Annuities Explained: What You Should Know

in Financial Planning, Retirement Planning by

Everybody knows about a checking account, advantages of a savings account or how to buy a certificate of deposit. However, if you ask them what an annuity is, you will probably get some shrugs. Ask a random person, “How much do you believe people in the United States have in domestic deposits in the bank versus money in annuity reserves held by insurance companies?”

  1. One dollar in annuities for every $3.3 in banks?
  2. One dollar in annuities for every $33 in banks?
  3. One dollar in annuities for every $330 in banks?

Most people would probably guess answers 2 or 3. In reality, there’s a large $1 in annuities for every $3.30 in banks for a product that isn’t very well understood.

What is an annuity?

An annuity is an insurance contract, a guarantee that you won’t run out of money in your retirement. An annuity can provide a steady stream of income for life. A guaranteed steady stream of income is the holy grail of financial planning, so why isn’t everyone flooding insurance companies to buy an annuity? Because any type of “guarantee” comes at a high cost and not everyone will need a guarantee.

A financially savvy person saving responsibly for his/her retirement might be able to self-insure. On top of that there are so many different varieties of annuities with hundreds of options, riders, disclaimers, footnotes and contingencies, making them extremely complex.

Different types of annuities

There are two basic types of annuities – immediate and deferred.

  1. Immediate annuity – If you need a guaranteed stream of income right away, you can convert a lump sum to an immediate annuity that pays out monthly, quarterly or annually. You can opt to get payments for a fixed number of years or until you die. Yes, if you have retirement savings, you can start drawing down from that but there is always the risk of running out of money if the money is no longer growing with inflation. For example,at age 50, if you want to retire and have $500,000 in savings, you can choose to park that in a Certificate of Deposit which will give you 2% at the maximum as interest. So the interest income will be $10000 or $833 a month. If you start drawing 4%, $20000 a year or $1666 a month you will run out of money in 30 years. If the interest rate goes down, you will lose the money even faster. Instead if you buy an annuity with the $500,000 for a male you can get an income of $2500 per month as long as you live; if you are female you can generate $2200 per month for lifetime (according to the quote I received from immediateannuities.com). Essentially you are buying the guarantee that however longer you live you will never run out of money.
  2. Deferred annuity – If you are years away from your retirement and want to make sure you have a fixed income coming in every month in your retirement, you can get a deferred annuity. You invest tax deferred money in the annuity to receive payments at a later date. Until you are ready to start receiving the payments you will money will grow tax free similar to your 401k.

Each of these can have multiple options – single premium, flexible premium, fixed annuity, variable annuity, life income annuity, joint annuity, equity-indexed annuity, to name a few.

  • Single premium – You buy an annuity using a lump sum.
  • Flexible premium – you pay multiple premiums to the company.
  • Fixed – Your money will earn a fixed interest rate set by the insurance company. When you begin receiving income, a fixed payment is guaranteed.
historical annuities rate
  • Variable – You money will be split into sub-accounts depending on your risk level, and be invested in stocks, bonds or other investments.  The annuity pays a minimum income which could go up depending on performance but the downside is it has substantially higher fees than mutual funds.
  • Equity-Indexed – A variation of a fixed annuity where the interest rate is based on an outside index, such as a stock market index. Similar to variable annuity this product pays a minimum rate which might go up if the index performs better.
  • Life income – You receive income as long as you live, even if payments exceed the amount of money you put into the annuity. If you buy an installment refund rider your beneficiaries will continue to receive payments even after you die until the total amount paid to you and your beneficiaries equals the premium. If you didn’t buy any rider, the insurance company will keep the money.
  • Joint and life income – Provides income as long as you or the survivor live.

The Advantages Of An Annuity

Annuities offer two types of benefits – tax related and investment related.

