Is An Annuity Right For You?
If you are considering an annuity, make sure you have all the information you need to make an informed decision. Annuities are sold by commissioned sales agents using tactics that are often questionable and sometimes predatory. (The same information broadly applies to the use of life insurance for investment purposes.)
While annuities can be beneficial for very specific circumstances, they are less-than optimal investments and most individuals are likely to benefit more from a well-diversified portfolio of stocks and bonds. Federal and state regulators have repeatedly called annuity sales practices into question, especially for the misleading way in which they are presented and the lack of easily-understood disclosures.
Following are answers to:
What is An Annuity?
What’s the difference between the types of annuities?
When is An Annuity A Good Idea?
What are the downsides of annuities?
How can I understand what my alternatives are?
What is an Annuity?
Despite how they are often sold, annuities are insurance contracts and not investments. An annuity transfers a portion of the risk of investing from the client to the insurance company. The insurance company then charges significant annual fees (sometimes as much as 7% or more of the account balance) in order to take on this investment risk. This compares poorly to ETFs and mutual funds, even if the investor is paying a professional personal financial advisor.
Annuities have four basic fees within the contract, with a profit element baked into each. First is an investment management charge, similar to the fees a mutual fund company charges. Second is an administrative charge to cover the insurance company’s operating expenses and profit. Third is the mortality and expense risk charge to pay for the life insurance built into the annuity as well as other risks to the insurance company. Finally is the surrender charge which is a fee to force you to keep the annuity contract for a period of time (sometimes more than a decade). The surrender charge is designed to make sure the insurance company makes enough money off the investor to pay for the salesperson’s commission.
These fees can be a major problem if the account balance diminishes due to extended periods of low returns. The insurance company will demand a significant immediate payment to keep the contract in force. If the investor can’t pay the additional amount, all previous premiums invested are lost.
Annuities are always sold on commission, with the sales company or sales representative earning a significant-up front fee to sell the annuity. Commissions can be as high as 8% of the invested amount for immediate annuities or up to 3 years of premium payments (investment contributions) for annuities where the investor is making monthly or annual contributions.
There are three basic types of annuities, and many insurance companies will mix and match the types with different types of life insurance to create new products. Sometimes, these new products can be to offer unique benefits, but they are also often used by salespeople sell annuities to people who have heard bad things about the previous ‘incarnations.’ Marketing terms like “Bank on Yourself”, “Personal Pension”, and others often further confuse the issue (and the public).
Fixed Annuity
A fixed annuity offers a set, ‘guaranteed’ interest rate similar to a savings account. As premiums are paid into the annuity contract, the balance grows, but is then reduced to pay for the annual fees the insurance company charges. During retirement, the rate of return and fees continue; and a fixed monthly income stream is provided to the retiree.
Fixed annuities are the simplest types of annuities to understand, but also generally have the lowest rates of return. If an annuity is right for you, the lower risk and return is actually a good thing, considering annuities are often used to avoid risk.
The guaranteed interest rate can be adjusted by the insurance company, and investors should be careful to understand how the guarantee works and how they might have their rate of return cut below the original guaranteed amount. Another major concern is the lack of inflation protection (or expensive inflation protection) associated with the annuity.
Variable Annuity
Variable annuities have a rate of return which varies based on stock values. This provides a partial solution to the inflation problem of a fixed annuity, but also exposes the ‘investor’ to additional risk. As premiums are paid into the annuity contract, the balance grows and possibly shrinks depending on stock values, and the balance is further reduced to pay for the annual fees the insurance company charges. During retirement, the variable rate of return and fixed fees continue; meaning the retiree will experience changes in their income from month to month.
Variable annuities are more complex to understand, and also expose you to more risk with potentially more return than a fixed annuity.
The fees associated with all annuities greatly reduce the rate of return, and investors should be careful to understand the true costs of the annuity to make sure it is worth the reduction in investment risk.
Indexed Annuity
One of the most commonly sold annuities, these annuities are hybrids between the fixed and variable annuities and are tied to the growth of a stock index. Premiums paid into the annuity contract are credited with a growth rate based on a complex formula. The rate of return has a fixed minimum amount so the annuity balance won’t lose value during market downturns. To pay for this benefit, the insurance company will keep most of the profits during bull markets through the Participation Rate and the Cap. The insurance company will also keep all dividends paid by the stocks. This makes indexed annuities very profitable for the insurance company.
Indexed Annuities are called by multiple names, including “fixed index annuity” and “equity indexed annuity.”
They are very complex products and are inappropriate for many investors due to their complexity.
