Underperforming IRA

Q: I would greatly appreciate some insight on a situation that has made me concerned with my husband's IRA.

Last year he invested in a VA for his IRA due to the fact that the investment company he had it in (which did well for the 20 years he was with them) was not performing as well as in years past.

A: Thank you for your questions. I know that all the options of how to invest an IRA can be confusing. Unfortunately, there is a lot of hype out there and, in my opinion, the financial services industry is great at selling the sizzle and delivering very little steak!

This is especially true... in the area of annuities. You purchased the variable annuity based on the belief that the principal was protected and other guarantees. Often there is a wide gulf between what the investor thinks a product does and what it really ends up doing.

These are complex financial instruments that are sold using generalities. As with anything, the devil is in the details, and the more you know the details the less important some of these guarantees become.

For instance, a principal guarantee on a variable annuity. The ones that I'm familiar with guarantee that you can withdraw so much a year for a certain number of years, thus getting back your principal even if the market goes to zero.

Think about that for a minute. Let's say they allow you to take 7% a year. It would take over 14 years for you to get back your principal. What are the probabilities of the market being worth less over a 14 year period? Very, very small.

Or there are the guaranteed income provisions. Many investors think that these living benefits guarantee that they will earn 5-7% a year regardless of what the market does. They believe that if they leave their money in and 10 years later decide to take it out that they will have earned at least the 5-7% a year.

Nothing could be further from the truth.

These living benefit riders don't apply if you surrender the annuity. They ONLY apply if you take a lifetime income stream from the annuity. Even then, if you ever cash it in, what you get is based on the actual earnings of the annuity less any withdrawals. What you get when you cash it in isn't ever based on the 5-7% guarantee.

Let me explain it this way. Picture two columns on a piece of paper. The first column is the actual value of the annuity from year to year. So if the market goes up, so does that value. If the market goes down, so does that value. There isn't 5-7% added to this column when the market goes down. That column works just like you expect.

The second column is the 5-7% column. This column takes your initial investment and increases it by the 5-7% each year. Some policies take into account 'high water marks', etc., but think of this as the 'benefit' column.

So 10 years down the road you decide to cash in your annuity. You get the value in the first column, the value in the second column meant nothing.

In a different scenario, let's say that 10 years down the road you decide to start taking the income stream of 5%. That income stream is based on the second column. So if the second column was $200,000 your income stream would be $10,000 a year guaranteed for life.

So far so good.

Time has passed and you have been receiving the $10,000 a year. Your situation changes and you need (or want) what's left of the money in the variable annuity. Here's where the surprise happens. What you get isn't based on the value of the second column, what you get is based on the first column less any withdrawals you've made.

Actually, every time you get a payment, they reduce both columns. That payment affects the growth of the first column (as it should).

What if you die? Do you get what's left in the second column? No. Your heirs get what's left in the first column.

There's one other thing to keep in mind. Let's say you give me $100 and I agree to pay you $5 a year. I can pay you that $5 a year for 20 YEARS and all that I've done is given you back the $100 you initially gave me. Keep that in mind when you look at the 'income stream'. There's a big difference between an 'income stream' and a guaranteed 'return'.

That's why I don't place a lot of value on the guaranteed provisions associated with annuities. I expect that few people will ever use them or get the benefits that they expect.

That's why an annuity should first be evaluated based on it's investment potential. These benefits are designed to take your eye off of the underlying investment. The benefits can give an investor a false sense of security thinking that changes in the market won't hurt them. They will.

When evaluated as an investment, I believe that there are many alternatives that are much more attractive and that allow the investor to retain the control, flexibility and access to their money.

For more information, take a look at this Special Report:

Financial Self-Defense

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