Annuities: Are They The Right Solution For You?
There are few products in financial services that inflame the passions of financial professionals more than annuities. Passions between the pro-annuity and anti-annuity camps can run so high that you’d think a fistfight is ready to break out.
Much like our political landscape today, it’s almost impossible to convince one side or the other that there’s any middle ground on the issue of annuities. You either hate them, or you think they’re the solution to all life’s problems.
I’m here to give you the “middle ground” view of annuities. I’ll talk about why these products generate so much passion. But I’ll also explain in plain English the real-life scenarios where annuities might be of use to you, and when you might want to avoid them.
Why Pro-Annuity People Love Annuities
You’ve probably had annuities pitched to you if you’ve ever spoken to someone (or company) who sells insurance or other financial products. The pitch goes something like this:
- “Why take a chance with your hard-earned money in the stock market when you can buy an annuity and get guaranteed income for life?”
- “Why pay taxes on your investment income today when you can buy an annuity and get tax-deferred growth?”
If you lived through the stock market drops after the Tech Bubble and the Great Recession, hearing the words “guaranteed income” sounds pretty appealing.
Unfortunately, most companies have abandoned traditional pension plans. But annuities offer the hope of generating pension-like income.
And then there are taxes. No one wants to pay taxes. So you’re interested if you can invest money in an annuity where you won’t have to pay taxes until some time in the future.
Factually speaking, both of these pitches are “correct.” Annuities can give you a “guaranteed” stream of income. And yes, they offer tax-deferral on your investments.
That’s why the pro-annuity crowd love annuities. They’re an easy product to sell to a battle-scarred investor looking to get away from the stock market’s constant ups-and-downs.
But does that make annuities the best solution for your financial goals?
Why Anti-Annuity People Hate Annuities
On the other side of the fence, we have the anti-annuity crowd. You’ll find a lot of anti-annuity folks in what’s called the “fee-only financial planner” crowd.
The basic reasons why these folks hate annuities is three-fold:
- Annuities can be very complex, and few people who buy them understand what they’re getting in to
- Annuities tend to have high embedded fees, which may or may not be clearly disclosed to you
- Annuities can lock you into the product – sometimes irrevocably. So if your life circumstances change and you want to get out of an annuity, you’ll either have to pay a high “surrender charge” or you won’t be able to get out at all!
What makes the anti-annuity crowd’s blood boil the most is that for the most part, annuities are “sold,” not bought. Meaning, you didn’t wake up one morning wanting to buy an annuity. Instead, someone sold you on the idea of buying one and made a commission in the process.
Factually speaking again, the anti-annuity crowd is “correct.” Annuities are complex and a lot of buyers don’t understand what they’re getting into. Fees tend to be high. And once you write the check out to buy an annuity, your money is pretty much locked up.
So does that mean you should avoid annuities at all costs?
Understanding the Motivations
Both the pro-annuity and anti-annuity camps make good points. But when you peel back all the rhetoric from each camp, here’s what you need to understand.
First, most people who sell annuities make a commission off of them. And these commissions can be quite “fat.” That’s an expense that you, the annuity buyer, pay. You won’t see a line item in your annuity that says, “Commissions paid = $X.” But rest assured, you’re paying the commission.
Here’s an example. If Mr. Jones, the salesman, sells Widgets and makes his living off of selling Widgets, what do you think he’s going to recommend you buy? Widgets. A good salesman is going to try to convince you that Widgets are the best product out there. Do you need a Widget? Maybe. Maybe not. But if Mr. Jones needs to put food on the table for his family, he’s probably not going to spend too much time going over the reasons why you DON’T need a Widget.
Secondly, the anti-annuity crowd seems to take pleasure in demonizing annuities because “you can do better in the stock market.” While they might have fancy Excel spreadsheets “proving” that the math of investing in the stock market is better than annuities, they can also be tone deaf to what the client is asking for: certainty.
Stock and bond market returns are volatile. That’s a fact. And while the anti-annuity advisor might be capable of constructing a portfolio that will out-perform what an annuity can do, there’s no “guarantee” that their portfolio will perform as expected.
The other (unspoken) motivation I see from the anti-annuity crowd is the loss of income that happens when a client buys an annuity. If you’re my client and I’m managing $100,000 for you and charge you a fee of 1.00% on those assets, I make $1,000 a year from you.
So if you were to take that $100,000 and buy an annuity with it, guess what? That $1,000 fee I was earning from you goes away…and I’d start hating annuities!!
Now let me be clear: I’m not trying to paint a broad brush against one camp or the other. All I’m doing is trying to educate you on what each side’s motivations are. When you know the motivations, you’re equipped to make better financial decisions.
Get Clear About What an Annuity Is
Annuities are insurance. They’re manufactured by insurance companies. Sold by insurance salespeople. And you pay an insurance “premium” when you buy an annuity. I’ll say it again: Annuities are insurance.
Why do people buy insurance? To protect themselves from risk. We buy car insurance so that we can replace our car and pay medical bills if we get into an accident. We buy homeowners insurance so that we can replace our home and belongings if it burns down in a fire. Same deal for life insurance.
Insurance protects you from risk. You pay an insurance company a premium to protect you from a risk that you hope doesn’t happen. Your house may never burn down but you have peace of mind knowing that the insurance company will cut you a check in such an event. That peace of mind is well worth the annual premium you pay.
