Annuities are among the most common financial products sold by financial advisors, brokers, registered reps and insurance agents. But what are they… and are they right for your retirement portfolio?
What Is an Annuity?
There are various types of annuities, but at the core, all are just a way to accumulate money and create a retirement income stream.
Basically, an annuity is a contract with an insurance company by which you pay the company a certain amount of money. That money is known as a premium. You can make either periodic payments or a lump-sum payment. The insurance company invests your premiums and in return will pay you a stream of income either immediately or at some point in the future. You may also be able to take a full or partial lump-sum payment as well.
Annuity premiums are paid with after-tax dollars. And the money is taxable at ordinary income tax rates. The money in the annuity grows on a tax-deferred basis. Annuities can also be held in a retirement plan such as a 401(k), 403(b) or an IRA.
Types of Annuities
Variable annuities (VAs) are invested in sub-accounts that are much like mutual funds. The amount available for distributions depends on the amount that you paid in and how well the underlying investments have done.
Variable annuity sub-accounts are offered in a variety of asset classes such as stocks, bonds, cash-like options and other sub-asset classes. Many popular mutual funds offer a VA version as well. Be aware, though, that even though these sub-accounts may sound like a popular mutual fund, they are different. They have a separate portfolio that may or may not be identical to the mutual fund’s holdings. Additionally, the sub-account will often carry the higher fees of the annuity contract.
Money contributed to a variable annuity grows tax deferred until either withdrawn or annuitized. (“Annuitizing” involves converting the total investment into the periodic payments you will receive.) VAs can be a good addition to your retirement savings efforts. But for most people, a 401(k) or IRA should be fully funded before going down this route.
- Another vehicle for tax-deferred investment growth.
- Many VAs are layered with fees.
- Sub-accounts are often inferior to their mutual fund “cousins.”
- All annuities can be problematic when it comes to estate planning.
Fixed annuities are issued by insurance companies and pay a guaranteed rate of interest. They can be deferred or immediate annuities. The fixed rate of interest gives retirees a level of certainty in terms of the rate of return. Often these vehicles pay a better rate of interest than instruments like CDs.
- They pay a fixed rate of interest.
- Most have low minimum investments.
- The deferral of taxes until annuitization or withdrawal.
- Sometimes the rate is fixed for only a certain period of time; the rate can then drop after this “teaser” period.
- When you annuitize, the payments are generally not indexed for inflation.
Immediate annuities generally allow you to begin receiving payments within 30 days of paying your premium. An immediate annuity can be thought of as the opposite of a life insurance policy. With life insurance, you pay premiums for a number of years and then your heirs receive a death benefit upon your passing. With an immediate annuity, you pay a lump-sum premium and then receive a series of monthly payments over the course of your lifetime.
- The ability to lock in a fixed income stream for your lifetime or a set number of years, depending upon your choice.
- Immediate annuities often provide a better return than safer instruments like CDs and money market accounts.
- Fixed immediate annuity payments can be eroded by inflation over time. Some contracts may offer an inflation rider, but there is a cost to this protection.
- Payments for a variable immediate annuity can vary over time and could be subject to the performance of the underlying investments.
Deferred annuities allow you to make a premium payment(s) and then defer annuitizing until a later date. As premium payments are made, the money is credited to your accumulation account. You then get a promised rate of interest (fixed annuity) or a return based upon earnings (variable annuity).
Both fixed and variable annuities can be deferred.
At some point in the future, the contract owner can choose to annuitize the contract for varying periods ranging from a guaranteed number of years to your lifetime.
- You can postpone taking the earnings or interest income and paying taxes on it.
- The returns on a fixed deferred annuity may not always be as high as other safe investment alternatives. You should make a full comparison before committing your money here.
- The tax-deferral aspect of a fixed variable annuity may not be advantageous if you find yourself in a higher tax bracket in retirement as many do these days.
Indexed annuities track the return of a market benchmark like the S&P 500. You receive a portion of gains on the index with downside protection. This limits your potential losses and may provide a minimum level of return. These are heavily marketed by annuity sales types as a way to get equity-like returns without the risk of the stock market.
- In the opinion of this writer, none.
- Limited upside participation in the underlying index.
- Complex structure with hidden fees and expenses.
- Some carry hefty surrender charges.
