownership to consider the other types of title. Tenants in common, as an example allows multiple owners (more than two). Community property and joint tenancy are some other options. Study your options before proceeding in these circumstances.

An IRA account is also a retirement account but it is slightly different then a 401K. It is possible to take money out of an IRA account without penalties to pay for a house, education or medical expenses. These come with certain IRA limits, however. Make sure you understand both the IRA and Roth IRA rules before making a choice. The traditional IRA benefit is the IRA deduction where as the Roth IRA is the tax free income upon withdrawal. Since the IRA is an individual retirement account and you do not receive matching contributions from your employer.

The type of savings fund that can get you the most flexibility over time should be used when saving for retirement. This retirement fund is called a 401K. The 401K account is funded via wages that are taken directly from your employer into a retirement account. 401K contributions come from your pretax salary and cannot be taxed themselves. The name 401K came from the IRS code that created these types of accounts.

One of the best advantages to having a 401K fund is that you can make a lot of money in the long term as well as save money on taxes. Your contributions will be subtracted from your salary and then your tax is calculated. So you still receive the full salary but are only taxed on a portion of it.

Additionally there are pension laws in place that protect the retirement account as it is viewed as a personal investment. You don’t have the guarantee against loss like you would with a fixed annuity. Though these laws are designed to help.

A few of the disadvantages are that you cannot access the money in your 401K until you are 59 1/2. If your employer does contribute to your 401K then only your contributions will be going towards your investment, like is the case with IRA accounts. Also a 401K is not insured by the Pension benefit guaranty corporation. Like is often the case with a fixed annuity.

There are many different investments you can make in your 401K. It is suggested that when starting you invest in stock but you can also invest in money market funds, bonds, maturities and more. You have control over your investments and can change your investments every time another contribution is made. Financial experts suggest being more aggressive when you’re younger and have a longer time horizon, as most individuals are too conservative. Towards the end of the 401K term you want to be a bit more selective, but to make money you need to invest in stocks. Stocks do very well when you are buying and selling in the long term.

The 401k rules can get a little confusing, but the following are some basics. It is possible to make all of your retirement contributions from your pre-tax salary or you can make part of contributions from this area. According to the IRS these types of contributions need to be made quickly, within 7 days of the end of the month. The amount you can add to your 401K as pre-tax dollars has a limit but you can also make after-tax contributions.

After-tax contributions have a different set of 401k or IRA rules and these funds can be easier to withdraw then pre-tax money. There are also additional rules for highly compensated employees and low-income employees. These laws were put into place so the top executives would not design a 401K that was only advantageous to them. The 401K from companies must be a good plan for the majority of the employees in the company. So highly compensated individuals actually have different rates.

It’s important to note that retirement accounts like IRA’s are individual accounts; so taking title is an easy choice. When evaluating your other accounts, especially joint ownership accounts, you should take a look at the many choices. It may be more beneficial to set up a joint tenancy or tenants in common account rather than a community property account, for example. The simple act of setting up title can have big implications.

The 401K differs slightly from the IRA account, but they share many similarities. You can take an IRA deduction, just like a 401k. Roth IRA rules differ in that you can’t take an IRA deduction, but you get to withdrawal the funds tax free in retirement. It is possible to take a 401k loan for yourself, but there are some drawbacks. These 401k loans can be used to purchase a house, medical expenses or paying for education.