If you learn nothing else from this post please take this away: Annuities are insurance.
Annuities are NOT investments. Yes, some types of annuities have investments in them but annuities themselves are NOT investments. They’re insurance. Unfortunately, many salespeople will sell annuities as investment products, which creates confusion.
2 Big Risks That Annuities Can Protect You From
Now that you understand that annuities are insurance, let me explain to you the two areas where annuities can help you. I’ll caveat this by saying that everyone’s situation is going to be different. And before any insurance peeps send me a nasty message …Yes, I’m aware there are other situations where an annuity might be valuable (tax-deferral, legacy planning, etc).
Reason #1: Protect Your Investment Principal
Many types of annuities offer principal protection. What this means is that if you put in $100,000, that $100,000 will always be there. You’ll be protected from the market’s downside.
For example, a variable annuity (VA) is an annuity that you can buy to invest your money. Many types of VAs will offer principal protection. Meaning, if the value of your investments go down while you’re in the VA, the insurance company will “guarantee” that you don’t get back anything less than what you put in.
If you’ve been burned in the stock market in the past, this kind of protection might sound good. But the cost to offer that guarantee isn’t free, as I’ll get into below.
Reason #2: Provide a Guaranteed Income Stream, Especially in Retirement
We have a “problem” in this country. People are living too long. It’s putting a strain on Social Security and is a big reason why companies have abandoned pensions.
In the insurance world, they call this “Longevity Risk.” Put simply, Longevity Risk is the risk of you out-living your retirement savings.
Income annuities are designed to address this problem. You pay a premium – say, $100,000 – and the insurance company will pay your $X per month, each month for the rest of your life. If you live past 100 years old, they’ll keep payin’ you.
The best “guaranteed” income stream you have is Social Security. With all its flaws and confusing set of rules, there’s simply nothing like Social Security. You get a monthly check for life, and that monthly check is inflation-adjusted each year. Not even annuities do that.
But an income annuity can help put another layer of “guaranteed” income on top of your Social Security check. And if that kind of income certainty is important to you, then an income annuity can be an important tool in your retirement toolbox.
Nothing’s For Free: Beware the Guarantee
“Guaranteed” income and principal sounds great, right? But remember, annuities are insurance. And when you buy insurance you pay a premium.
Fees and expenses in annuities can easily run 2-3% the value of your investment in them PER YEAR. When I say “fees and expenses” the natural reaction is to think that the insurance company is somehow ripping you off. That’s not always the case (although they might be!).
Insurance companies have to spend a lot in order to offer guarantees on principal and income. They have to enter into complex hedging schemes and buy reinsurance. And insurance is heavily regulated, which increases the cost.
In short, there is a high cost of getting a guarantee on your principal or future income. It’s also a big reason why insurance companies lock you into an annuity. The more “sticky” the annuity, the cheaper it is for the insurance company to hedge and offer these guarantees.
The anti-annuity advisor will tell you to skip paying those huge fees and let them manage a conservative, low-cost portfolio for you. That’s fine. But the anti-annuity advisor doesn’t guarantee your principal or future income.
Finally, let’s talk about this word “Guarantee.” Insurance salespeople love to throw that word around because potential annuity buyers like to hear it. But the question you have to ask is: “Guaranteed by whom?”
Guarantees are offered by the insurance company. And there’s no guarantee that the insurance company you buy from will be around when you’re ready to collect on that guarantee. Financial companies can and do go bust. And in the Great Recession, some of the biggest annuity sellers almost went bankrupt.
If the insurer goes bankrupt, your “guarantee” is worthless. So don’t put too much stock in a sales pitch saying, “Hey, this company is strong and A-rated by AM Best.” Lehman Brothers was “A-rated” when it went bust in September 2008.
Final Thoughts on Annuities
Annuities can be a powerful tool in your retirement income toolbox. But they’re also complex and the cost of getting guaranteed principal & income is high.
Remember, the “problems” annuities are designed to solve is to give you a guaranteed income stream and/or protect your principal. If you don’t need or want to pay for another layer of guaranteed income, then you don’t need an annuity. It’s that simple.
If you do desire another layer of guaranteed income, then here’s some advice.
Avoid complex annuities. Especially ones that are investment-oriented and come with all sorts of bells and whistles, called “riders.” These types of annuities have high embedded fees which erode the value of what you’re seeking. You can likely do better in a low-cost, conservatively-managed investment portfolio.
Instead, look for simple income annuities, such as a Single Premium Income Annuity (SPIA), Deferred Income Annuity (DIA), or Qualified Longevity Annuity Contract (QLAC). These can be very good options if you’re keen to add another layer of guaranteed, steady income on top of your Social Security check. Again, avoid the costly bells & whistles on these products.
And lastly, enjoy annuities in moderation. Don’t put your entire retirement nest egg into annuities. It might be hard to get that money out if something happens and you need it. Plus, if you happen to die early, then that money can be lost.
There is a “middle road” when it comes to annuities. A fee-only financial advisor who isn’t an anti-annuity zealot will dispassionately assess whether an income annuity might be right for your retirement income plan. Even better, they don’t earn a commission by recommending you buy an annuity.
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