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Annuities: Pros, Cons, and What are They, Anyway?

by | Sep 28, 2021

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

Guarantees

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).

Retirement Satisfaction

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

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.

Surrender Schedule

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.

Benefits

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.

Fees

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.

Death Benefit

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.

Annuities for Retirees

Because certain annuities can offer a guarantee of income in the future, they may be attractive to investors looking to ensure a steady stream of income in retirement. With today’s low interest rates, market volatility, and economic uncertainty, it could be a good time to brush up on your annuity knowledge, especially if you’re thinking about retiring in the near future.

How do annuities work for retirees?

An annuity is a contractual financial product typically sold by an insurance company. In the most basic form, an individual purchases an annuity with a lump-sum payment and receives income in the future, either in the form of periodic payments or in a lump sum. Annuities often have an accumulation phase, when the lump sum is held and invested by the insurance company, and a distribution phase, when the owner receives the money back, with interest.

From fixed to indexed to variable annuities, these products can be designed to invest the funds in a variety of ways. Because there are so many types of annuities, there are also many riders and features that are available as add-ons to various annuity products.

But many advisors agree that consumers considering annuities should only purchase them based on the guarantees they offer. These agreements can include the income payment amount, the duration, and the rate of return promised during the accumulation phase. These guarantees are backed by the financial strength of the provider, so it’s important that investors purchase an annuity from a stable company.

Income annuities

For people seeking income during retirement, income annuities could be a good option. These products are structured to provide regular income payments to the owner at some point after the initial investment. For simplicity’s sake, let’s take a look at two types: single-premium immediate annuities and deferred-income annuities.

Immediate annuities work exactly how they sound. A lump-sum premium is paid, and the annuity income stream begins immediately. With deferred annuities, a lump-sum purchase is made, and annuity income payments are deferred to some point in the future.

The income can also be structured in different ways, including lifetime income, joint-life income, or income for a certain period of time.

Deferred annuity strategy for retirement income

With retirement planning, one of the main challenges is determining whether your savings will last as long as you need them. You simply don’t know how long you will live, so it’s impossible to know how long your money will need to last. With the promise of guaranteed lifetime income, income annuities can help solve this problem.

In retirement planning, the rate at which retirees begin to draw down money from their retirement portfolios is known as a “withdrawal rate.” For decades, many advisors used 4% as a “safe” withdrawal percentage, meaning that investors could safely withdraw 4% of their nest egg each year during retirement and feel confident that the portfolio would last at least 30 years. Today, due to low interest rates, many advisors think 3% is a better withdrawal rate. Of course, there is no guarantee that the portfolio will last that long.

But annuities can provide that guarantee. One retirement income strategy that has become popular among some pre-retirees is to purchase a deferred-income annuity during the last five to 10 years before retirement, with the intention of beginning income payments at retirement.

So what happens to the invested amount during the “deferral” period, or accumulation phase? Usually, the company offering the annuity product will provide a fixed return on the investment each year during the time the owner has allotted to wait until the funds are distributed. This means that your investment may not grow as much as your funds would if have if they had been invested in the stock market, but the benefit is that you are guaranteed a predetermined rate of return. This strategy can also potentially yield a higher average rate of return during the deferral period than alternative safe investment options like CDs.

Once that accumulation period is over, the investment is then annuitized into income payments. Depending on the age of the owner, there is a chance that the withdrawal ratio for a deferred-income annuity could be well above the 3% that many advisors use for investment portfolios today.

Maximizing guaranteed income for pre-retirees

But just as all investments have tradeoffs, so do annuities. The deferred-income annuity may be the best strategy for maximizing guaranteed income for the pre-retiree, but it comes at the cost of sacrificing flexibility. Much like creating one’s own pension, when a person purchases the annuity, in many cases, he or she would have little or no access to that investment as a lump sum. That means he or she wouldn’t have as much cash on hand if other expenses were to arise. You should work with an advisor to take that into consideration when crafting your retirement plan.

While some annuity products can have riders and add-ons that allow for increased flexibility, those add-ons can drive the benefits down. But if you don’t need those extra perks and flexibility and can afford to part with your money for a while, you’ll be able to get a richer benefit later.

While I understand why some selling practices and poorly implemented strategies have led to distrust among many consumers, those bad apples shouldn’t ruin it for the whole bunch. If structured properly, the right annuity could offer a smart strategy for income-seeking investors.

I’m not advocating for or against the use of annuities in any given portfolio. But for investors focused on income, certain annuities could be a solid tool for a portion of your portfolio, provided you fully understand the product, how it fits into your overall plan, and whether the advisor helping you purchase the annuity is looking out for your best interests.

