Investing is emotional for many people. Those emotional responses have led to detailed studies in the field of behavioral finance. Researchers have now proven that many of our investment decisions are driven by emotion.

But, even in an area where emotions are common, the depth of emotional responses to one asset class stands out. Many investors either love or hate annuities and few have no opinion on the subject. Because emotions run so high, the question of whether or not an annuity is right for you is often clear.

For many, the answer is no. For many others, the answer is yes. The right answer, for everyone, is that it depends on your personal circumstances.

A Long History

Some sources date this asset class back to ancient Rome. But, the first modern annuity seems to have been developed in France in 1653. That year, a banker named Lorenzo Tonti developed a method for raising money in France called the tontine.

Subscribers purchased shares of the tontine and received a share of the income generated by the underlying investments. This is similar to a modern day mutual fund but with one big difference, as tontine shareholders died off, their income was spread among the surviving investors.

Eventually, the last person alive collected all the benefits. The use of tontines spread to Britain and the United States where governments used them to finance public works projects.

But, eventually the practice was eventually banned “because it created an incentive for shareholders to bump off their partners in exchange for a greater payout.”

A Modern Update

Now, annuities are generally based only on the lifetime of the investor, or joint lives in the case of couples. Safeguards exist in modern society to limit the practice of “bumping off partners.”

By definition, an annuity is a contract between an investor and an insurance company where the investor agrees to make a payment and the insurance company agrees to provide income for a certain amount of time or for the life of the investor.

That’s an annuity in the simplest terms possible. But, there are various options to the contract that make the annuity a slightly more complex instrument. Payments could be in a lump sum or over time. The income could be guaranteed for a minimum amount of time and transferable at death or not.

Income can be protected against inflation, or not. The amount of income could also be fixed or it could vary based upon various factors related to changes in the financial markets. Other variations of the contract exist and, in short, annuities are a complex investment in modern terms.

That complexity accounts for some of the emotional responses to the contracts. Each addition to the contract carries a cost. Those costs can add up quickly and it is possible an investor could pay a large amount of money for a relatively small amount of income in some cases.

However, that complexity allows for many investors to build the product that is exactly right for them. Some investors will find potential tax savings and guaranteed income that is protected against inflation to be important and they understand those benefits carry a cost.

The Pros of Annuities

Taxes are another complex and emotional issue for investors and annuities, like other investments, have tax consequences that should be considered by potential investors. There are pros and cons associated with tax issues.

Annuities can grow tax deferred, but there could be tax penalties if the funds are accessed early. This is a situation that requires an investor to honestly appraise their circumstances. If they may need access to cash quickly, an annuity or other tax sheltered plan may not be right for them even though that is an advantage for other investors.

Perhaps the biggest advantage of annuities is the fact that they offer guaranteed income. If your goal is to have income during retirement years, you may focus on investment returns and believe the biggest risk is a market crash. In reality, the biggest risk an investor faces could be longevity risk.

Longevity risk is the risk that an investor outlives their money. As health care advances and helps individuals live longer, longevity risk increases. It’s possible, even with a low withdrawal rate, that retirement savings can run out well before an individual quality of life deteriorates.

Annuities can be structured to provide guaranteed income for life, effectively eliminating longevity risk. This is an advantage that is important to consider.

The Cons of Annuities

One of the underlying factors for the negative emotional response to annuities is the costs associated with the products. There have been some companies that offered unusually high cost products in the past and there are still some relatively expensive products in the market.

Research can guard against this. But, expect to face some complex information when looking at fees. Vanguard is a low cost provider and an excellent company that makes disclosures as clear as possible. The firm notes:

“The Vanguard Variable Annuity has an average expense ratio of 0.52%, versus the annuity industry average of 2.26%—excludes fees for optional riders. Actual expense ratios for the Vanguard Variable Annuity range from 0.40% to 0.71%, depending on the investment allocation. The expense ratio includes an administrative fee of 0.10% and a mortality and expense risk fee of 0.19%. The expense ratio excludes additional fees that would apply if the Return of Premium death benefit rider or Secure Income (Guaranteed Lifetime Withdrawal Benefit) rider is elected. In addition, contracts with balances under $25,000 are subject to a $25 annual maintenance fee.”

As you can see, the clear disclosure still requires some level of analysis. The lowest cost annuity will not offer some of the benefits in the form of riders that could be attractive to many investors. There could also be annual fees associated with the account no matter which company offers the product.

Are Annuities Right for You?

After doing your research, it could be that an annuity makes sense for you. If that’s the case, more research will be needed. Annuities are available for low minimums of just a few hundred dollars. Low cost annuities are also available.

