What is an annuity?
Before I show how you can evaluate an annuity, I want to explain the different types of annuities and how they work. Annuities come in many different types, and you have to know what you’re looking at before you can accurately judge it. Beyond that, understanding the types of annuities will give us a common verbiage for evaluating them. It will also help you know the situations when a specific annuity is appropriate.
So, what is an annuity? Simply put, an annuity is a contract between an insurance company and an individual. The individual gives the insurance company a lump sum of money and in return, the insurance company promises to pay the individual a certain amount of income every year for the rest of their life.
Next, why buy an annuity? You buy an annuity so that you don’t have to worry about outliving your money. That’s the absolute simplest answer.
When you buy an annuity, you’re transferring the risk of outliving your money, longevity risk, to the insurance company. They’re able to pool their risk, by selling a large enough number of annuities that the law of large numbers kicks in, which allows them to estimate how much they’ll pay out in any given year. They can’t say for sure how long you might live, but they can predict the average lifespan across a group of thousands, from which they can calculate how much they’ll pay out in any given year.
That’s the basic idea of an annuity. It’s simply a means of transferring the risk of outliving your money to an insurance company, in exchange for a slightly lower payout than you would have received on your own. The difference in payout is why insurance companies exist; that’s how they make a profit.
Types of Annuities: Single Premium Immediate Annuities
Coincidentally, I’ve been describing a Single Premium Immediate Annuity, or a SPIA. SPIA’s are the simplest annuities available and, not coincidentally, one of the least common options. I’ve been working with clients for over a decade, and I can count the number of SPIAs I’ve seen on one hand. While rare, they can be a valuable tool for retirement planning.
The benefit to a SPIA is that it provides the highest amount of guaranteed income possible, for the rest of your life. When I say the highest amount possible, I mean in comparison to other types of annuities and to the normal Safe Withdrawal Rate from a diversified portfolio. I typically use a safe-withdrawal rate of 5% when estimating portfolio income, while SPIAs can provide withdrawal rates of 7+%.
What’s the downside? Your money is no longer yours. Instead of having X amount in your account, you only have a guarantee of a monthly check. You won’t have access to your money if you have an emergency, so you don’t want to lock your entire retirement in a contract. You won’t pass that money on to your family either, except in very specific circumstances. You can add a joint life to your SPIA, similar to adding a spouse to your pension at work, but that’s the only way to pass part of that money to your beneficiaries.
Who should buy a SPIA? They work well for a few specific situations.
Someone without a pension wanting guaranteed income to cover living expenses.
For example, a couple needs $6,000 per month to live comfortably, but their only guaranteed income is through Social Security. They receive $3,500 monthly from Social Security and they want to guarantee the rest via SPIA. They have $500,000 in their IRAs for retirement.
Based on their age, they can receive an 8.9% payout from an insurer (I looked current rates up HERE.) They know they need an additional $2,500 per month or $30,000 per year, so they divide $30,000 by .089 and they get ~$337,000. This leaves them with $163,000 to be invested normally, to help with inflation or other unexpected expenses.
SPIAs are also a good option for those with limited resources and family history of longevity. The higher payout helps you get the most from your money, without worrying about a downturn in the market.
Oh, and SPIAs don’t have fees. When you put $100,000 into the contract, your payout is based on the full amount.
Types of Annuities: Fixed Annuities
Next up is the Fixed Annuity. Fixed annuities come in two flavors, a traditional fixed annuity and a Multi-Year Guaranteed Annuity. The term of the guarantee is the biggest difference between the two. MYGAs offer a guaranteed rate for a set period, often 3 – 7 years, while the rate on traditional fixed annuities changes based on prevailing interest rates.
One of the key attractions of fixed annuities is the safety they offer. The interest rate is guaranteed, ensuring that the annuitant knows exactly how much they will earn on their investment. This makes fixed annuities a lower-risk investment compared to products with returns tied to market performance. This guarantee is particularly appealing to retirees or those close to retirement who prioritize preservation of capital over high returns.
It's important to note that fixed annuities typically have limited liquidity, especially in the early years of the contract, although they do have more flexibility than SPIAs. Withdrawals made before a certain age (usually 59 ½) may incur penalties, and there may be surrender charges for taking out money in the initial years of the annuity contract. Therefore, they are often best suited for long-term planning rather than short-term investment needs.
Fixed annuities are best suited for individuals who are risk-averse and looking for a reliable source of income. They can be used in place of bonds, particularly for those who are comfortable with the known, fixed return. Likewise, MYGAs can be used in place of CDs, as long as you understand that they don’t have the same FDIC guarantees as a CD from a bank. They offer a way to protect your principal while earning a steady, predictable return.
