Should you buy an annuity? This decision ultimately comes down to determining what problem you are trying to solve and then seeing if an annuity solves it. As financial planners, we have seen many annuities sold to people that did not provide the benefits they were looking for, or did so at a cost that outweighed the benefit provided. It was always because the clients didn’t know what questions they should be asking. 

Many people are looking for an income stream in retirement that will cover their expenses. Some types of annuities can provide the first part of that equation (a guaranteed income stream that can last as long as you live), but they often fall far short of the “cover expenses” part, especially considering the rising cost of living (aka inflation).  

An annuity is just one tool in the toolbox when it comes to crafting a complete financial plan. It is important to understand what an annuity can and cannot provide. Annuities certainly have their uses, but we find they are often too broadly recommended, and their downsides are not explained sufficiently, if at all. We will attempt to rectify that in this blog.
 

What is an annuity?

Annuities come in two main varieties: accumulation-focused annuities designed to grow a pool of assets, and income-oriented annuities designed to provide an immediate or future income stream that may be guaranteed to continue for life. In this article we will focus on income-oriented annuities. These come in many varieties based on when income is to start being paid and how income values are determined.  

Immediate Annuity: You pay the insurance company a lump sum, and the company pays you a monthly/quarterly/annual payment for a specified period. With an immediate annuity, you usually lose access to the lump sum you paid to the insurance company. In return for a smaller regular payment, the contract can be designed to leave to your heirs any portion of the lump sum not already paid out in income if you pass away before receiving the full amount of the lump sum back in your payments. 

Deferred Annuity: You pay the insurance company a lump sum, and you can decide at a future date to ask it to pay you a monthly/quarterly/annual payment for a specified period or for life. With some types of deferred annuities, you can withdraw up to 10% of the account per year without penalty before starting to take income, but other withdrawals from the lump sum may be subject to surrender charges over a period of time, usually seven to 15 years. These charges can range from 0% to 10% or more of the lump sum amount. The point of the annuity is to eventually draw the periodic payments, so making withdrawals is not ideal. 

Within immediate and deferred, you can have the following annuity types. 

Fixed Annuity: The payment amounts are determined when you start receiving payments, and they never change. They are based on your life expectancy and interest rate at the time income starts. In a fixed annuity, your payments are not tied to investment markets in any way and will never decrease (although they will buy less over time). Some contracts provide the option to have payments increase over time; selecting this type of income results in significantly smaller initial payments. 

Variable Annuity: The payments fluctuate based on underlying mutual fund–like investments available in the contract. You may decide how to allocate your lump sum within a limited selection of options available in the contract. Your payments may go up or down along with the value of the selected funds, but they will have more potential for long-term growth than a fixed annuity can provide. 

Index Annuity: These are designed to be a hybrid of fixed and variable annuities, providing some of the growth associated with a variable annuity, plus the protection against loss associated with fixed annuities. The return each year is tied to the market performance of one or more indexes chosen from a selection offered in the contract. If the index goes down in a year, the contract sets a loss floor that may prevent any losses or may limit them to a particular value, such as 10% of the contract. If the index rises, the return of the contract is limited to a portion of the increase in the index. It is important to note that index increases are limited to price changes only, not incorporating income received from dividends. Dividends can make up 30% or more of returns when investing in an index, so limiting portfolio growth to price movement only is very restrictive. These are sometimes referred to as equity index annuities. 

The limitation on upside returns is one of the most dangerous features of an index annuity, as most long-term stock returns come in periods of significant volatility, both up AND down. Market returns are never an even +8% every year; they are +23%, -15%, +2%, -10%, +18%, etc. By limiting your annual returns, you are seriously reducing your potential for long-term portfolio growth. Index annuities are complicated products that are often a terrible deal for investors, so much so that the SEC has issued an investor warning. 

Riders

A rider is an additional feature added to an annuity for an additional cost. Riders provide specific benefits, such as a guaranteed increase in potential annuity income or a death benefit. All riders come with fees as well as restrictions in order to obtain the maximum benefit available from the rider, such as limitations on withdrawal amounts. Many riders will stop providing benefits at some point, such as when income begins to be taken from a contract or once the annuitant reaches a certain age.  