Annuities could be right for you, especially if longevity risk is a primary concern and especially if assured income is a top priority.

Energy investments are appealing for a number of reasons. They are a hedge against inflation, at least in part. This is because inflation has almost always been associated with higher energy prices. This relationship still holds, for now, but may change as alternative energy sources increase production.

These investments are also a bet on economic growth. As economies grow, they use more energy. This is a relationship that seems unlikely to change although more efficient technologies may mean that growth in energy consumption is smaller than it would have been in the past.

Many energy investments have also provided income. This is because many of the producers are mature companies with extensive infrastructure that has been paid for. These companies then return capital to share holders, often through dividends.

Infrastructure assets are expensive and were once viewed as an important component of returns to the oil and gas companies. But, in recent years, companies have been lowering the value of those assets, in accounting terms, writing down the value of the assets.

Source: The Wall Street Journal

This trend leaves investors wondering if investments in energy infrastructure is attractive. Fortunately, there are investments in the sector that don’t involve buying the assets.

Buying the Income Stream

An asset class known as royalty trusts provides an interesting alternative. Royalty trusts generally invest in the energy sector.

The idea of a royalty trust is similar to the idea of allowing an oil company to drill in your backyard. That is actually not a farfetched idea since new fracking technology has allowed drillers to place wells on individual’s property.

In this case, the oil company would pay for the equipment and all required maintenance and operating costs. You, as the property owner would receive a share of the income but carry none of the risks. You would be enjoying royalties from the energy production.

Now, production will vary over time. And, that means the income from these investments will vary over time.

Royalty trusts are a pass through investment. Income from oil and gas fields, coal mines or other commodities passes through the trust to the trust’s investors. In this way, royalty trusts are similar to master limited partnership or MLPs.

Like an MLP, the trusts are traded like stocks. Both can provide significant income and both carry favorable tax treatment, at least for some investors. You should check with your personal tax adviser before investing in this, or any asset class since all tax situations are unique.

The major difference between the two investments is that MLPs own infrastructure like pipelines, generate revenue by charging a fee for others to use the asset. Royalty trusts own the rights to cash flow from production facilities themselves, like wells and mines.

MLP revenues will generally be locked into long term contracts. This prevents large swings in income for investors. With royalty trusts, income will vary from quarter to quarter, based on the performance of the commodity.

Royalty trusts are a way that producers can finance production. “It is common for numerous oil and gas producers to sell their producing assets to a royalty trust,” one expert noted.

“By doing this, the company has created a revenue stream that investors can then buy into. From there, all the royalties produced in the trust are distributed to the shareholders as income. Simply put, purchasing into a royalty trust is like purchasing specific cash flows.”

A Specific Trust Investment

San Juan Basin Royalty Trust (NYSE: SJT) owns royalties from working, royalty and other oil and natural gas interests owned by Southland Royalty Company, the predecessor to Burlington Resources Oil & Gas Company LP, in properties located in the San Juan Basin of northwestern New Mexico.

Almost all of its assets, 99% of the trust’s estimated proved reserves, consisted of natural gas reserves. SJT was founded in 1980 and is expected to continue operating for another 10 to 15 years.

SJT has been trading in a relatively narrow range for several years but has been volatile in the past.

The distributions, however, have been in a generally rising trend.

The current yield is about 11.2%. This is well above the historic yield which has averaged 6.1% over the past seven years. The high yield could indicate the trust is undervalued or that the distributions are likely to decline.

SJT makes monthly distributions. The amounts vary and it’s reasonable to factor a negative outlook into the decision process. Assuming the distribution is half of last year’s level, the yield would drop to about 6%. That is still above average, but much lower than the current yield.

Advantages of royalty trusts include high yield because trusts are required to pay out essentially all of their cash flow as distributions. Because of this, nearly all royalty trusts with ongoing operations have above average yields.

Due to depreciation and depletion, distributions from most trusts are not considered income in the eyes of the IRS. Rather, the cash distributions are used to reduce an owner’s cost basis in the stock, which is then taxed at the lower capital gains rate and is deferred until an owner sells.

The trusts pay no corporate income tax which increases the amount of cash flow available for distributions. The trusts also benefit from a number of tax credits, although these can change as tax laws are changed.

Royalty trusts are a pure play on commodities. The distributions vary with the price of commodities. This means they can be volatile.

Royalty trusts will not be the best choice for all income investors. But, SJT is trading near $7 and the current yield is more than 11%. Its low price makes it accessible to small investors who have few opportunities for double digit yields.

While it can be tempting for small investors, the tax situation must be considered. There will be extra forms and if a tax preparer is used, this could lead to higher costs. If software is used, it could require an upgrade to the basic software. These costs could offset the income for some investors.