Are annuities bad for consumers?

Like many things in the world of investing, it’s almost impossible to make a broad generalization about a specific investment and then claim that the generalization will apply to everyone. That’s the downside of any generalization, whether it’s regarding a type of investment or something else. Even if the generalization is true in most cases, there could still be outliers, or situations that show the contrary.

Therefore, my response to the question is “No, all annuities are not bad.” There are pros and cons to annuities, just like any other investment. With that said, let’s talk about things that are bad and how they could apply to the purchase of an annuity.

1. High Fees Are Bad

This is one of those generalizations that is true in every case I can think of. It’s straightforward. If you can lower your costs, you’ll get a better deal, and your investment is more likely to perform better.

How should you determine if fees are high? One thing that isn’t completely fair is to compare the costs of an annuity to the cost of a mutual fund or other alternatives, because the comparison is not equal. An annuity might provide benefits that the mutual fund account does not provide. To fairly identify if the fees for a specific annuity are high, you need to compare to a similar annuity, with similar benefits.

If you find a similar annuity product with significantly lower fees compared to an annuity that you own, that’s bad.

2. Not Understanding Your Annuity is Bad

Based on what I’ve read and heard, consumers often run into problems with their annuities because they didn’t fully understand how the annuities worked when they purchased the annuity. A good rule of thumb for consumers is to avoid anything that you don’t understand or can’t explain. You don’t have to become an expert, but you should be able to recite the basics. It’s also the job of the financial professional to help you with that, but we’ll talk more about that below.

One of the biggest things that cause annuity complaints is the lack of liquidity that comes with a typical annuity surrender schedule. In other words, early withdrawals could trigger surrender charge penalties of upwards of 10% in some annuity contracts I’ve seen.

Another big issue with annuities is the lack of understanding about how they can grow and how the benefits work. This is commonly seen with indexed annuities, where growth is often limited by an index cap or participation rate. If you own an annuity with these types of provisions, you should know what these terms mean.

If you are unaware of how the provisions in your annuity work, or if your financial advisor has not explained them to you, that is bad.

3. Buying Things You Don’t Need is Bad

Of course, we all aspire to get to the place of financial independence, where we can make purchase things we don’t need, or the “extras” guilt-free.

But, what about annuity “extras?”

Something that adds to the complexity of annuities, and hence the lack of understanding about annuities, are the riders that are often attached. These are optional add-ons that could come in the form of extra income benefits, death benefits, etc. They also come with a cost, but that doesn’t necessarily make them bad. If lifetime income is important to you, then a lifetime income rider could be a terrific addition for your annuity.

However, if income is not a concern, but you have an income rider that costs 1% per year, that’s bad. If you’re not concerned about leaving an inheritance to your heirs, but you have a death benefit rider that costs 1% per year, that is bad.

It’s imperative that you only add rider benefits that you need or want. Doing so will help lower costs and maximize your outcome.

4. Being Misled is Bad

Unfortunately, the distributors of some annuities are not held to a fiduciary standard. That is because annuities are insurance products sold by insurance agents. For those insurance agents who are not held to a fiduciary standard, their only incentive is to sell as much of their approved products as possible, to receive the maximum possible commissions.

I often hear radio commercials and television shows promoting certain annuity products, but these advertisements don’t share the entire picture. Indexed annuity advertisements, for example, usually include a claim that you can “Participate in the gains of the S&P 500 with zero downside risk.”

In most indexed annuity contracts, this is true. The growth options typically include some form of index option that is tied to the performance of an index like the S&P 500. However, they don’t mention that gains are limited by caps and participation rates, and that by participating in the annuity, you’ll have to give up full liquidity for 6, 8, or even 10 years. I would guess that many purchasers of annuities don’t fully understand these things up front, which leads to their dissatisfaction with these products.

It goes without saying that if there is an advisor making this misleading and incomplete claims, that is bad.

So, are annuities bad?

Does this mean that all annuities or indexed annuities are bad? Absolutely not. All annuities are contracts. If you find an annuity contract with provisions that suit your needs, for costs that are relatively low and fair, and you fully understand the limitations that come along with the contract, I think annuities can be a good financial tool.

All investments come with a tradeoff. If someone is presenting an investment to you that sounds too good to be true, it is. Run in the other direction.

Is an Annuity Right for Me?

There are a few questions you can ask yourself to determine if an annuity is right for you.

  1. 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.
  2. 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.
  3. 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.
  4. 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.

Bottom Line

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 joe@carsonallaria.com.

Joe Allaria, CFP®

Joe Allaria, CFP®

Wealth Advisor | Partner

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