Special thanks to Isaac Naatz and Jon Roen for helping me write this post.
Recently a reader asked what an annuity is, and I’m pretty sure they aren’t alone in wondering. Annuities are a complicated beast, but the simple answer is that an annuity is a hybrid between insurance and an investment. An annuity is an investment with some kind of guarantee built in.
Annuities get complicated when you dive into all the options available. And the options are many. The payments can be fixed or variable. The life of the annuity can be a fixed period of time or can pay for life. Payments can kick in right away, or may be delayed any amount of time. Some annuities double as life insurance by carrying a death benefit. Sometimes the annuity tracks the stock market, but with a guaranteed minimum return. Often an annuity pays out an amount on a regular basis, or at least gives you the option to do so. Basically, if there’s something you’d like your money to do, there’s probably an
app annuity for that.
Obviously an insurance or investment company isn’t going to give you something for nothing. In return for the guarantees built into the annuity, you do sacrifice some potential yield. Because of this, annuities are not the best way to maximize returns on your wealth. Your annuity is unlikely to beat long-term stock market returns.
Why Buy an Annuity?
So if annuities are a lousy way to build wealth, why buy one? Simply for the guarantees built in. In a typical stock market investment, your money is the mercy of the stock market swings and slumps. True, the stock market has always rebounded even from the worst of slumps and proceeded to notch serious gains, but you only realize those gains if you stay put in the market. There are times in life when you can afford to take on risk, and when you have time to ride out market slumps. But there are also times when you need guarantees built into your investment.
One common and practical reason for an annuity is to ensure that you don’t outlive your retirement savings. Once you retire, you start depending on your investments for income. If you draw them down to fast, you might run out of money before you die. If you draw them down too slowly, you may be taking a smaller ‘income’ than necessary. If your stocks or bonds suddenly lose value, you are forced to sell at heavily discounted prices.
An annuity can solve this problem by converting a lump sum into a guaranteed monthly income for the rest of your life. So while life insurance insures against you dying too early, annuities insure against you living too long, while also protecting you against market fluctuations during a time when you need to count on your investments for steady income. Annuities can offer the stability that most other investments can not.
Another time where an annuity might make sense is as you approach retirement. During this time, you can’t afford to have the value of your nest egg savaged by a stock market drop and then be forced to withdraw at market lows. An index annuity with a guaranteed return can expose you to some market upside while shielding you from downside.
Remember that not all annuities offer the same guarantees. Different guarantees such as the option to take lifetime payments or guaranteed returns come in the form of ‘riders’ that can be added to an annuity. Again, the more guarantees built into an annuity, the higher the cost. These are some of the most popular income riders that can be added to an annuity:
Lifetime Guarantee Withdrawal
This is typically be a percentage of the ending value after the surrender period has expired. For example, let’s say a client put $100,000 into an annuity and after 7 years the value is $150,000. Let’s also assume that the annual withdrawal rate maxes out at age 65 at a rate of 10%. Typically this rider would be purchased in conjunction with a Guarantee of Principal rider as well. At age 65 the client can take $15,000 of income per year without incurring any sort of penalty as well ensuring that the original $100,000 is protected from any sort of market drop. In this instance it would make sense to invest the annuity rather aggressively, since you cannot lose the $100,000 you invested from market downturn. However if the client kept taking $15,000 per year (over-withdrawing at this point) the annuity value would drop below $100,000 since they would now be pulling from their principal.
Guaranteed Annual Growth
Usually you will find these with index type annuities. For instance, the issue will guarantee that each year during the 7 year growth period the clients assets will be guaranteed to grow at least 3% – 5% annually. However, they will also have a cap on growth. For example, if the cap is 9% and the market did 11%, you would only get 9%. So in a 2008 type crash where the market dropped 40%, you would still make your guaranteed 3% – 5%. But in the years that followed where the market made double-digit gains, you’d be stuck with 9%.
Just as it sounds. Regardless of market fluctuations, your principal is guaranteed.
Guaranteed Income Rider
Again, just like it sounds. The annuity will guarantee a monthly/annual payout set by the issuer that the client can exercise at a given point in time.
Tax Benefits of an Annuity
Besides the guarantees, annuities also can be used to protect your returns from taxes or defer taxes on your returns. However, for many people, a simple IRA or 401k may fit their needs better. Annuities can also be a way for high net worth individuals to pass on to your heirs in a tax-free way (in the case of death, annuities are treated as life insurance by the IRS)..
Proceed with Caution
Annuities often get a bad rap, and sometimes justifiably so. Some financial advisers will tell you that all annuities are bad. This advice partly comes from an earlier era when all annuities charged exorbitant fees. Fortunately, the annuity industry has changed, partly in response to these critics.
However, as with any financial decision, you still need to proceed with caution when buying an annuity. Not all annuity salesmen are looking out for your best interest. You should ask yourself two things when buying an annuity. First, what are you sacrificing in yield, fees, and flexibility? Second, does the annuity meet your needs. If the benefits of the annuity are not worth what you’re sacrificing in yield, then the annuity isn’t for you.
Find the Best Place for Annuities in Your Puzzle
The bottom line is that choosing when to buy an annuity, and how much annuity to buy boils down to the amount of risk you are willing to handle. Determine how big a piece you want it to be in your overall retirement plan. If you were extremely risk averse, you could use annuities to fund your entire retirement (at the expense of potential growth) or just the final years. You might be comfortable living off your other investments up until 80. This adds a little more risk to your retirement, but you’ll be able to annuitize higher lifetime payments for less money this late in your life. You may decide you want all your income to come from annuities, or you may just want to establish an income floor. Weigh your risk tolerance and your needs. Just remember, as with other insurance and investments, you exchange risk for a price. Less risk equals less return (or more cost).
Where to Buy an Annuity
Different annuity providers offer different payouts at different ages and different times and with different terms. As with regular insurance, quote around to find the best annuity rates. Remember, focus on the reason you’re buying the annuity. If you’re buying the annuity for the guaranteed lifetime payouts, shop for the annuity that gives you the biggest lifetime payout for your buck. If you’re buying it for a guaranteed growth rate, focus on that number.
Also keep the safety of the company in mind. Although your annuity is protected by state guarantees up to a certain amount, you don’t want to deal with the hassle of your annuity provider going out of business. The Comdex score is a good measure of the safety of an insurance company. This score compiles ratings from several rating companies into a 1-100 score. Although the Comdex score is typically a paid score, an insurance company should provide you their score on request. Otherwise, you can access scores for free from here.
When you’re shopping, just remember what your goals are for the annuity and what your needs are. Don’t let anyone tell you that they have the ‘best annuity out there,’ or that you need such and such a feature on your annuity. Salesmen that use those kinds of phrases are typically the ones you want to avoid.
While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.