  • You will sleep well at night: Life expectancy has nearly doubled since 1900. One of the top worries among people saving for retirement is outliving their retirement assets. Annuities provide a solution for that. With the right annuity, you can get a guaranteed stream of income, however long you live. If that peace of mind is important to you, annuities are worth a look.
  • Control risks: A variable annuity will let you take risks (via the underlying investment options) while giving you some control of the outcome (via the option of guaranteed minimum income). So in a way it lets you take financial risk and reduce it at the same time. For example, if you get a variable deferred annuity with minimum income, you can get the peace of mind that you will receive $x no matter how you invest the money in the annuity. If your annuity’s performance is great you will receive $y (>$x) for life. If the performance is poor, you will still receive the $x promised for life. So you can take risks but can also have the peace of mind.
  • Tax deferral: When you buy a deferred annuity, the earnings are tax deferred. You can let the money grow until you start making withdrawals. If you are in a high tax bracket now and expect to be in a low tax bracket at retirement, this can add a good chunk of money to your nest egg.
  • Unlimited contributions – unlike the tax advantaged accounts like IRA or 401k, there is no yearly contribution limit for an annuity.  Annuities allow you to sock away a large amount of cash and defer paying taxes. This can be especially beneficial for people who are nearing retirement and have to catch up or people in a high tax bracket now, but who expect to be in a lower tax bracket during retirement. Yes, if you hit the megamillions jackpot, you can invest that in an annuity and postpone the day Uncle Sam knocks on your door.

You should run away from an annuity – disadvantages of an annuity

  • Annuities are too costly for the benefits they provide.  Below is a laundry list of costs that come with annuities.
    • Mortality and expense risk fee (M&E fee): This is the major fee (typically 1.25% per year) which pays for the carrier to assume the risk that you and other annuity owners will live longer than expected.
    • Annual contract fee: This fee might be a fixed dollar amount ($30 an year) or an expense ratio (typically 0.15% per year). For high value annuities, this fee might be waived.
    • Investment management fees:  This is similar to the management fees you would pay an investment manager if he manages your investments. Variable annuities can have a lot of subaccounts, each of them holding a different investment. Similar to mutual funds, if the investments are index funds or exchange trade funds, the fees is lower. If they are actively managed funds, the fees can be very high. You will also pay the underlying fund expense ratio.
    • Optional rider fees: You can add a lot of riders to your annuity like guaranteed living benefits for deferred variable annuity or long term care insurance. Each of these riders will cost money.
    • Commissions: When you buy an annuity through a broker you will pay a commission. The commissions can range from 1% to 10% depending on the product (the longer the surrender period, the higher the commission). Even if the broker tells you that there is no fees, read the prospectus thoroughly, it might be built into the annuity. Sometimes, this is included in the M&E fees, sometimes it is not.
    • Withdrawal or Surrender charges: Penalty/fees for taking out part or all of the cash value of the annuity prior to a specified date. If you invest the money and want to take it out before this date, you might lose a major portion of your money.
  • You already own an income annuityIt is called Social Security. If you have worked and paid payroll taxes in the United States for at least ten years (or forty quarters) you own an annuity from the Social Security Administration. If you are still in the workforce, you own a deferred annuity. If you are 65 or older, you can start taking payments immediately, which means you own an immediate annuity.
  • Reduced liquidity – Annuities provide a guarantee. To provide that guarantee you are giving up the access to your money for a certain period of time – the more generous the guarantee, the longer you will relinquish access. If you want to get your hands on the money, you will find out that annuity contracts have a lot of fees and penalties that might shrink your investments drastically.
  • Annuity taxation – Annuity earnings when you start drawing the payments are taxed as ordinary income. In contrast, if you owned mutual funds or stocks, you will be paying the long term capital gains rate on the earnings. The current ordinary income tax rate ranges from 10% to 39.6% depending on the income, whereas the long term capital gains tax rate is 0% for taxpayers in the 10% and 15% tax brackets, and 20% for taxpayers in the 39.6% bracket. This can make a huge difference, depending on your income at retirement.
  • Lack of transparency – Annuities are a very complex insurance product. You have to spend a lot of time and effort on research to make sure you are buying the right product for your needs.

Should You Get An Annuity?

