If you have ever met with a financial adviser about investments, chances are he or she may have proposed annuities as a good way for you to go. However, when you scan the blogosphere for posts about investing, you hardly ever read about annuities. You read about index funds, mutual funds, stocks and real estate and now and then about bonds … but hardly ever anything about annuities.
Should you consider annuities?
What is an annuity?
With an annuity you turn a lump sum investment (usually $5,000 or more) into a steady stream of cash flow back to you. What sets most annuities apart from the more traditional investments is most of them will pay you that cash as long as you live.
That is an important distinction. When you invest in an index fund and you retire, you have a finite amount of money to draw from. You have to decide how much to draw every month or quarter to live from. If you draw too fast, you will run out of money; if you draw too little, you will have money left over at the end. None of us know how long we will live and, therefore, we can never know exactly how much to draw.
An annuity typically solves that problem — the annuity provider assumes the risk. If you live long, they will lose money on your transaction and, if you pass away early, they will gain. They use actuarial tables to guide them in that risk. It should come as no surprise, then, that most annuity issuers are life insurance companies.
Types of annuities
There are two types of annuities, and within each there are two more subdivisions. You can picture it in the following matrix:
Deferred annuities begin paying you after some period to which you and the provider both agree. For instance, if you receive a $20,000 inheritance when you are 25, you can specify that the annuity be deferred for 30 years. You agree to begin receiving payments when you are 55 years old.
Immediate annuities begin paying you right away. Taking the same example, an immediate annuity will begin paying you a monthly sum right away from the $20,000 with which you buy it. (Naturally, it follows that the longer you defer the annuity, the higher those payments will be.)
Fixed annuities will pay you a fixed amount every month, quarter or year (depending on which period you select). The amount will never go up or down, even if the economy, stock market, real estate market or interest rates go to that hot place in a hand basket.
Variable annuities will pay you an amount which will depend on the economy, the stock market, the bond market and the real estate market. If those variables do well, a variable annuity will pay you more than the fixed annuity of same initial value and term would pay. However, if those things do take the trip to the hot place, your cash flow will suffer.
Benefits of annuities
1. Risk transfer. Probably the biggest benefit from annuities is that the risk of running out of money is transferred from yourself to the insurer. You may get less of a return than when you invest for yourself, but at least you know you will get it until you die.
2. Risk reduction. Some annuities offer you a guaranteed minimum return. If the markets tank, you are protected. The flip side of that equation, of course, is that your upside is limited. People who are extremely risk-averse usually are prepared to take lower yields in return for the peace of mind when headlines are screaming about the next financial collapse.
3. Taxation. Most annuities accrue their earnings or interest “behind the tax curtain,” i.e., without incurring any income taxes. When you withdraw such annuities, however, you will pay ordinary income taxes on the increase, and you forfeit any capital gains taxation from which you may have benefited.
4. No limits. Unlike retirement funds — like a Roth IRA or 401(k) fund — there is no limit to how much you can invest in annuities. This benefits people who either make lots of money or who want to catch up on their retirement investing. If you make good money and you hit your contribution limits for your 401(k) and IRA funds, an annuity allows you to keep investing for the future while locking in the benefit on the gains on those investments.
5. Protection from creditors. If you have a reasonable net worth and make your living in a profession with a high risk of lawsuits, such as a medical doctor, it is nice to know that your annuities are protected in several states from any claims. Therefore, buying annuities can be a good strategy to protect your assets to ensure that your retirement funds remain safe for your old age.
Drawbacks of annuities
1. Low yield. Because most annuities include an insurance risk, the actual returns earned on such an investment will be smaller than you can earn if you invested for yourself in things like index funds, property, etc.
2. Illiquidity. Deposits into annuity contracts are typically locked up for a period of time, known as the surrender period. These surrender periods can last anywhere from two to more than 10 years, depending on the particular product. Surrender fees are typically steep, starting out at 10 percent or more, although the penalty typically declines annually over the surrender period.
3. Fees. The high fees of managed mutual funds has driven the growth of index funds; but fees for annuities are even higher, making it one of the most criticized aspects of annuities. The annuities typically pushed by brokers and investment advisers carry commissions around 10 percent. If you invest, say $50,000, $5,000 will be taken right off the top and given to the person who sold the contract. That leaves only $45,000 of your money to earn a return. In addition, many states have what is known as a state premium tax, which is also taken right off your initial investment.
4. Redundancy. Investing IRA money into an annuity to get the tax benefit (as some are advised to do) is a waste, because everything accruing in an IRA is already sheltered from income taxes.
5. Shady tactics. In a way not unlike the timeshare industry, annuity sales practices have attracted a lot of criticism. Most people buying annuities don’t fully understand their options. Many are afraid of investing in general and are drawn to the promise of someone else handling their investing for them. The result is that many contracts are written to benefit the seller, while leaving the buyer with much less than they could have gotten from other, simpler, investments like normal index funds. After all, the only things insurance companies can invest in are the very same things individuals can: stocks, bonds and real estate.
Not all annuity sellers are shysters and not all contracts are detrimental to their buyers. Unfortunately, though, there are enough such cases to cause buyers to do their homework … the very thing they wanted to avoid having to do in the first place.
6. Inheritance taxes. For example, let us say you have invested, say, $50,000 in index funds through your IRA (Roth or traditional). When you die, that investment is worth, say $150,000. Your heirs will receive an inheritance valued at $150,000 (called the basis). If they turn around and sell it right away for $150,000, they will owe no income taxes, because that investment cost them $150,000 (the basis).
However, if you invested the same $50,000 in an annuity, which is also worth $150,000 at the time of your death, your heirs are deemed to have received something worth $50,000. If they sell it the same way as the index fund, the $100,000 gain will be taxed as ordinary income. There is, as they say, no step up in basis, as with normal investments.
The details may vary depending on your situation, but the principle of no step-up in basis remains pretty consistent in annuities.
The math behind the investment
Say you have $50,000 to invest and you want to wait 20 years before you begin to draw against it. It’s simple math to figure our more or less what that will be worth if you invest your funds in a simple, low-cost index fund. The insurance company will effectively do the same. (Index funds generally are the best-earning stock investments out there, so they will earn that or less.) Let’s be conservative and assume a 7 percent average return on that investment. The insurance company will take about 1.5 percent annually in fees, and that will leave you with 5.5 percent. Why do it their way?
As a straight-up investment, annuities rarely make sense. It is only when you add in the insurance protection (which isn’t free) that it makes sense. It comes down to the value you place on that insurance.
Should you buy annuities?
As noted above, annuities generally earn less than simple investing but can be effective to reduce risk. As a general rule, annuities make sense for people with high incomes and high exposure to capital loss, as well as to people who are sufficiently risk-averse to accept returns below what is achievable through a normal, diversified investing portfolio.
They do not make sense as a simple retirement investment, because you can achieve the tax deferral benefit within your IRA and/or 401(k) retirement plans. (The only exception to this is if you are about to exceed the maximum 401(k) and IRA contributions.)
They also rarely make sense for seniors over 60, because other investment options with higher payouts are available to them. For example, municipal bonds yield more attractive payouts with no reduction in principal.
Everyone’s situation is unique and, therefore, all of what I’ve mentioned above is given only as a general guideline. If you have a lump sum to invest, pay the money to consult an adviser who does not sell annuities.
What are your thoughts about the risks and benefits of annuities? Is an annuity a good investment from your perspective?
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Is an annuity a good investment?
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