Author: Nick Prigitano
Annuities. Often considered a dirty word to both financial planners and consumers alike. As financial planners, we have seen many annuities sold to people who later regret the purchase. Whether they are high in fees, inflexible, or just not quite what they thought it was, many times these purchases come with buyers' remorse.
Like any tool in a toolbox, an annuity is just another weapon in a financial planner's arsenal when it comes to crafting a complete financial plan. However, you have to understand what the annuity will and will not do. Annuities certainly have their uses, but we find they are often too broadly recommended, or incorrectly avoided, based on preconceived notions about the product. Here's what to consider when deciding whether to buy an annuity or not.
What is an annuity?
When it comes to annuities there are many different kinds. You can purchase a variable or a fixed annuity, immediate or deferred, a single contribution or numerous contributions over time. 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, at the end of the day, the general purpose of an annuity is to provide a guaranteed stream of income for a certain period of time, usually the life of the individual, and possibly their spouse as well. The guaranteed stream of income is the differentiating factor between annuities and other investment options.
What are the benefits of an annuity?
Although annuities get a bad rap, they certainly can provide numerous benefits when used appropriately. Mainly, they provide a guaranteed stream of income usually for the life of the individual. This means that you can't outlive this income regardless of how many years you are on this earth.
Although it may not seem like it, retirement can be a long time. If you retire at 65 and live to 95, that's 30 years' worth of time where you’ll need your assets to cover your expenses. No one knows for certain how long they will live - this is a huge unknown in a financial plan, but a critical one that must be accounted for. You can't outlive a lifetime annuity, which is probably it's biggest benefit when considering how to fund a potentially long retirement.
Another benefit is that it is a guaranteed source of income for your life. How can the income be guaranteed? It's guaranteed because an annuity is essentially a contract between you and the insurance company which says if you provide a certain amount of money (terms vary) then the insurance company will provide you income for as long as you live.
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 are receiving the income, you get it regardless of what the stock market is doing. This guaranteed stability can be attractive to retirees who want to live on a fixed income in their golden years.
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's important to know the tradeoffs so you, and your financial advisor, can help make the decision of whether the pros outweigh the cons with this financial product.
One thing that annuities are known for are high fees. Like many financial products in recent years, the costs associated with annuities has come down, but some products can still be quite expensive. The fee structure of some annuities can be confusing because they come in multiple layers. Also, fees for fixed annuities tend to be less than variable annuities, because the products are simpler.
There is a fee to acquire the product in the form of some sort of sales charge, or annual management fee.
If the annuity doesn't start right away (a “deferred annuity”), there is normally a "surrender charge" - a fee that is assessed if you decide to cash out your investment (or change to a different type of product) before a certain amount of time has elapsed from the purchase date (often 7-15 years). The surrender charge often declines annually, but can be quite costly if you cancel the product before the surrender period is over.
Mortality charges compensate the insurance company for the risk it takes
If your annuity comes with investment options (variable annuity) those specific investments will have fees associated with them (similar to a mutual fund expense ratio). 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. This can potentially be a major drawback when it comes to deciding whether to buy an annuity or not in your financial plan.
Another consideration with annuities is that when you buy an annuity and turn it into a stream of income (known as “annuitization”), you give up control of 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 gone forever. Unless the annuity comes with a death benefit (which would include another fee or reduced monthly benefit), you no longer get to decide where that money goes when you pass away, whether you pass in 1 year or 30 years. You have spent the money purchasing the annuity stream of income.
However, there are normally ways to reduce some of this risk. With an annuity you can usually choose to elect a benefit where if you don't receive the total amount back from your purchase you can choose where the remainder will go. For instance, if you paid $100,000 for an annuity but only received $25,000 back before you passed away, you could add a beneficiary to receive the $75,000 that you did not receive before you died.
However, like most benefits with an annuity, this comes at a cost. The cost is usually in the form of a lower monthly payment than if you elected not to receive a death benefit. Another tradeoff to weigh if you decide to use an annuity.
As financial planners, we are always harping on the risk of inflation. The cost to buy things today will not be the same as they will be in the future. Generally, over time the cost to acquire products and services to maintain your standard of living increase. 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 but increased faster than inflation. Although the stock market will not be a smooth ride, and will fluctuate up and down, sometimes severely over the days, months, and years of someone's investing timeline, it’s one of the historically best ways to fend off inflation.
When you buy an annuity, unless it's a variable annuity, you don't have to worry about the stock market dropping. 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.
Like with many aspects of annuities, you can reduce the inflation risk by also purchasing an inflation rider where your monthly payment will increase for inflation over time. However, the cost of that is your starting monthly payment will be much lower than if you elected to not have it increase. Another big tradeoff to weigh.
So, should I buy an annuity?
Buying an annuity is a big decision considering how complex the products can be, and the amount of tradeoffs you have to weigh. We believe it's best to speak with an unbiased, fiduciary, financial planner who will give you the pros and cons to help you weigh the tradeoffs
As we've discussed, there are some great benefits that come along with annuities, mainly a guaranteed source of income that you cannot outlive. But this comes with some serious drawbacks such as giving up control of the money; the expenses associated with the product; and the risk that inflation poses to your retirement plan.
Each individual will weigh the pros and cons differently, and each financial plan is unique so it is difficult to provide clear-cut rules as to who should buy an annuity or not. As a general rule of thumb, 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, if only because of the loss of control of the capital during your lifetime. However, if accompanied by a diversified investment portfolio and cash savings, it can have a place in a financial plan for someone who is extremely risk averse.
Understanding your goals, objectives, and risk tolerance is key to determining whether an annuity is appropriate for you. Without answering these questions it’s impossible to determine whether you should buy an annuity or not.
When used appropriately, annuities can be a useful tool in a complete financial plan. Too often they get a bad reputation for being inappropriately recommended or for being overly complex. Annuities should neither be shunned nor adored, but their benefits and costs should be weighed to determine if they work well in your financial plan. If you need help reviewing your financial plan or your retirement strategy, please reach out to one of our unbiased, fiduciary advisors.