Should You Buy an Annuity?
Have you seen ads for annuities either on television or online? Whenever the stock market declines, I seem to see a lot more annuity commercials that attempt to take advantage of individuals fear of losing money. These products are often sold by brokers for a commission which can lead to unethical sales. Not to say annuities cannot be useful, but are they a suitable retirement product for you specifically? Throughout this blog I will cover an overview of annuities, how you can use them, and who they could benefit.
Key Takeaways:
· What are the different types of annuities available?
· The benefit of purchasing an annuity
· Understanding how a fixed annuity works.
· How to use an indexed annuity
· Is a variable annuity right for you?
· How death benefits and living benefits with annuities work
· My take on using annuities wisely
What are the Different Types of Annuities Available?
There are four main types of annuities that you can purchase. In the order of least to most risk, there is the single premium immediate annuity, fixed annuity, indexed annuity, and variable annuity. There are several ways to purchase an annuity as you can use a variety of income sources including your 401(k) or savings. For example, any qualified accounts such as an IRA, 401(k), 403(b), or lump sum pension payment can be rolled into an annuity tax-free.
The first annuity that I will cover is the is the single premium immediate annuity (SPIA) where you pay a certain amount of money to an insurance company. You hand the lump sum over to the insurance company and they agree to give you a certain amount of money either on a monthly or annual basis. If you are concerned about outliving your money, then you could give it to the insurance company, and they will continue to pay you throughout your life until you pass away. If you are single, then in general none of the money goes to you beneficiaries as the payments cease once you pass away.
To contrast, if you’re a married couple and you buy one of these, then the insurance company will continue to pay the benefit until the second death. The benefit of a SPIA is that if you live a long time then you can make a significant amount from the annuity. Underwriters determine at what age they expect people will die based on many factors and years of data. Those who live longer than the average stand to make significant profit as the benefit will continue until they die. Unfortunately, those who pass before the determined age will not see profit as the early years of an annuity return the initial lump sum invested.
The Benefit of Purchasing an Annuity
There are options or riders that you can attached to the annuity such as a period certain option. Let’s say that you buy an immediate annuity with a 20 year period certain. If you were to pass away after 15 years, then the remaining 5 years would be paid to a beneficiary. One issue with buying the annuity with a period certain option is that your payout will be lower than what it would have paid if you opted for a basic immediate annuity. If you think about it, if the insurance company does not pay you interest and they pay out 5% a year, then for 20 years you will simply receive whatever you paid them initially. Any payments after that 20 years will be paid out of their pocket so for the immediate option to make sense, you would have to at least live beyond the period that it would take to get your money back.
Although all insurance companies will pay you some interest. The interest that you get is dependent upon where interest rates are at the time when you buy the annuity. Currently, interest rates have risen significantly so it may be a good time to buy an annuity. Inflation continues to increase which coerces the Federal Reserve to increase interest rates to curb the rampant inflation. Purchasing an annuity during this time would lock in a higher interest rate assuming they come back down once the Fed pivots back to bullish. For over ten years interest rates were close to zero, if they still sat at that level, then I would not recommend buying an annuity as you’d be locking in a low rate.
Understanding How a Fixed Annuity Works
Let’s compare the annuity options for a 65 year old married couple that are Connecticut residents versus the annuity options for a 65 year old single female. If you gave the insurance company $300,000, then the best payout you used to be able to receive was $1,223 a month or $14,648 which equates to a 4.95% payout. In this case it would take 20.48 years to get your initial investment back, and any following year would provide profit. Therefore, for the annuity to be worth it, at least one of the individuals would have to survive past that point. Remember, that does not include the opportunity cost of investing that money somewhere else.
To contrast, the 65 year old single female who is also a Connecticut resident can get $1,406 per month or $16,872 for the same $300,000 initial investment. That equates to a 5.26% payout which is larger than the amount for the couple because the annuity will only insure one life. Once she passes away, the payments from the insurance company will cease. In this case, the individual would have to live 17.8 years to get their initial investment back.
Additionally, if she was a man then the payout would be larger and the number of years to recover the initial investment would be lower because men tend to pass away earlier than women. Therefore, for the investment to make sense for an individual you would have to be very conservative and have longevity in their family. By longevity, I’m referring to how long direct family members have survived in the past because if they have typically lived long lives then it would be fair to assume that he/she will do the same.
