Annuities: Pros, Cons, and What are They, Anyway?
Some people love them. Some hate them! So, are annuities good or are they bad? The truth is that because there are so many different types of annuities, they cannot all be characterized as either good or bad. Each annuity should be evaluated independently based on each individual’s situation.
Annuities are so misunderstood that it seems hardly anyone can agree on the definition. A simple Google search will yield a variety of definitions, but the main themes seem to include: annuities are financial products where you can invest your money, they are insurance contracts between you and an insurance company, and they can provide guaranteed income for a period of time or for life.
Even then, those themes fall far short of accurately describing all types of annuities. That’s why it’s important to understand that annuities do come in different varieties. Certain types are designed for certain situations. Although they can often get a bad rap for being complex, expensive, confusing, and oversold, not all annuities are created equal.
An annuity coupled with the right financial situation can result in positive outcomes. At the same time, those that do not align with the goals and objectives of the annuity owner can lead to poor outcomes. I would argue the same can be said about any type of investment.
At the core of the issue, investors need to be aware of a few things; what makes annuities unique, what are the various types, and a few criteria to help evaluate each type.
Unique Annuity Features
One unique feature of annuities, as compared to a traditional portfolio of stocks and bonds, is that they can provide guarantees. These guarantees are part of the annuity contract and are backed by the financial strength of the insurance company offering the guarantee. In practice, annuity guarantees could involve how the annuity value grows (a guaranteed growth rate), how the annuity can provide income for life (guaranteed income), minimum interest rates, and more.
According to a study done by the Insurance Retirement Institute (IRI), approximately 70% of Baby Boomers want guaranteed, lifetime income. However, only 14% of Baby Boomers plan on purchasing an annuity, which could help provide that guaranteed income.
Annuities Address Longevity Risk
The same study found that only 25% of Baby Boomers reported being confident that their savings will last throughout retirement. Longevity, or the risk of living a long time, is one of the main reasons Baby Boomers are concerned about outliving their money.
Unlike a portfolio of stocks and bonds, which can be completely depleted, certain annuities can provide income that is guaranteed by the insurance company to last for life, even if the annuity owner lives far past a normal life expectancy. This is a unique feature that you cannot get from a more traditional investment portfolio, where we aren’t allowed to use the “G” word (guarantee).
In addition to providing guarantees and uniquely addressing longevity risk, can annuities also make you happier? According to a 2012 study by Towers Watson, retirees with more annuitized income were found to have a higher level of retirement satisfaction. This finding was true across all respondents, including those with more wealth and those with less.
The study did not explore why this was the case, but it reason seems rather obvious. With more annuitized income (income coming from pensions or other lifetime income sources), it’s natural to think that retirees would be less concerned about stock market volatility and what their portfolio is doing on a day-to-day basis.
One might also think that with more annuitized income, it may give the annuitant a sense of having a “license to spend.” After all, the regular payments received through annuitization or lifetime benefits can be expected to continue…for life!
On the other hand, it seems intuitive that those relying on a larger withdrawal percentage from a traditional portfolio might be less inclined to spend their money, knowing that it could run out.
While these aren’t the only unique benefits that annuities can offer, these are certainly some of the main things you should know about them. But, as we discussed before, you should also understand the different types of annuities.
Types of Annuities
Single-Premium Immediate Annuities (SPIAs)
If the name doesn’t give it away, a single-premium immediate annuity (SPIA) is a product that requires a one-time premium purchase and then generates an immediate stream of income. The income can be paid out for a certain period of time (i.e. 10-year period certain), or for the life of the SPIA owner.
If the SPIA owner is married, there may also be a joint-life payout option, which means the SPIA would generate income until the 2nd spouse passes away.
Perhaps not surprisingly, the income generated for a single-life payout is higher than for a joint-life payout. Why? Because the insurance company knows that they will likely have to pay out for a longer period of time when you select a joint-life payout.
Unless any additional riders or period certain features are added, the income generated from SPIAs typically ceases at death. However, SPIAs may allow for a return of premium rider at the time of purchase. A return of premium rider provides that if the SPIA owner dies prior to withdrawing the amount used to purchase the SPIA, the remainder can be paid out to a beneficiary (or beneficiaries).
Without a return of premium rider, the annuity no longer becomes an asset after purchase and thus, no longer appears on the owner’s balance sheet. This is similar to how a government pension is usually treated after income begins. It has no value as lump sum, but only value that is expressed as income over time.
Again, adding additional riders like return of premium (and others that increase the risk for the insurance company) will likely lower the income amount that is paid out to the annuitant.
