Is an annuity a good move? It’s very confusing to determine fact from fiction with the plethora of information written about annuities on the internet. Like most everything else in life and especially in financial planning, there is no one-size-fits-all. The best answer here is “it depends.” Remember too, that opinions about annuities can be skewed depending upon who is giving the opinion. A certain well-known investment advisor advertises widely that he hates annuities, but one must ask if that’s because his company makes money on investments only and profits when you liquidate your annuity. Insurance salesmen who are not required to give fiduciary advice and who are not reviewing the annuity in context with your entire financial plan may exaggerate the benefits of annuities while downplaying or ignoring the pitfalls. Neither side is trustworthy. Below are some factors to review for and against annuities to help you make a decision that is appropriate for you.
- Annuities are ideal to provide predictable income to cover fixed expenses. If you have predictable income such as Social Security benefits and pension money (which are both annuities, by the way), and the sum of your predictable income covers a portion but not all of your fixed expenses, an annuity can be used to provide the remainder of that stream of income needed to cover your total fixed expenses. Fixed expenses are just what they sound like they are – these are the expenses that come each month for your necessities like housing, property tax, insurance premiums, food, utilities, etc. The money that you want for discretionary spending, like entertainment, travel, gifts, etc., are items that you would like to spend money on but are not necessary to live. Why would you want predictable income to cover all of your fixed expenses? So that you do not have to worry in retirement where your money will come from to pay the bills to live. You are creating a paycheck for yourself that covers the necessities. Is it possible to create a predictable paycheck for fixed expenses with investment assets that are in the market? Yes, but it can be a lot more difficult and a lot less predictable. As we all know, the market fluctuates, and when there is a market downturn, it’s not ideal to sell assets that have lost value so that you can have the money you need. Doing so can significantly shorten the lifespan of your nest egg. Better to wait until the market is back up to sell, so that you don’t lock in a loss and lose important dollars that are needed to fuel years of your retirement. Could you rely on something fixed like bonds to pay that predictable stream of income? Yes, but an annuity could be a better alternative or a good addition to bonds, if properly structured, because of inflation and interest rate risk.
- Once your fixed expenses are covered, you can feel more comfortable taking additional investment risk with your investment accounts, which then serves to further increase your long term rate of return under the well accepted assertion that stocks earn a higher long term rate of return than bonds.
- Some annuities are very low cost, and some have no fees at all. We hear a lot about the terrible annuities with very high fees – as much as 3% – 4% once you add everything up. The high fee annuities are typically found in variable annuities that come with not only rider fees and M&E fees, but costly underlying “subaccounts,” which are the mutual fund investments inside the annuity with high expense ratios. But you don’t hear much about the annuities with zero fees or low fees. These are the annuities that give you the things you like that your investment accounts cannot give you: guaranteed increasing income, locked-in interest credited to your account, zero downside risk when the market declines, and a locked in death benefit for your survivors should you pass away prematurely – without fees or a low fee of 1.2% or less. That being said, you are giving up some of the upside when the market is rising that you would otherwise be getting if you were in the stock market, which is why annuities are not suitable for young people who have a long time horizon to weather the rise and fall of the market. The annuity companies vary in how much of the growth they will credit you, but all place a limit on that upside. For example, in the stock market, there is no cap to your potential earnings (as well as an unlimited downside), but with a fixed index annuity, you will be given an annual cap on the percentage of interest credited, or you may be given a “participation rate,” which has no cap but which lowers how much of the growth will be allowed. To illustrate this point further, if your annuity states that you will be allowed an “80% participation rate” on the growth of the index you selected over the course of a year, then if that index rises by 15%, you will be credited with 12%. If that same index were to decline over the year by 12%, you would receive zero interest and your account balance (typically called the “accumulation” value) would remain unchanged. If the cap or participation rate is very low, even if you are charged no fees on your annuity, in effect, you must add this to the negative side of the equation as you evaluate the annuity, since the low cap or rate is an opportunity cost.
- Not all annuity companies are the same. Some fixed index annuities provide generous upside with increasing income that continues to increase throughout your lifetime which you could not take on your own if you were to follow the 3-4% safe withdrawal rate rule. Michael Finke, Ph.D., CFP®, and Wade Pfau, Ph.D., CFA®, highly respected professors at the American College, have conducted multiple research studies that conclude that annuities used in combination with investment assets increases the probability of success of not running out of money for retirees. Pfau’s book, Safety-First Retirement Planning, discusses how annuities can provide longevity protection as opposed to bonds by hedging the risks associated with not knowing how long you will live.
- Some annuities come with a feature that doubles your lifetime income if you become diagnosed with a chronic illness and need Long Term Care. Typically, this doubling of income requires that you meet the definition of chronically ill as determined by your doctor (you cannot perform two out of the six “Activities of Daily Living” without assistance. For people who cannot qualify for Long Term Care insurance, this is a great feature that allows them help should they need it, as annuities do not require any medical underwriting.
- Annuities that provide lifetime income don’t necessary require you to “annuitize.” You can “turn on” lifetime income after allowing your money to grow for a period of time and then later, if you change your mind, you can withdraw your accumulation balance in full without penalty if you are out of the “surrender period.” What is the surrender period? That’s the number of years from the beginning of the contract that your annuity company will assess a penalty for leaving altogether. Most annuities allow you to withdraw up to 10% of your balance each year penalty free (called your “free withdrawal), but they don’t allow you to remove the entire balance altogether until 7-10 years have elapsed from contract issue. Each year, the penalty which can be as high as 8-10% initially decreases by about 1% each year until it finally disappears altogether.
- The tax treatment of annuities allows interest to be tax deferred until money is withdrawn, which could be of benefit to people in high tax brackets who are looking for some tax relief on their non-IRA assets. If the annuity is funded with IRA money, then there is no additional benefit, as IRA’s already enjoy tax deferral. However, if the annuity is funded with “non-qualified” money, which is money that is not from a qualified account such as an IRA, then the growth is not taxed until removed from the annuity. When you start lifetime income or take a withdrawal, the entire sum is considered taxable at ordinary income tax rates, until the withdrawals have exceeded the amount of total interest that has accumulated inside the annuity. Had that money not been inside of an annuity, only the interest is taxable at ordinary income tax rates. Therefore, in my opinion, the tax treatment of annuities is not much of a benefit to most people, especially in a rising tax rate environment.
- If you fund an annuity with Roth IRA money to create lifetime income, you can enjoy tax free income, as the tax status of the Roth IRA money is unchanged inside the annuity. As your lifetime income paid to you from the annuity increases each year, there is no worry about increased income taxes owed, since taxes were already paid on the Roth IRA money years ago.
- Choose an annuity company with high ratings by independent ratings companies such as AM Best, S&P, and Moody’s, as the guaranteed income is based upon the claims paying ability of the issuing company. There is also protection offered by the state in which you live up to certain limits, called the State Guaranty Fund.
–Michelle Gessner, CFP®
Safety-First Retirement Planning, An Integrated Approach for a Worry-Free Retirement, Wade Pfau, Ph.D., CFA®, RICP