If you remember in my second podcast, A Retirement Income Planning Strategy that Works, I discussed an alternative option to buying a fixed annuity. This strategy is modeled using the Guyton Guardrail Strategy where you build a portfolio that you leave invested over the long term and take withdrawals dependent on the condition of your portfolio. This strategy could potentially leave you with extra money in the end and may increase your income down the road.
The issue with immediate annuities is that your income does not increase for inflation. This can cause long term problems because the payout you receive at the later end of your annuity will be worth a fraction of what they used to in real dollars. To remedy this, you could purchase an inflation rider where your income increases by 1-2% each year. Although, it will cause your payouts to be reduced. This happens because the inflation rider will increase the amount of money that the insurance company will have to pay you, so they pay it out in lower amounts to compensate.
The next option would be to buy a fixed annuity which works similar to a bond or CD. The insurance company pays you a certain amount of interest for a fixed period of time based on what you’re looking for. For example, they could pay you 2% interest for 3 years or more if you were comfortable with that money being unavailable to you for the extended amount of time. If you wanted the money out earlier, then you would have to pay a penalty to get your money back called a surrender charge. For this reason, you may be able to get a better rate on your fixed annuity than you would from a CD, or possibly a Corporate Bond since you won’t have access to your money.
Therefore, if you are a conservative person who wants to make more than what the bank is willing to pay then a fixed annuity may be a good option. Fixed annuities also allow you to defer interest unlike a CD where interest earned is taxable annually. If you are a person who uses CD’s, then I would suggest looking into a fixed annuity to take advantage of the tax deferrals. Although, the negative is that your money is locked up for that period with a surrender charge for premature withdrawals. Additionally, if you take your investment gains out before age 59 and a half then you would have to pay taxes and/or penalties because the annuity works like a retirement account.
How to Use an Indexed Annuity
The next type of annuity is an indexed annuity where the interest you receive each year is based on the performance of a corresponding index. The indexes offered range from company to company with some being better than others. For example, say you are looking to purchase an index annuity with the S&P 500 as the underlying asset with a 4% cap and a one year term. On the first day, the insurance company would look at the value of the S&P 500. One year later the insurance company would revisit the value of the S&P 500 and look at the difference. If the index is up 3% then you would make 3%, while if the index was up 5% then you would only receive 4% because the cap at 4%. If the index lost money, then you would not make any money from the variable portion, but you could lose money in the end if there are any fees that you have to pay to hold the annuity. That would result in a loss because a $0 gain and $150 in fees would result in a -$150 holding period return.
These index annuities have the potential to generate more interest for you over time than a fixed annuity. Let’s just say that the fixed rate on an annuity is 2%. While the index annuity can earn up to 4% interest based on the performance of the index. For the most part you’d probably hit the maximum interest because the S&P 500 averages about 9% per year assuming you are able to purchase an annuity with a major underlying index. This would make you 4% each year instead of the 2% that you would have received from the fixed annuity. Although, if you have a couple years where your index grows less than 2%, potentially a few negative growth years, then you would likely have been better off purchasing the fixed annuity.
Index annuities as often misunderstood, people hear that they are tied to an index, and it causes them to think they are an alternative to investing in the stock market. Although it’s completely different. The interest that you earn is a lot less than you could have made by just investing in the S&P. The benefit is that you don’t experience the downside of a falling stock market. If you were directly invested in the stock market and it had a -8% return on the year, then you would experience that lost while the annuity would simply pay 0% interest. Therefore, if you are a conservative investor who is okay with making 0-4% on your locked up money then it could make sense to purchase an index annuity. Just be aware that it’s not going to be what you would earn by directly investing in the stock market.
Is a Variable Annuity Right for You?
The last annuity that I will cover is the variable annuity. The variable annuity works like buying a mutual fund within the variable annuity. There are investment options that you can choose from, and it depends on the company that you decide to buy from. There may be a dozen investment options while other custodians have hundreds. These investment options mirror similar mutual funds which will result in a larger upside than you would find in an index or fixed annuity. The advantage is that you don’t have limitations on the upside, while the disadvantage is that you fully participate in the downside.
If you have money that’s in another annuity or looking for tax deferral, then the variable annuity could be a good option for you. Like a qualified retirement account, the money that is inside the annuity is tax deferred until you withdraw the money. The other advantage is that there are no limitations on contributions. Let’s say you want to contribute money to a traditional IRA account. You can only put $7,000 into the IRA if you are over 50 years sold, but with an annuity of any type there is no limitation.