Given the costs and restrictions involved, it is reasonable to ask if you would be better off just keeping your money invested versus buying an annuity with an expensive and restrictive rider. 

The point of the annuity

With so many different types of products that do vastly different things, it’s no surprise that many consumers get confused.  

Regardless of how the product is structured, the general purpose of an income-oriented annuity is to provide a guaranteed stream of income for a certain period of time, usually the life of the individual. The guaranteed stream of income is the differentiating factor between annuities and other investment options. Going back to our question, what problem are you trying to solve by purchasing the annuity? 

What are the benefits of an annuity?

The benefit of an annuity is that it provides a guaranteed stream of income for a period of time. A lifetime annuity means that you can’t outlive this income regardless of how many years you are on this earth.  

The insurance company is generally taking the investment risk, not the person buying the annuity. This is not the case with the stock market. Although historically the stock market has always gone up over time, the ride has been very bumpy along the way. Having an annuity alleviates some of this concern because once you begin receiving the income, you receive it regardless of what the stock market is doing. This guaranteed stability can be attractive to retirees at the time they purchase the annuity. 

What are some annuity downsides?

As with anything in life, there are tradeoffs when it comes to purchasing an annuity. In order to receive a guaranteed source of income for life, regardless of what the stock market is doing, you need to give up something. It is important to understand these tradeoffs.  

Fees:

One thing that annuities are known for is high fees. The fee structure of some annuities can be confusing because the fees come in multiple layers. Fees for fixed annuities may be difficult to see because they are built into the rates offered on the contract (e.g., the company expects to earn 6% on its investments and offers to provide 4% to the owner of the contract).  

• Mortality and expense charges are incurred annually to compensate the insurance company for the risk it takes. 

• Administrative fees that are separate from all other charges may be charged annually. 

• If your annuity comes with investment options (a variable annuity), those specific investments will have fees associated with them, similar to a mutual fund expense ratio.  

• A deferred annuity normally has a surrender charge — a fee that is assessed if you decide to cash out your investment or withdraw more than a certain amount of the account, usually 10% of the value in a one-year period. The surrender charge often declines annually after the purchase of an annuity and disappears after seven to 15 years. It can be quite costly if you need to cancel the product before the surrender period is over.  

• Fees will be charged for every rider attached to the product. These fees are often based on the potential income provided from the rider, rather than on the current account value. 

• Depending on the product, there may be other fees or costs not discussed here that are unique to that product. 

Knowing how much the product will cost you in total can be challenging to calculate and surprisingly expensive. Depending on the annuity, fees are often 2%-3% of the investment per year with no rider, and are often 3%-4% for a variable annuity with an income-oriented rider. This can potentially be a major drawback when it comes to deciding whether to buy an annuity as part of your financial plan. 

Control:

Another consideration with annuities is that when you buy an annuity, you give up a large amount of control over how to spend those assets. You can spend the monthly income stream you receive for life any way you want, but the money spent on buying the product is usually committed to that contract forever, or may be accessible only with significant consequences for the income you purchased the product to provide in the first place. The vast majority of income-oriented annuities will deplete their account values and death benefits relatively early in your retirement, unless the annuity comes with a death benefit (which would include another fee or a reduced monthly benefit). This means that in most cases, you no longer get to decide where that money goes when you pass away. You have spent the money purchasing the annuity stream of income. If the money had been invested instead of handed over to the insurance company to buy the annuity, the investment balance and earnings would pass to your heirs.  

Inflation:

Generally, over time, the cost to acquire products and services to maintain your standard of living increases. Inflation is the silent killer of many retirement plans. One of the historically best ways to combat this is to invest in the stock market, which over a longer time horizon has not only kept up with but increased in value faster than inflation. Although the stock market will not be a smooth ride — it will fluctuate up and down, sometimes severely, over the days, months, and years of your investing timeline — it’s one of the historically best ways to fend off inflation.  