When Does an Annuity Makes Sense?
There are a number of circumstances in which an annuity might make sense for an individual or a family. Annuities are not bad products, but they are unfortunately sold to people who would be better served with other investment and insurance alternatives. Here is an example of some of the scenarios where an annuity would make sense.
You make way too much money
You are already saving tens of thousands of dollars into investment accounts: maxing out your retirement contributions at work; your personal IRA contributions; and your contributions to applicable Health Savings Accounts, 529 Education Savings Accounts, and other tax-advantaged accounts.
If you are already saving the max you can to retirement and other tax-advantaged accounts, an annuity might be appropriate. One place an annuity shines is in the ability to allow someone to put extra money toward retirement when they’ve hit the cap on ALL their retirement accounts and other tax-advantaged accounts. Although an annuity only offers limited tax benefits (read more below) for an investor, it does offer some tax benefits. For this to make sense, you would need to already be saving $25,000 to over $100,000 each year into your other accounts.
The Stock Market is literally Causing you Health Issues
Your Doctor has diagnosed you with a medical condition caused by anxiety or stress, and you and your doctor have identified the stock market is a major factor in the stress.
If you are having medical issues due to stress brought on by swings in the stock market, paying the additional fees for an annuity might be well worth it to minimize the medical issue. The fact the insurance company is taking on the investment risk is a big plus in this circumstance, and will likely allow you a better return than a savings account. While annuities are expensive, the cost is worth your health.
You are buying an immediate fixed annuity to supplement Social Security
Social Security is not enough to pay for your basic living expenses such as rent, food, and medicine; and you are feeling anxiety about the size of your portfolio after meeting with a fiduciary and fee-only Registered Investment Advisor.
If you are already retired an annuity might be a good choice for a small portion of your retirement funds to provide you with your basic living expenses. Realize Social Security provides the same benefit, however, so an annuity may not be necessary to provide for your basic living needs. And if you also have a pension, the need for an annuity is unlikely. If you are highly risk averse, annuitizing a small portion of your portfolio to supplement Social Security for basic living expenses (like housing, food, and medicine) could be a good idea.
You or Someone You Care For Is Financially Incompetent
The person the money is meant for is incapable of managing money, and will likely run out of money if left on their own. This might be because of a mental disability, drug addiction, lack of maturity, or other factors.
A big disadvantage of annuities is that the recipient of the income stream doesn’t actually own the money in the account, the insurance company does. But if the beneficiary is financially incompetent, this becomes a major advantage. It is impossible to ‘run out of money’ when you don’t actually own and can’t access the money. In this case, the insurance company basically acts as a parent, managing the finances and doling out a monthly allowance.
What are the downsides of an annuity?
Annuity sales representatives rarely disclose the potential downsides of annuities and often use aggressive tactics to get investors to purchase the annuity. While there are bad actors, the majority of annuity advisers are good people who want to help their clients; but they may not realize the potential downsides of the product. There are multiple factors which cause these poor sales practices including; the conflict of interest created by commissioned sales, the fact annuity advisors don’t have a fiduciary duty to their clients, and the practice of insurance companies emphasizing sales training for the products.
Below are some of the biggest concerns related to the use of annuities or life insurance as an investment vehicle.
Low Rates of Return
Annuities have very low rates of return built into them, and over long time periods generally will pay out less retirement income compared to a balanced portfolio of stocks and bonds. Even variable and indexed annuities, which allow for ‘participation’ in stock market returns have rates of return which are significantly lower than investing directly in the stocks the annuities are based on. This is not a fault of annuities, it is a fundamental feature of the insurance company taking some (or most) of the upside in exchange for taking on some (or all) of the risk.
The problem is, the sales practices are often designed to show the annuity as the best of both worlds, beating other safe investment opportunities and using scare tactics to instill distrust in the stock market. Annuities are often presented with projections comparing the annuity to the returns of a savings account or a Treasury Bill. This creates a false sense of growth potential considering savings accounts and short-term Treasuries barely keep up with inflation. A true comparison would be to a diversified bond portfolio for fixed annuities and to a diversified portfolio of stocks and bonds for variable and indexed annuities.
High Costs
As mentioned above, annuities also have very high fees built into them, further reducing the investment opportunity relative to the potential opportunity of a well-managed portfolio of stocks and bonds. The fees associated with annuities can eat up nearly all of the growth of the investment over the first decade, and will greatly reduce the potential returns over longer periods of time.
