Annuities: the Good, the Bad, and the Ugly

If you're looking for a way to secure your financial future and create a steady stream of income in retirement, annuities are often the first stop most people make. But what exactly are annuities, and how do they work? I’ll break down the basics of annuities, including the different types available and the pros and cons of investing in them.

What is an Annuity?

Simply put, an annuity is a financial product designed to provide a regular income stream, typically in retirement. It's essentially a contract between you and an insurance company, where you make either a lump-sum payment or a series of payments, and in return, the insurance company promises to pay you back, with interest or gains/losses, over a specified period of time.

Another way to think about this is in terms of risk transfer.  You are transferring the risk of your money’s growth to the insurance company instead of retaining the risk and investing on your own.  But that often comes with trade offs!

Types of Annuities

There are several types of annuities, each with its own features and benefits:

1. Fixed Annuities: With a fixed annuity, your money is invested by the insurance company in exchange for a fixed rate of return. The insurance company guarantees you a fixed rate of return for a set period of time, which is often a lower rate of return due to a lower amount of risk taken. Fixed annuities offer stability and predictability, making them a popular choice for investors who want to minimize risk or need a guaranteed amount of money to secure their basic living expenses.  Fixed annuities are typically stable in the amount and won’t decrease due to market performance.  

2. Variable Annuities: Unlike fixed annuities, variable annuities allow you to invest your money in a small range of investment options, typically in stock and bond mutual funds that are limited in choice by the annuity. Your returns are tied to the performance of these underlying investments, meaning they have the potential for higher returns but also come with greater risk if the investments go down in value.

3. Indexed Annuities: Indexed annuities offer a middle ground between fixed and variable annuities. Your returns are based on the performance of a specific market index, such as the S&P 500. Indexed annuities offer the potential for higher returns than fixed annuities while providing downside protection.  All are different in how they may protect the downside.  Some protect the first 10%, 20%, etc and then you start taking losses past that.  Upside is often limited in these types of products as well where they will cap your returns at say 8%.  For example if you’re tracking the S&P 500 in your annuity and it returns 24% for the time frame in question and your cap is 8%, you only get 8%. 

Pros and Cons of Annuities

Now, let's take a closer look at the advantages and disadvantages of investing in annuities:

Pros:

1. Steady income: Annuities can provide a reliable source of income in retirement, helping to supplement Social Security and other retirement savings.  

2. Tax-deferred growth (with non retirement dollars): With annuities you bought outside of your retirement account, your investment grows tax-deferred, meaning you won't pay taxes on your earnings until you start receiving payments.

3. Guaranteed income: Some annuities offer guaranteed income for life, providing peace of mind and financial security in retirement.

Cons:

1. Fees and expenses: Annuities can come with high fees and expenses, including sales commissions, administrative fees, rider fees and investment management fees, which can eat into your returns over time.  

2. Limited upside potential: participation rates and cap rates can severely limit your wealth building potential inside an annuity.  

3. Limited liquidity: Annuities are designed for long-term investing, and withdrawing money early may result in surrender charges and tax penalties.  Most surrender periods are around 7 years - meaning, if you take your money out before that time, there is an additional fee to do so.

4. “Paper money” vs real money: Many annuities offer an upfront bonus to increase your withdrawal benefit.  For example, a company may offer a 20% bonus to your money, but it only applies as long as you keep the funds with them and withdraw from them.  If you decide that annuity is no longer right for you, you don’t get to take the bonus money with you. 

5. Complexity: Annuities can be complex financial products, with many moving parts and intricate features that may be difficult to understand for the average investor (I’m going to be honest, for the average advisor as well.  Every annuity is unique and I always have to clarify what the insurance company means with each contract).  Most also do not reprice on a daily basis, but instead anchor on a certain date to determine your benefit. 

6. No step-up in cost basis (with non retirement dollars): if you pass an annuity on to your heirs, they will inherit your cost basis and have to pay taxes on gains (if any).  

7. Insurer can default: Any company can go out of business and that’s true with insurance companies.  Make sure you understand how good of a position the insurance company is in before you purchase the contract.  Your state has a guaranty association that backstops it a bit, but it may not be the entire amount.

Conclusion

Annuities can be a valuable tool for retirement planning, offering a way to generate income and protect against market volatility. However, they're not right for everyone, and it's essential to carefully weigh the pros and cons before investing. Annuities are often sold based on fear (I’ve seen them bought based on fear too… and regretted it later).  If you're considering an annuity, be sure to do your research, shop around for the best rates and terms, and consult with a CFP® professional, not an insurance agent who says they are a financial advisor, to determine if it's the right choice for your financial goals and risk tolerance.  

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