One of the biggest thing to understand about SPIAs is that these contracts are almost always irrevocable, meaning you cannot change your mind after you make the annuity purchase (NOTE: Most annuity contracts offer a free-look period of 10-30 days for the annuity owner to undo their purchase. The time of the free-look period varies state-to-state). Therefore, it is imperative that you fully understand these types of products before you purchase them.
Deferred-Income Annuities (DIAs)
Deferred-income annuities (DIAs) work very similar to SPIAs, except the DIA income stream does not begin right away. The income start date is generally some point in the future and is written into the annuity contract at the time the annuity is purchased.
Like SPIAs, DIAs offer similar payout options (period certain, single-life, joint-life) and similar rider options (return of premium, COLA, etc.). Generally, the longer you allow your annuity income to defer, the higher your income benefit will be.
Also, like SPIAs, DIAs are irrevocable in virtually all cases, so you cannot change your mind after you pass the free-look period.
Fixed Annuities and Multi-Year Guarantee Annuities (MYGAs)
A fixed annuity or MYGA is a type of annuity that simply pays a stated interest rate for a stated period of time (i.e. 2% for 5 years). Upon first glance, these can appear to work much like a certificate of deposit (CD). However, MYGAs and all annuities benefit from tax-deferral, something CDs do not have.
On the downside, MYGAs often have much steeper early withdrawal penalties when compared to CDs, so those considering this type of annuity need to be aware of surrender charges that could occur with an early withdrawal. The surrender schedule explains what the surrender charges are in each year of the contract, and they usually decrease as you get further into the contract.
MYGAs can also be annuitized to provide income like the SPIAs and DIAs mentioned above. Once annuitized, it cannot be undone, so that is a decision that needs to be carefully thought out.
However, some fixed annuities offer income riders that may provide for a lifetime income guarantee without the annuity needing to be annuitized. This can be attractive to annuity owners because it prevents them from having to make an irrevocable decision. In other words, annuitants can receive income provided by an income rider for a while but can then choose to stop the income and withdraw the remainder of the annuity value (surrender charges and taxes could apply).
The fees for fixed annuities are often zero unless extra riders and benefits are added. Therefore, the insurance companies will price in their profit when offering certain fixed interest rates.
Fixed Indexed Annuities (FIAs)
Fixed indexed annuities (FIAs) operate similarly in spirit and structure to a fixed annuity, but also offer additional growth options, called index options. These index options can be complex and misleading. They are usually oversold on radio shows and television shows as a way to “participate in the upside of the stock market with no downside risk.” You’ll see in a minute why that is not a fair description.
A common index option seen in FIAs is an annual S&P 500 point-to-point index with a cap. That sounds like a mouthful, and it is (thus, you may be starting to see why annuities get a bad rap for being complex). However, allow me to explain how these indexes work.
An S&P annual point-to-point index (with a cap of 4%) would simply measure where the S&P 500 index is on the purchase date of the contract and then measure again one year later. If the index goes down during the contract year, the annuity owner typically earns 0%. What if the S&P 500 index declined significantly to the tune of 30%? The FIA owner would still earn 0%. That’s one positive feature of FIAs.
But there is a flip side to this coin. If the S&P 500 earned 10% and the cap rate is 4% (mentioned above), the annuity owner would earn only 4%. Essentially, the annuity owner would be able to earn between 0-4% with a 4% cap rate. That is why promoting these annuities as “able to provide the upside of the stock market” is not a fair description whatsoever. If the market is up 30%, the annuity owner only gets the gain up to the cap rate.
Other indexes use a participation rate, which also lowers the earnings of the FIA owner. Let’s again look at an S&P 500 index option, but this time with a participation rate of 30%. This means that if the S&P 500 index gains 10%, the FIA owner’s participation rate is then applied, resulting in a 3% gain.
Unfortunately, most index options offered by insurance companies are even more complex, making them difficult to understand for the average retail investor. This can lead to disappointed annuity owners who thought they would attain a higher return on their investment, only to be left re-reading the fine print on an index they never truly understood.
However, indexes aside, FIAs can also be coupled with income riders that can provide lifetime guaranteed income without having to annuitize the annuity. In my experience, I’ve often seen this used as a common strategy for retirees looking for more guaranteed income.
The benefit of this strategy is that the start date of the lifetime income benefit does not need to be determined at the time of the purchase. Therefore, the FIA owner can delay their income start date if circumstances change, which usually leads to a higher lifetime income benefit.
Also, without any riders, FIAs rarely have stated annual fees. The insurance company will price in their profit when deciding on index caps, surrender schedules, fixed interest rates, etc. The downside is that these caps can change year-to-year (often not in your favor).