While a fiduciary and fee-only advisor might have a total annual cost of between 1% to 2% of the invested balance (including fund management fees); an annuity might have a total annual cost of between 4% and 7% of the investment balance.
Lack of Liquidity
Annuities don't allow you to easily change investments once you begin the contract. Withdrawal fees (surrender charges) are significant and can last more than a decade. Once you sign an annuity contract, you have only a few days to cancel the contract and get your money back.
While traditional investment accounts might charge you $25 to $50 to close your account and get your money out; annuities can charge as much as three to four years worth of annual contributions. This often leads to the investor losing all of their invested balance to the surrender charge during the first three to ten years of the annuity contract.
Misleading Statements About Tax Advantages
The tax advantages of an annuity are over-sold and are significantly less than the tax advantages of an IRA or 401(k) plan. The only tax benefit annuities offer is the ability to avoid taxes while the account is growing. Unlike traditional retirement accounts, annuities don’t provide you with a tax deduction for contributions made to your retirement. And unlike Roth retirement accounts, the annuity income in retirement from account growth is taxed as ordinary income. Until you max out your retirement contribution limits, you are always better off tax-wise with an IRA or 401(k) plan.
Annuity advisors will often claim the annuity offers tax-free income in retirement. This is not true. Insurance payouts in retirement are taxed the same way (or worse) as any other taxable account with return of capital being tax free and growth being taxed as income. The advisor is referring to taking loans out against the policy, which isn’t income, it’s taking loans.
These loans must be repaid, have interest charges that eat into the cash balance, have immediate tax consequences due to the policy paying the interest, and create a higher risk the policy implodes leaving the investor with both a tax bill and depleted savings. The way the sales pitch gets around these problems is assuming the investor will die and all will be taken care of by the death benefit. Most retirees don’t like the idea of being forced to fix an imploded retirement by dying.Inflation Risk
One of the biggest concerns for retirees in retirement is inflation. Retirement income from most annuities aren't adjusted for inflation, so what seems like plenty of money at the beginning of your retirement will likely leave you in financial hardship toward your later retirement years. An inflation adjustment rider can be added, but you'll experience a significant reduction in the monthly income paid by the annuity company. Typically retiree must give up 25% to 35% of the original monthly retirement income to gain the inflation protection.
Single Company Risk
Annuities are often sold based on their financial security and the avoidance of stock market crashes. The problem is, there is still a risk, it’s just all of the risk in an annuity is concentrated in one insurance company. While regulations make insurance companies less likely to go out of business than other industries, insurance companies can and do go out of business. And if the insurance company you chose goes out of business, your annuity income will likely be greatly reduced or be eliminated altogether.
Choosing an insurance company with an excellent rating and a long history can help mitigate the risk. But when considering retirement planning, you need the insurance company to be around for decades in the future. A lot can change in a company’s financials over a 30 or 40 year time period.
Aggressive Sales Practices with no ongoing support
Annuity sales practices can be very predatory, and a bad annuity advisor (sales rep) can easily lead you to believe something which isn't true. Annuity advisors are also paid 100% on commission for selling the annuity, which means they have little incentive to help you in the future (other than to sell you another product). In fact, regulators have a name for the practice of immediately contacting a client when the surrender period ends to make another commission on a new annuity product. It’s called ‘churning.’
Annuity sales practices have often been identified by regulators as problematic and anti-consumer. And these annuity sales practices are one of the main reasons the Department of Labor attempted to implement their fiduciary rule.
As you are making this decision, you are likely talking with a 'financial advisor' who sells annuities. Realize these advisors are really commissioned product sales reps and you are getting advice with a high conflict of interest. You potentially will get a very well-rehearsed sales pitch disguised as advice, and you may not be presented with the downsides of the investment nor the alternatives.
How can I understand what my alternatives are?
If you are considering an annuity, make sure you have all the information to make an informed decision. You can get a second opinion from a fee-only and fiduciary financial advisor before you make this decision. Fiduciary advisors have a legal obligation to serve their client's best interests (most advisors don't) and the fee-only part means they don't earn extra money from kickbacks or commissions if you follow their advice.
RECEIVE A FREE ANALYSIS OF YOUR ANNUITY CONTRACT
To help combat the problems with annuity sales practices, Purposeful Finance offers a free annuity review so you can see how the annuity contract you are considering compares to the returns you might get in the stock market. We’ll use the information from the annuity company to compare how your investment might otherwise do in the stock market using their assumptions. Then, you’ll be better prepared to make an informed decision on what is right for you.
No person related to Purposeful Finance sells annuities, and the analysis will not have a pitch to buy a different annuity.