Variable annuities will have more investment options, but also more cost. The cost is usually higher than it would be with an indexed annuity or at the fixed annuity. These could get as high as 3% so if you are buying one then you would want to shop for the lowest cost options available. You would also want to understand the surrender charge including the penalty and the period that your money will be tied up. There are also options without a surrender charge that are becoming more popular and can often be accessed through fee only advisors, like myself.
How Death Benefits and Living Benefits with Annuities Work
There are other features that an indexed or variable annuity could offer which I will now cover. One of which is known as a death benefit that includes a certain guarantee that is paid out to you in the case of your death. For example, if you put $100,000 into a variable annuity and it declined to $50,000 because the underlying investments went down then your family would still be paid your initial investment of $100,000. Another feature is the enhanced death benefit which is similar to the death benefit but includes a fixed increase in your benefit each year. Say we purchased the same annuity for $100,000 with a 4% fixed death benefit increase. If you passed away ten years later, then your beneficiaries would receive $140,000 instead of $100,000.
Although, these riders can get complicated which is a criticism of annuities as there’s a lot of moving parts. That said, there is another benefit that was created in the past 15 years called the living benefit. A living benefit is nice because you don’t have to die to enjoy it. Similar to a single premium immediate annuity (SPIA), you get a certain payout from the insurance company without having to annuitize. These range across the board dependent on your age, whether you purchased a single or joint, your state, and when you purchased the annuity since interest rates have been rapidly changing. Prior to these increased rated, you would be able to get a payout between 3.5-5% without having to annuitize or give up control of the principal.
Although, as I mentioned before, the insurance company does not give you this benefit for free it will likely cost you between .5-1% extra. Let’s say that you were looking to do this with a variable annuity, your cost would likely be 2.5-3% on the low-end and 3.5-4% on the high-end. Therefore, I would recommend you shop around if you are interested in purchasing one of these annuities because the costs can significantly vary.
Let’s say you were able to find a higher payout than you could with the SPIA annuity and were hoping that over time your income from this annuity would go up. If you were able to average a 6% return while you withdraw 5%, then that would leave 1% behind. Unfortunately, these additional fees that you are paying (2.5-3%) are going to eat away at your principal every year. This makes it very difficult for your income to ever go up.
Similar to what was discussed prior with it taking 17 to 20 years to get your money back, the same is true with an annuity with a living benefit. With either an index annuity or variable annuity for the initial however many years, 18-120, the insurance company is just paying you with your own money and you’re paying them a lot in fees. Therefore, rather than doing that I prefer withdrawal strategies such as the 4% method or the Guyton Guardrail Strategy illustrated earlier in the blog. Make sure that if you follow one of these strategies, that you use low cost index funds to reduce any fees that you must pay on the account. Rather than those fees going to the insurance company, you can use the money you save on fees to increase your income down the road.
My Take on Using Annuities Wisely
We have now covered the pros and cons of each available annuity. To recap, the first thing you should do is seek advice from a fiduciary fee-only planner rather than a broker to avoid any conflicts of interest. There are high commissions on annuities which can result in misguided sales that benefit the broker. There could also be fees that are not disclosed which the broker may not mention to you. The next step would be to investigate all the costs involved with the annuity you are interested in as certain annuities can be quite costly.
The other thing you should do is investigate the financial strength of the annuity company that you are dealing with. I would recommend that you use a highly rated insurance company because that can limit any potential problems down the road. It would not be wise to give a lump-sum to a sinking company because there would be a chance the company couldn’t cover their payments in the future.
Lastly, for any annuities that you already own, I would suggest you review them to ensure they still make sense to hold. If not, then you have a few options. You could either look for a new annuity with lower cost as there are likely more available now than when you purchased your initial annuity. The other option would be to follow a new investment strategy that doesn’t utilize annuities. For example, you could open an IRA and purchase various investment products rather than tie your money up in an annuity.
My goal in writing this blog was to provide the reader with an overview of annuities and to understand how each type works. However, if you are still unsure about the fit of an annuity in your investment portfolio, then I would suggest you contact a financial advisor. I personally offer a Free Consultation where we could discuss this and whether my services could be a good fit for you.