Longevity annuities are designed to ensure that the contract holder doesn’t outlive their money. These generally require that you wait until age 80 or older to begin annuitizing or withdrawing your money. Typically, you might invest a relatively small portion of your nest egg, leaving the rest in more traditional retirement accounts like an IRA or 401(k).
- Provides a backstop against running out of money later in retirement.
- Can have the same impact as buying a much larger immediate annuity.
- If you die before payouts begin, all of the money is lost to the insurance company.
Hefty Fees and Expenses
One of the disadvantages of many annuities is their high fees and expenses. The details on these fees and expenses are nearly impossible to find within the documentation provided.
It is not uncommon to see annuities with internal expenses exceeding 2%–3%. Also, many contracts have steep surrender charges that kick in if you try to remove funds from the contract prior to a set date.
Mortality and expense (M&E) fees are the charges by the insurance company to cover the costs of the insurance guarantees and the administrative expenses of selling and servicing the annuity. These charges are built into the contract and deplete the underlying returns and value of your account.
Surrender charges are used by insurance companies to limit withdrawals from the account during the early years of ownership. A contract might carry a surrender charge of 8% for the first few years that then gradually decreases over time. A contract might have a surrender period of eight, 10 or more years. I’ve seen some as high as 15 years.
Using 8% and a $100,000 balance, this equates to an $8,000 surrender charge if you tried to withdraw your balance. This applies even when you roll it over to an annuity at another company. These charges can be significant. So be sure to find out all of the details before writing a check.
Investment management fees are the fees charged to oversee your investments. These fees are rarely as low as those on an equivalent mutual fund. Often the M&E charges are hidden as part of the subaccount expense ratios.
Do Annuities Make Sense for Retirement Savers?
The answer, of course, is “it depends.” Annuities have both pros and cons. Some pros and cons are related to annuities in general. Some are specific to the contract you might be looking at. It is often said annuities are sold, not bought. This means too many annuity purchases are made as the result of aggressive sales tactics.
Here are some pros in favor of annuities:
- Your benefit is guaranteed by the insurance company. That said, make sure the company is financially sound. Defaults on annuities are very rare. But if the company can’t meet its obligations, your backstop is the appropriate state insurance commissioner. That may or may not cover your entire benefit.
- An annuity can be another leg of your “retirement stool.” It can complement other sources of income such as Social Security, a pension, and withdrawals from retirement accounts like a 401(k) or an IRA. The lifetime income can be a backstop, should you spend down your other accounts too quickly.
Some cons regarding annuities:
- High expenses on many contracts. This is especially noticeable on many variable annuities. The industry average is 2.26% per year lost in fees.
- Non-qualified annuities are taxed at ordinary income tax rates. These are annuities that are not held inside of a qualified retirement plan or an IRA. Your premium dollars grow tax deferred while invested in the contract, but the amount that is gain is fully taxable when withdrawn. The rest is considered a withdrawal of your premiums and is not taxed.
- A lack of transparency in many contracts. Trying to decipher the underlying expenses in some annuity contracts is a frustrating experience. These contracts are written by attorneys, and the language often doesn’t resemble plain English.
- Annuities can be tricky when it comes to estate planning. Be sure to consult with your financial or legal advisor.
Annuities in Retirement Accounts
There is much disagreement among financial advisors as to the wisdom of holding an annuity in an employer retirement account such as a 401(k) or 403(b), or in an IRA. There is no added benefit, as the distributions will be fully taxable upon distribution, unless some of the contributions were made with after-tax dollars. Some say the ability to annuitize is the benefit. You need to weigh the costs of the annuity to determine if this benefit is truly worth the costs.
Options for Beneficiaries
Annuities have a beneficiary feature. For spouses, continuation of the payments can be an option, though there are others. The options for non-spousal beneficiaries can be complex. The rules for a trust being a beneficiary are complex as well. Before buying a commercial annuity, you need to understand what happens to the contract upon your death and decide if this fits with your plans.
It is often said annuities are sold, not bought. If an annuity makes sense as part of your retirement planning, then become knowledgeable and informed. Don’t allow yourself to be sold a contract that is high priced and may not meet your needs.
Annuities offer a stream of guaranteed income that can enhance your retirement income. It is important to understand all the implications of buying an annuity, both pros and cons.