Types of Annuities: Equity Indexed or Fixed Indexed Annuities
Fixed indexed annuities, also called equity indexed annuities, are interesting.
On one hand, the absolute, hands-down, worst annuities I’ve ever seen have been EIAs.
They were sold as a way to get all the upside of the stock market, without taking any risk.
Turns out, the only person making money from that pitch was the salesman.
On the other hand, some EIAs have solid terms and can likely provide higher returns than bonds, but without stock market risk. The problem is finding annuities with good terms.
Not coincidentally, the worse the annuity terms, the higher commission they typically pay the salesman. Some EIAs pay a 10% commission to the salesperson. You can imagine the conflict of interest that creates.
Fixed indexed annuities returns are linked to a stock market index, such as the S&P 500. Unlike direct investments in the stock market, these annuities provide a level of protection against market downturns. The insurer typically guarantees a minimum return (which could be as low as zero percent), ensuring that the principal investment is not lost even if the linked index performs poorly.
Equity Indexed Annuities typically apply a participation rate and, or, a cap, which determines how much of the index's gain is credited to the annuity.
For instance, if the participation rate is 80%, and the index increases by 10%, the annuity is credited with an 8% return.
If the participation rate is 80% and the cap is 10%, but the index returns 15%, the annuity is credited with a 10% return.
The worst EIAs I’ve seen have had both low participation rates and low cap rates. One annuity was so bad that if the S&P 500 averaged 10% annual returns, the client would have only made 1.5%.
Fixed indexed annuities may have limited liquidity, typically a 10% per year withdrawal, similar to fixed annuities, with penalties for early withdrawal and surrender charges that decrease over the life of the annuity. Additionally, they can be more complex than traditional fixed annuities, often involving various fees and charges, such as administrative fees or charges for additional riders.
I look at most annuities as tools in the toolbox, waiting for the right situation, but I don’t feel that way about EIAs. I’ve never sold an EIA and I never will.
Types of Annuities: Variable Annuities
Variable annuities are probably the most confusing type of annuity. They combine investments and insurance, offering the opportunity for capital appreciation and the security of future income. Unlike fixed annuities, which provide a guaranteed return, the returns on variable annuities depend on the performance of investment options chosen by the holder. Here's a detailed look at variable annuities and their features, including living benefits and various riders:
What is a Variable Annuity:
Investment Options: Policyholders invest in a selection of sub-accounts, which are similar to mutual funds, covering a range of assets like stocks, bonds, and money market instruments. The value of the annuity and the income it eventually provides depend on the performance of these investments. Some VAs offer sub-accounts through popular, low-cost fund families like Vanguard.
Phases: Variable annuities typically have two phases: the accumulation phase, where you make contributions and the investments grow (or decrease) based on market performance; and the annuitization phase, where the accumulated capital is converted into a stream of periodic payments.
Living Benefits:
Definition: Living benefits are optional features that provide income guarantees. They're designed to offer protection against market downturns or other risks. If you buy a VA, it’s likely you’ll want a living benefit rider.
Types of Living Benefits:
Guaranteed Minimum Income Benefit (GMIB): Guarantees a certain level of income regardless of the market performance of the investments. Typically this means that your Income Base or Benefit base grows at a guaranteed annual rate. Watch out on this, as some unscrupulous advisors will conflate growth of the Benefit Base with growth of your principal. They’re definitely not the same.
Guaranteed Minimum Withdrawal Benefit (GMWB): Allows the policyholder to withdraw a certain percentage of the total investment each year, irrespective of the portfolio’s performance.
Guaranteed Minimum Accumulation Benefit (GMAB): Guarantees that the policyholder will have at least their total investment amount after a specified period, regardless of market conditions. This is similar to the GMIB in that it’s often stated that your Benefit Base will double in X amount of years, at which point you can begin withdrawing Y percentage per year.
Riders:
Definition: Riders are additional features that can be attached to a variable annuity for extra cost. They allow customization of the annuity to better fit individual needs and goals.
Common Riders:
Death Benefit Riders: Ensure that beneficiaries will receive a certain amount, often at least the amount of the initial investment, in the event of the policyholder's death. Some policies offer an enhanced death benefit, which provides a death benefit that grows by a guaranteed percentage each year. This can be a good option for those who want to pass money to their families but aren’t able to obtain traditional life insurance. It can also be a good option for those who have significant assets and want to lock in a guaranteed return for those assets prior to passing them on to their kids or others.
