In this article, I'm going to dive into the intricate world of annuities - what they are, my thoughts on them, and whether or not they are a good investment for your retirement savings given the current market.
What is an Annuity?
An annuity is a financial product that straddles the fence between insurance and investment. With an annuity you exchange a sum of cash today -- typically from your retirement nest egg right as you begin to retire -- for consistent periodic payments in the future. How much that monthly payout is and how long it lasts depends greatly on the type of annuity purchased and lots of fine print.
Retirees often are steered toward annuities by financial planners because they typically have high commissions associated with them. Often these products are not the best choice for the retiree due to high fees associated with surrendering the account within the first five to seven years.
(In the meantime, the advisor has gotten his commission.) This has given annuities a black mark within the personal finance industry.
However, there are cases where putting at least a portion of your portfolio into an annuity makes sense. The option is definitely worth exploring. Let's dig into the details and underlying fundamentals of an annuity.
Types of Annuities
There are two main categories of annuities
- Deferred Annuity
- Immediate Annuity
However, within each main category, there are various products that work in similar, but different ways. Let's look at some of the most common options.
A deferred annuity is an investment product that has two phases: a contribution phase and a withdrawal phase. A person not nearing retirement would elect to begin investing in a deferred annuity. In doing so they would make consistent contributions into the account which would grow with tax deferred.
As they invest the money through the years the account grows based on the investments selected. When retirement age is reached the retiree begins to take withdrawals from the account.
There is also an insurance portion where the principal and investment earnings are guaranteed to be paid out to your heirs if you pass before the annuity is completely tapped out.
The second main type of annuity is an immediate annuity. Whereas a deferred annuity delays withdrawal of funds (or the receiving of an income stream from the annuity) an immediate annuity starts receiving income immediately.
A person that is set to retiree would choose this option, hand the investment company a portion of their portfolio, and in exchange get monthly payments in exchange for the lump sum.
Fixed annuities have fixed payouts to the investor. When you go to purchase an annuity you are given options as to whether the payments are tied to inflation or if they stay at the same rate for the entire time. Having the payments tied to inflation costs more than getting the same payment for the entire period of the annuity.
For example, a 65-year-old man might exchange $250,000 of his portfolio for $1,418 in monthly payments for the rest of his life.
That's about 6.8% returned to him each year. If he wanted those payments to increase with inflation the next year -- to $1,460, assuming 3% inflation -- he might have to give up $300,000 or $350,000 of the portfolio instead.
At its most basic level, a fixed annuity acts like a certificate of deposit. Retirees can choose to give up a portion of their portfolio in order to receive the security of consistent payments to go along with other retirement income streams. Giving up the entire portfolio has its own risks and is usually not recommended, but trading in 25% to 50% can provide the monthly income security you might be looking for.
A variable annuity is the opposite of a fixed annuity. Instead of consistent monthly payments, the amount you receive is based on the performance of the investments within the annuity.
This benefit is typically put into a heavy "sell" to a retiree. "As the market goes up, your payments keep going up!"
As you might imagine this is not always the case.
Here are the risks to variable annuities:
- If the underlying investments in the annuities sub-accounts go down, your payouts go down.
- The investment gains within the annuity are taxed at regular income tax rates when you withdraw the funds. Compare this to your typical investment where holding it for more than a year means you only pay capital gains tax. The difference in tax rates can be significant especially for high-income individuals.
- Variable annuities have high setup, maintenance, and surrender fees. For example, you might pay a 3% commission right off the top. For a $250,000 annuity that is $7,500! Then they hit you with management, investment, and insurance fees each year that can total another 3%. When you are trying to get better performance from the underlying investments you already are 3% or more in the hole before you even get started.
- Lastly, if you decide you don't like the annuity in two years and want to cancel you end up getting hit with huge surrender charges. Not only did you pay the 3% sales commission on the front end, but most variable annuities have a 5% to 7% surrender charge during the first few years of the policy that slowly decrease with time. At 7% of $250,000 that would be another $17,500… on top of the $7,500 you paid in sales commission on the front end.
Equity Indexed Annuity
If fixed annuities give a fixed payout and variable annuities are based on how the market performs, equity-indexed annuities are a combination of the two. The advisor trying to sell you on an equity-indexed annuity typically pitches it like this:
- You get a guaranteed minimum return on the investment so you know your monthly payments won't decrease
- You get to participate in the upside of the market so your payments can increase when the market does well, but…
- You are protected if the market goes down
A common fear of retirees is outliving the money they have saved up for retirement. When you're in your 80s or 90s you aren't exactly going to be rushing back to work to get an income to pay for your expenses.
A longevity annuity is designed to combat this problem by delaying payments until a specific age (usually around 80). It's like buying an income insurance policy.
The only downside? It's like buying an income insurance policy. Just like you pay insurance premiums and if you don't file a claim the insurance company keeps the money. You don't expect a refund on your car insurance premiums each year, do you?
Likewise, if you die before the longevity annuity kicks in, well, the insurance company says thanks and gets to keep the money you gave them to set up the annuity. Financial advisors often recommend dedicating a small portion of your portfolio to a longevity annuity -- say, 10% -- as insurance against running out of money when you retire.
Are Annuities a Good Investment?
The answer is: it depends.
It depends on your total nest egg, your risk tolerance, how often you want to be checking and adjusting your portfolio, and how much income you'll need in retirement.
Few legitimate advisors would recommend putting 100% of your portfolio into an annuity unless you were so risk-averse that you couldn't bear the thought of seeing the portfolio value go down.
On the other hand, relying on the stock and bond market for 100% of your retirement income can make retirees uneasy as well. A compromise is usually in order based on your risk aversion and income needs.
Someone that is confident in their portfolio and not as heavily risk-averse might convert 25% of their portfolio into a fixed annuity to provide a foundational level of income each month then using the remaining 75% of the portfolio to generate withdrawals and income to cover the remaining monthly income needs.
Likewise someone with heavy risk aversion might convert 65% of their portfolio to guarantee a stronger level of monthly income and then leave the remaining amount invested into conservative investments during retirement.
Before investing in any type of annuity it is always good to consult with a financial advisor that you really trust.
Something that our advisors here at Personalincome.org recommend as a great retirement solution is a gold IRA.
Learn more about them here.