You shouldn’t consider getting an annuity if you are not already taking maximum advantage of the tax advantaged accounts (401k or IRA) because these plans provide the same tax advantage but without as many fees.  If you have maxed out all your tax advantaged accounts, then you can explore annuities to see if they are right for you.

  • You are in high tax bracket: If you are in a high tax bracket and have money left over to set aside for retirement, if you park all of that in mutual funds, you will have to pay tax every year on those earnings. Depending on your goals, you might want to consider an annuity to set aside money tax deferred. Do the calculation to see what is more beneficial to your situation – paying taxes or paying the cost of the annuity. In a way, annuities are similar to whole life insurance. Whole life insurance’s goal is to provide for your family after you die, annuities are for you to get you through your retirement.
  • You really would like to have a pension and don’t mind paying for one: If you have low expenses and decent retirement savings but the idea of a pension really appeals to you, you might want to talk to a financial adviser to see if converting part of your savings to an income annuity makes sense.
  • You are a pessimist and running out of money during your retirement keeps you up at night: You believe the US economy is a gigantic house of cards that can collapse anytime. If you want to stick to safe investments in retirement like Certificate of Deposits and think the interest rates are going to be close to zero, you might want to convert your lump sum to annuities (see the example above in the “immediate annuities” part in the different types of annuities section).
  • You expect your life expectancy to be longer than average: Women on average live longer than men. If everyone in your family lives longer than the average person, take the longer life span into account when you work out the required retirement savings and check if an annuity will work for you.

Not all annuities are created equal and not all of them will fit your needs. Talk to a fee-only financial advisor and do all the calculations to figure out if an annuity is good for your retirement goals.

Before you buy an annuity

ANY contract you sign, ANY financial product you buy, it is always wise to ask questions and thoroughly understand what you are buying. Yes, there are regulations in place to protect consumers up to a certain basic limit but no one cares more about your money than you do. So before you buy an annuity make sure (1) you understand the annuity (2) you have done your research and believe you are a good candidate for this product (if you need assistance with this, talk to a fee-only financial advisor, do not believe the advice from the insurance salesperson who is selling you the annuity)(3) you are buying a product that is suitable for your needs and matches your goals and (4) you are buying it from the best possible source, taking the fees and risks into consideration.

To do this, here are some questions to start with –

  1. How will an annuity help my retirement?
  2. How will this annuity reduce my risk?
  3. Is the annuity adjusted for inflation?
  4. What are guaranteed retirement income benefits?
  5. What is my risk tolerance? How will buying an annuity influence my risk tolerance versus investing my money in a mutual fund?
  6. How much money should I put into an annuity? What percentage of my assets should I have in an annuity?
  7. What is the rating and strength of the annuity issuer?
  8. What are the fees? What are the upfront purchase fees? How much will it cost me every year?
  9. How will I be taxed? Will I be taxed when I draw the money? Or when I pay into an annuity or both?
  10. How do I get my money out?
  11. What if I need to cash out my annuity; how much will I get? What are the surrender charges and penalties?  Does my contract have vesting?
  12. If my needs change, can I exchange this annuity for another one? How much will it cost? How much money will I lose in the transfer?
  13. Is there a free look period and how long is it?
  14. Is my annuity inflation adjusted?
  15. What is your commission for selling this product?

Top resources for further research on annuities

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Suba Iyer
Suba Iyer is a blogger by trade and a personal finance geek at heart. After living from paycheck to paycheck in spite of her above average income, she figured money is not just about math. It involves human psychology, application of knowledge to individual situations and having all the right information. She now dedicates her time to writing about intelligently leveraging knowledge, time and money.

14 comments

  1. Financial Samurai

    Beast of a post Suba. Well done! I’ve thought about annuities for a while given the guaranteed income and tax deferred component. I guess it’s because I still like to be liquid, and I still believe in my ability to make money that I don’t want to lock my money up so much just yet.

    Maybe if I fall ill, or get in an accident or lose my hands.. I’ll invest in an annuity. But not now.

    Thanks for highlighting all the pros and cons!

