An annuity is a contract sold by an insurance company. The buyer is either insuring against living a very long time or seeking a way to defer taxes.
Insurance companies exist to make money. This means if their math and projections are correct, most buyers will be worse off, but some will be better off.
Annuities have two phases – accumulation and payout. During the accumulation phase the customer is making payments to the insurance company, building the investment value of the contract. Most deferred annuities can be “surrendered”, or terminated for a cash value, during this phase. The payout phase begins when the customer “annuitizes” the contract and begins receiving income, thus reversing the direction of cash flows. In an immediate annuity, this happens immediately. Once annuitized, the customer typically loses the ability to terminate the contract and collect its cash value.
A major potential benefit of annuities is the stability of payments once annuitized. There is some evidence that retirees with steady annuity income are less prone to depression than those responsible for generating their own income from 401K plans.
A major problem with most deferred annuities is cost. The typical cost of owning a deferred annuity in the accumulation phase is between 2.5% and 4.0% annually, and there are often additional sales charges. These costs are extremely onerous and are the main reason most deferred annuity purchases turn into mistakes.
This chart shows the impact of a 3.5% annual fee on a $100,000 investment in the S&P 500 over the last 15 years.
Over this period, the market provided a reasonable return but investors subject to the type of high fees associated with many variable annuities would have suffered a meaningful loss instead. Annuities often offer “guarantees” against losses, but these usually only come into play if they are annuitized. As an investment to be cashed out, many annuities come pretty close to guaranteeing a lack of any meaningful gains.
Here is a breakdown of the major costs embedded in most deferred variable annuities:
- Separate Account (Administration) & Mortality Fees: 1.0% to 2.0%
- Investment Fund Fees: 1.0% to 1.5%
- Guaranteed Minimum Income (If selected): 1.0% to 1.5%
This is in addition to potential sales or surrender charges of up to 8%. Like mutual funds, costs vary significantly. There are some annuity providers with considerably lower fees.
To Annuitize or Not to Annuitize
It is estimated that less than 10% of people who buy a deferred annuity actually annuitize it. This means the vast majority of consumers end up using annuities as an investment vehicle rather than an insurance vehicle. Unfortunately, annuities are rarely good investment vehicles, primarily due to the fees described above.
Deferred annuities probably don’t make sense unless:
- You have a legitimate reason to believe you will live a lot longer than average, and
- You plan to annuitize
Immediate annuities typically have lower fees and are more likely to play a constructive role in retirement plans. For perspective, we recently looked at a popular single life fixed annuity for a 65 year old. It paid roughly 6.4% per year. As an alternative, one could buy a 30 year Treasury yielding about 3% and sell enough to generate the 6.4% income each year. The Treasury strategy would run out of money at age 87. For a 65 year old male, there is roughly a 40% chance of living past 87. This means buying an annuity added value less than half of the time. However, these are still attractive odds for those concerned about longevity risk. If you are willing to take some risk with small amounts of stocks and higher yielding bonds, annuities look even less attractive.
Types of Annuities
In very broad terms, there are four major types of annuities:
- Fixed Immediate – Provides a pre-determined periodic payment to the customer beginning immediately. It is generally funded with a lump sum.
- Fixed Deferred – Provides a pre-determined periodic payment to the customer after some period of time, which is called the accumulation period. It can be purchased with a lump sum or through periodic payments.
- Variable Immediate – Provides a periodic payment to the customer, beginning immediately, which varies based on the performance of underlying assets. It is generally funded with a lump sum.
- Variable Deferred – Provides a periodic payment to the customer, beginning after some period of time, which varies based on the performance of the underlying assets. It can be purchased with a lump sum or through periodic payments.
Most variable annuities switch to a fixed payout schedule once the accumulation phase ends and the payout phase begins.
- Life Annuity – Provides regular payments for the life of the policy holder. These tend to be favorable for the buyer if they live longer than expected, otherwise the insurance company benefits.
- Life With Cash Payment – Provides a regular payment for life, but pays a balance to a beneficiary if the amount paid out is less than the contributed amount.
- Life with Term Certain – Provides a regular payment for life, but pays a beneficiary for a set amount of time if annuitant dies before that time.
- Joint and Survivor – Provides income for the life of the annuitant and a designated survivor.
- Fixed Period – Provides fixed payments for a specified number of periods.
Typically, if the holder dies during the accumulation period, the value is passed on to beneficiaries. If the holder dies during the payout phase, all remaining value is lost. Death benefits during the payout phase can often be included in exchange for lower payouts.
The Three Primary Benefits of Annuities:
- Some annuities protect against the risk of living a very long time
This is the primary reason to buy an annuity, in our opinion. If you buy a “Life” annuity and end up living a very long time, you may get more money back than your original investments may have otherwise provided. The insurance companies know this, so you will have to really outlive the averages for it to pay off.
- Annuities can make planning easier by reducing uncertainty
Many annuities provide relatively stable payments, which reduces uncertainty. This is good, but it must be balanced with expected return.
- Investments grow tax-deferred (and why this isn’t always a benefit)
Annuities are usually funded with post-tax dollars and grow tax-deferred. If you withdraw money, you pay ordinary income tax on the amount received beyond your contributions. For most people, this means the annuity structure works in your favor when you hold high yield bond investments and doesn’t provide much benefit with stocks. This is because bond interest is taxed as ordinary income and will grow much more efficiently in a tax deferred account. Tax rates on stock dividends and capital gains are typically lower, providing less of a benefit from deferral. Often, the benefit is also lost by higher income tax rates when withdrawn. All of this is subject to a lot of uncertainty because we don’t know what tax rates will be on capital gains, dividends, or income in the future. You should almost never buy a deferred annuity with money that is already tax deferred in an IRA account.
And Five Major Problems:
- High fees
Annuities generate high margins for the insurance companies, who in turn pay large commissions to those who sell them.
- Inflation risk
Annuity payments are generally not adjusted for inflation. This means the value of the payments will be severely reduced if there is a period of high inflation.
Most annuity holders don’t understand their contract. Annuities are designed to sound great, but buried in the pages of fine print are clauses often showing they aren’t.
- Loss of access to principal
Once annuitized, you can’t access the principal. Flexibility and liquidity are very important because life is uncertain.
- Solvency risk
While rare, insurance companies can go bankrupt. If they do, annuity holders may lose some or all of their investment.
What if You Already Own a Deferred Annuity?
Every situation is different. If you are young and own a high fee deferred annuity, it likely makes sense to surrender and move on, even if it involves a steep penalty. If you are in or nearing retirement, you should evaluate the present values of the surrender amount and the expected cash flows if you annuitize.
Be wary of looking to another broker for advice – it is quite common for people to get talked into switching from one expensive annuity to another, with only the broker benefitting. Annuities are very confusing, often with 100 page prospectuses purposely designed to make it more difficult to make the right decision. But they are valid, legal contracts. When in doubt, the best thing to do is set aside a few hours, sit down with your paperwork, and understand your options. After that, you will usually know the best course.
Most people won’t benefit from buying an annuity.
If you expect to live into your nineties, a portion of your investment portfolio in annuities can make sense. To do so, you must utilize immediate annuities or actually annuitize your deferred annuity at a reasonable point in time.
Another situation where annuities are very helpful is to provide a stable source of income for individuals who would otherwise overspend if provided immediate access to money.
If you do buy an annuity, shop around. Some annuities are much better than others. Always do your own comparisons and never be sold. Never buy an annuity you don’t fully understand.
Craig Birk, CFP®
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