Like MYGAs, FIAs will usually have a surrender schedule for lump sum withdrawals. In other words, if you purchase an FIA, you need to leave your money in the annuity for a period of time, otherwise, withdrawing too soon will lead to early-withdrawal penalties (surrender charges).
On the bright side, many fixed indexed annuities offer a small portion of the total value to be withdrawn each year (usually after the first year and often around 10% of the contract value) without a penalty. This is referred to as the penalty-free withdrawal amount.
Variable annuities (VAs) have a few similarities to fixed and indexed annuities. First, income riders like the ones mentioned previously are available for VAs as well, meaning VAs can also be used to provide flexible, guaranteed lifetime income. VAs also typically have a surrender schedule associated for lump sum withdrawals. However, there are a few key differences with VAs as well.
The reason they are called variable is that the investment or growth component of a variable annuity is not a fixed rate or an index, but subaccounts that act very similar to mutual funds invested in the stock market. These subaccounts have a higher upside, but also a lower downside.
Next, VAs usually contain the highest fees of any type. The reason is that VAs usually contain several kinds of fees, including:
- Mortality and expense fees (usually helps provide some type of death benefit if the VA owner dies)
- Subaccount fees (similar to mutual fund internal expenses)
- Rider fees (optional, but apply if riders are added, i.e. income rider)
- Administrative fees
Of all the diverse types of annuities, VAs have historically received the worst reputation because of the high relative fees. This doesn’t mean all VAs are “bad,” but it simply means that investors should carefully analyze the fees of any investment and evaluate if the benefit is worth the fee.
Lastly, like FIAs and MYGAs, most variable annuities are not irrevocable, meaning the VA owner could wait until the end of the surrender period and withdraw the full balance without any annuity penalties (tax may apply and annuity owner must be over 59 ½ to avoid IRS early withdrawal penalties for non-qualified annuities).
Keys to Evaluating Annuities
As you can see, there are many types and variations of annuities. It can be difficult for someone unfamiliar to properly evaluate them. However, there are a few consistent factors you can use to evaluate any type. These factors are extremely important to know if you own or are thinking about owning an annuity, and most are referenced above.
If you purchase an annuity, how long do you have to wait before you can completely change your mind and take your money back out? If you’re under 59 ½, you’ll have to wait at least until this age to withdraw your money without a 10% IRS penalty.
For those that are over 59 ½, annuity surrender schedules still commonly range from 5-10 years (could be even longer). Surrender schedules are so important for annuity owners or prospective owners to be aware of.
What will you get from the annuity that you cannot get with other types of investments? How will the annuity grow in value over time? Will it provide lifetime income guarantees? Whatever you do, be sure that you clearly know how to answer these questions. Do not assume you know. Verify the answers by finding them in the contract in black and white.
Hopefully, this blog post has helped you understand the common fees associated with annuities. However, make sure you know each fee and know the total costs for your annuity or any you might be considering.
Strength of Insurance Company
As with any insurance product, the promises made are only as strong as the company backing them. Be sure to seek multiple agency ratings to confirm that the insurance company has a strong rating.
Be sure you understand what happens to your money when you pass away. Certain annuities die with the annuity owner. Others do not. Don’t leave any unwanted surprises for your heirs.
Is an Annuity Right for Me?
There are a few questions you can ask yourself to determine if an annuity is right for you.
- Am I okay with probability-based retirement planning or do I value safety first? The more traditional stock and bond investment approach is based on probabilities whereas annuity strategies are based more on safety first.
- Do I value optionality or would I prefer to lock in benefits and outcomes? Annuities are not known for being flexible, so if you think your plan may change, an annuity may not be the best fit for you. However, if you would like to lock in a certain level of benefits, annuities can help do so.
- Would I prefer to segment my income to certain windows of time or do I want perpetual income? For a level lifetime income, or continual “paychecks” in retirement, annuities are a good option. For changing income needs, a bucketing approach with stocks and bonds could be a better route.
- Am I focused on accumulation or distribution? Is your main goal to grow your money as much as possible? If so, a more traditional investment approach may be best. If income is your primary focus, the opposite would be true.
Are annuities good or bad? I don’t think anyone can say that all are either good or bad. There are ways that annuities can be used that make them beneficial to investors. There are also annuities that are misunderstood and overpriced, leaving annuity owners frustrated and restricted. Any time you don’t understand something, it can easily lead to even more frustration.
If you own an annuity or you are considering one, you can use this post as a guide to help you evaluate your decision. If you feel you need help evaluating your annuity, reach out to us and we are happy to give you a no-cost, no-obligation review of your annuity or any you might be considering to purchase. Give us a call at 618-288-9505 or email me at email@example.com.