    Reply
  2. Rob Thomas

    Hi Suba,

    This is a good post and I appreciate the balanced nature of it. At the end, you post that it’s advisable to ask what the commission is for selling the particular annuity. I assume this is because you think this could be a key motivating factor that could possibly thwart the salesperson’s ethics. I am also cognizant that much of the world has a fear of being forced to buy something they don’t need or want. What is viewpoint on why this question is advisable?

    Reply
    • Suba Iyer

      Suba Iyer

      @Rob, Yes the main reasoning behind the question is to see the real motivation behind the recommendation. It also will give you a better understanding of how open the adviser is with you. From my conversations with a few CFPs, this is a question they should be able to answer if they really think you need an annuity. A high commission doesn’t automatically mean the adviser is pushing something you don’t need. It will encourage an indepth conversation on “why” a particular product is a good fit. Question #1 will also address the fear of buying something they don’t need/want.

      Reply
  3. Rob Klein

    Not all annuities are taxed completely as ordinary income. Some annuities, such as single premium immediate annuities (SPIAs) and deferred income annuities (DIAs) purchased with after-tax dollars, have what is called an exclusion ratio. Part of the payment is taxable as income and the other part is considered return of premium.

    Where this comes into play is on tax planning for next after tax income, but also for Medicare premium surcharges. Medicare premiums are priced according to one’s modified adjusted gross income (MAGI). The exclusion ratio helps keep this down.

    The Treasury Department is allowing DIAs in qualified plans. They will help solve the guaranteed income problem stocks and mutual funds cannot solve.

    Reply
  4. Bob

    The comment about self insurance seems to indicate a lack of understanding of the point of any insurance. Why wouldn’t people self insure car or home coverage? Other risks? Insurance is a risk management tool. Annuities mitigate volatility and mortality risk. Brokerage institutions can’t do that. People pawn off risks they can’t handle. Insurance companies spread this risk over many many individuals as many types to………Educate yourself beyond populist, status quo drivel.

    Reply
  5. Drew Harrison

    Knowing your risk tolerance is a great tip I hadn’t thought of! If you have no idea what you can take then you’ll go crazy and stretch too far. What kind of tolerances would you recommend? Great post Suba!

    Reply
  6. Steven Harrison

    Thanks for this! I know a couple who were interested in getting a joint life annuity. They would do well to read through this article, so I think I’ll send it their way. Thanks also for pointing out the pitfalls.

    Reply
  7. Bill Barnett

    Annuities are an odd financial item. They can both make a person feel secure and stress out an individual. I didn’t know too much about the ins and outs of the subject before this article, but it seems that thorough research should be done before investing in an annuity. Who can I talk to to ensure I am getting the best financial advice?

    Reply
  8. James Bay

    I have been thinking about getting an annuity. I didn’t know about the immediate option. I will need to look into that. Thank you for the help.

    Reply
  9. Johnson McGee

    I like how you said, “If everyone in your family lives longer than the average person, take the longer life span into account when you work out the required retirement savings”. I’m going to look into this aspect of retirement. I haven’t even thought about it until now. Also, I’m going to open a 401K tomorrow. How much does it cost to open one?

    Reply
  10. Andre Beluchi

    Suba, it seems like you sure know very well about annuity. Do you by chance know if there are any type of cash for annuity program available? I mentioned this because of a friend that talked to me about this type of program that got me interested.

    Reply
  11. Paul Marble

    Looking for legitimate source to sell portion of my retirement annuity for debt consolidation and small business

    Reply
  12. Rockford Johnson

    Cool post! I learned a lot about annuities by reading this article. Thank you for explaining how “An annuity is an insurance contract, a guarantee that you won’t run out of money in your retirement. An annuity can provide a steady stream of income for life.” I don’t know much about annuities so it was really good learning about them and how they can help people.

    Reply
  13. Deb Pearl

    I have never heard of an annuity before. That is good to know that it is an insurance contract that guarantees that you won’t run out of money in your retirement. That is really great that it can provide a steady stream of income for life as well. I will have to see if my parents know what an annuity is. Thank you for the information!

    Reply

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