In my experience as a financial professional, I have found no financial product to be more polarizing than an annuity. Some folks love them, but others consider annuity to be a bad word. Even financial advisors of different types seem to be all over the board. Famous money manager and Forbes columnist, Ken Fisher once proclaimed “I Hate Annuities and You Should Too.” You can also easily find advertisements from insurance agents that will make you believe an annuity is the best thing since sliced bread (and can cure male pattern baldness). When combined with the blanket advice for the masses from financial gurus on TV and radio, it is no wonder many are puzzled by annuities. As with anything, the truth often lies somewhere in the middle. We will further explore some annuity basics, how they may fit within a financial plan, and considerations before purchasing an annuity.
In its simplest form, an annuity is an agreement between you and an insurance company to provide you with payments over a specific time period. You will often turn over a lump sum of money in order to receive the guaranteed payments for a period of years or more commonly for life. Financial historians can trace the origins of annuity-like arrangements dating back to Ancient Rome or possibly earlier. Because of the uncertainty of our own longevity and desire for stable income, you can see why annuities might be attractive to some folks (particularly those that anticipate a long life span in retirement for them or their spouse).
One of the reasons I believe annuities are often misunderstood is because of the various types of annuities that are available and have been marketed through the years. Below are some of the common types of annuities.
USA Today “Why you should consider annuities in your retirement planning.”
- Immediate vs. Deferred
Immediate annuities, which are sometimes called single premium immediate annuities (SPIA), or income annuities are one of the simplest forms of annuities in that you turn over a lump sum of cash in exchange for a pension-like income over your lifetime. These are usually purchased to provide a regular paycheck during retirement and can often provide the most income for the dollar amount invested. The major downside with this type of annuity is that you lose control of your money once the payments begin and your family may not get any of the money originally invested once you pass away.
Deferred annuities are most often purchased to accumulate money for retirement goals rather than providing immediate income. The annuity growth rate depends upon the type of annuity that you purchase. They can be either fixed (pay a fixed rate of interest that is guaranteed at purchase), variable (investment growth or loss will be based upon the investments you select), or fixed indexed (interest is credited based upon the performance of a particular index such as the S&P 500).
While both fixed and fixed indexed annuities do protect your money from experiencing market losses, your growth potential is also limited. Variable annuities may provide you with more growth potential but also carry additional fees. Additional features like death benefits and lifetime income benefits come with additional fees which may erode the overall growth of your money and could mean leaving less to your family than would be available from traditional investments.
An important aspect of annuities is that they are designed to be purchased as long-term investments with limited accessibility (particularly in the early years). In order to recoup their marketing costs including commissions paid out to salespeople, insurance companies will charge a penalty if you access more than a certain amount per year (typically 10% per year is accessible without penalty). The penalties can range from 10% to 2% and go down over a period of time known of as the surrender period. Additionally, fixed and indexed annuities may carry what is known as a Market Value Adjustment (MVA) that can decrease the value of amounts withdrawn during the surrender period. It is a good idea to have planned ahead and not put too much of your portfolio into an annuity to give you flexibility for whatever life may bring your way.
Tax and Estate Considerations
One benefit available through deferred annuities that are purchased using non-qualified funds (money not coming from an IRA or other retirement plan), is that the interest and growth you accumulate will be tax-deferred until it is distributed. Once the money is taken out, you will be taxed on the growth first at your current income tax rate. While the growth is tax-deferred it is not treated as capital gains, which may be taxed at a lower rate. Annuities purchased from money in IRAs, 401(k)s, 403(b)s, etc. do not receive any additional tax benefits because these accounts are already tax deferred. If you like the idea of an annuity for tax reasons, you should see if the additional fees outweigh the potential tax benefits to you.
Annuities do allow you to name a beneficiary, so that if there is money left at your death it will be payable to your beneficiaries and will avoid probate. The tax benefits of deferred annuities do not continue to non-spouse beneficiaries, and they do not get a step-up in the cost basis at death like is available on real estate and other investments. The beneficiaries will need to choose how to receive payments from the account (lump-sum, payments over 5 years, payments over their lifetime). One particular strategy that we have employed for wealth transfer to children is electing a non-qualified stretch annuity. This allows the beneficiary to defer gains over their lifetime but requires them to take a minimum distribution each year. If a distribution is not taken, then the annuity becomes payable in full as a lump sum.
While many investors seek annuities for the guarantees they provide, it is important to remember that a guarantee is only as good as the entity providing it. Do your homework on the history and financial strength of the insurance company backing the annuity before purchasing. You should understand key terms and how interest will be credited to your contract. If you are feeling unsure or can’t easily explain the annuity to your partner or family member it is probably best to walk away. Complex products often lead to disappointing results for investors, so never invest in something you don’t understand. A true fiduciary will take the time to make sure you are comfortable and understand how any recommendation fits within your plan as well as the tradeoffs.
Because of the varying types and complexity of annuity products, it is no wonder they are often misunderstood by investors. The financial incentives of money managers and insurance salespeople may also taint their views on annuities so it can be helpful to take them with a grain of salt when making decisions regarding your hard-earned money. Annuities are not right for everyone, but when used properly they can be a tool to solve for retirement income needs after you have maximized income from available pensions and Social Security. When it comes to annuities, simpler products are often better. If it sounds too good to be true it likely is.