When you buy an annuity, you don’t have to worry about the stock market dropping, unless it’s a variable annuity. But what often doesn’t get discussed is that the monthly payment you receive will usually not increase over time. Even if the amount you receive monthly covers your expenses today, it is unlikely that the same monthly payment will cover the same expenses 10, 15, or 20+ years from now. While you may reduce or eliminate your market risk, in its place you may take on additional inflation risk in your retirement plan. If you don’t have other assets to use outside of your annuity, your financial plan may still be in trouble if you did not account for this.  

As with many aspects of annuities, you can reduce the inflation risk by also purchasing an inflation rider under which your monthly payment will increase for inflation over time. However, the cost is that your starting monthly payment will be much lower than it would be if you elected to not have it increase. Also, it will likely result in yet another annual fee. 

You should go back to the original question: What problem are you trying to solve, and does purchasing the annuity solve it or cause new issues? 

Taxes:

Annuities may be purchased inside of an IRA as “qualified annuities” or may be purchased with taxable investments, in which case they are often called “non-qualified annuities.” For qualified annuities, all withdrawals will be taxable as income. For non-qualified annuities, the tax treatment of payments may be complicated, and is sometimes less advantageous than the tax treatment available in an investment account. 

Gains from a non-qualified account are taxed at ordinary income tax rates, the same tax treatment given to IRA distributions. This is the least desirable type of income when it comes to investments. The only type of income earned on a taxable brokerage account that is taxed at ordinary income tax rates is interest and short-term capital gains. Most of the gains on a taxable brokerage account are taxed at lower rates of 15%-20% for qualified dividends and long-term capital gains. 

For some types of income from annuities, the IRS will consider a portion of each annuity payment as income and a portion as principal. It will often take you 150-200 months (about 15 years) to get your money back, and you will still pay taxes each year on a portion of those annual payments.  

For other types of income from annuities, your income will be assumed to be entirely gain, taxed at ordinary income tax rates, until the value of the contract equals or is below your original investment. This is sometimes known as LIFO (last in, first out) tax treatment.  

Note that annuity terms vary significantly based on interest rate, age, the funding method used, and the specifics of the contract. You should speak with an annuity licensed agent regarding specific annuity benefits, terms, and conditions. 

So, should I buy an annuity?

As we’ve discussed, by buying an annuity, you can receive a guaranteed source of income that you cannot outlive. But this comes with some serious drawbacks, such as giving up control of the money, high expenses associated with the product, and a lack of inflation protection for your money. 

Each financial plan is unique, so it is difficult to provide clear-cut rules as to who should buy an annuity. An annuity is just another tool in a financial toolbox and should usually be used to complement a comprehensive financial plan, if used at all. Rarely should an annuity be the only source of income used in a plan, because of the loss of control of the capital during your lifetime. However, if accompanied by a diversified investment portfolio and cash savings, an immediate fixed annuity can have a place in a financial plan for someone who is extremely risk averse.  

The cost of the annuity and the amount of the monthly payment as a percentage of the cost are determined by your age, interest rate, and other factors at the time of purchase. 

Ultimately, the decision to buy an annuity is based on what risk you are trying to mitigate. The biggest risk to your portfolio is often the rising cost of living, not short-term stock fluctuations in your investment portfolio. The best protection against the rising cost of living (think of the cost of a postage stamp) is usually owning stocks. A fixed-payment product like an annuity will give you a monthly payment you can’t outlive, but it may end up being so small (in terms of purchasing power) at the end of your life that you would have been better off keeping that money invested. Understanding your goals, objectives, and risk tolerance is key to determining whether an annuity is appropriate for you.  

Summary

When used appropriately, an annuity can be a useful tool in a complete financial plan. Too often we see annuities being inappropriately recommended or being overly complex and expensive for the client’s situation. You should carefully review the benefits, risks, and costs of an annuity by reading the annuity contract before you purchase to determine if it works well in your financial plan. If you need help reviewing your financial plan or your retirement strategy, please reach out to a member of our team.