Long-Term Care Riders: Provide funding for long-term care expenses if the policyholder becomes chronically ill. Traditional LTC insurance can be prohibitively expensive for many. Using a LTC ride on an annuity can be an efficient way of paying for some or all LTC expenses.
Considerations and Costs:
Variable Annuity Fees and Expenses: Variable annuities often have higher fees than other retirement products due to their complex nature and the costs associated with managing the investment options. These fees can include administrative fees, mortality and expense risk charges, and investment management fees.
I’ve reviewed two dozen variable annuities over the last few months and total expenses ranged from 2% to just under 4%. Those are…expensive. The point here is that you don’t want to pay those expenses unless you plan on using the extra benefits.
Surrender Charges: If funds are withdrawn early, especially in the initial years after purchase, surrender charges may apply.
Tax Treatment of Variable Annuities: The growth in a variable annuity is tax-deferred. Taxes are paid when withdrawals are made, and they are taxed as ordinary income. Annuities held in IRAs or Tax-Sheltered Annuity accounts, also known as 403(b)s, are only taxed when money is withdrawn from the actual account.
How to Review An Annuity
I’ve said it before, annuities are tricky. Evaluating annuities takes a bit of research and a bit of experience. Here’s the process I use.
Establish client goals and priorities.
Gather information on current income needs, assets, and existing investments, along with specifics on any annuities
What is the current cash value?
Do you have a gain? Is the current cash value more than you invested?
Is there a surrender charge?
What is the current Income Base / Death Benefit?
Are there any living benefits?
What investment options are available?
How has the annuity performed over the last few years?
What is the annual cost for the annuity?
Is the annuity in a retirement account or a Non-Qualified account?
Identify alternate options.
If the annuity is in an IRA, the contract can be surrendered without tax penalty. Surrender charges may still apply.
If the annuity is in a non-qualified account, then the contract can be surrendered or the funds can be transferred into a new annuity via 1035 exchange. The 1035 transaction allows for deferral of gains in the contract, so that you won’t pay capital gains taxes. If you surrender the contract, be aware that you will owe capital gains on any gains realized.
There are some solid options for low-cost variable annuities from Nationwide, Jackson, and others. These are often positioned as annuity-rescue products, as they’re primarily investment vehicles to maintain tax-deferral through the 1035 exchange.
Evaluate current annuity with respect to overall goals and priorities, while considering alternate options, to see if annuity benefits outweigh costs.
Are annuities a good investment? A Variable Annuity Case Study
Earlier I mentioned the 86-year-old grandmother that had been taken advantage of by an annuity salesman. Here’s the process I went through as I reviewed her specific policies. (I’ve changed some of the specifics on here to safeguard her info.)
Client Goals: Client doesn’t need income from her annuities, as her spending is covered by her pension and Social Security. Her main goal is to pass as much as possible on to her children.
Other than an emergency fund, all of her investment assets are tied up in annuities at the moment. Here are specifics on the annuities.
I didn’t include the fees, but all except the fixed annuity were at least 2.5% or higher and one was at 3.43%. All annuities are currently out of surrender.
When I broke down the annuities, I noticed a few important items. First, two of the annuities have Death Benefits that are significantly (>50%) higher than the current surrender value. Second, sometimes it’s worth paying capital gains due to the high expenses of an existing annuity.
Alternate Options: The options are fairly simple here. We can leave the annuities as they are, we can surrender them, or we can 1035 the non-qualified contracts into new annuities. We can also begin taking income from the annuities.
In this case, the client doesn’t want or need income, so that option is out.
Surrendering the policies with the increased death benefits would forfeit the higher amount, so that’s out for those two policies. The remaining annuities could be surrendered though.
To keep the death benefits and carry out the client’s wish of leaving a legacy for her family, the two annuities need to be kept as-is.
Here are the final recommendations I made for the client:
The client wants to leave the most legacy possible for her children: this plan does that.
Keeping the top two annuities will keep their current death benefit. Surrendering those policies would have cut overall costs, but it’s likely she wouldn’t, at 86, have enough time to make up the difference and build her investments back to the higher amount.
There is a gain in the fixed annuity, however it will be better to pay capital gains taxes on the $5,000 rather than move that to a new annuity. For a relatively small amount of income, I would prefer to keep that money in a liquid, accessible place. The fixed annuity was purchased around 2015, at which point interest rates were super low. It was fine at the time, but rates have risen significantly, and the policy rates haven’t changed.
The VAs in her retirement accounts have no substantial gain in either the death benefit or income base, so it’s probably that the more efficient growth outside the annuity will put her in a better position to pass the assets along to her kids. Beyond all that, taking the money out of the annuities will make the estate settlement simpler for her executor.
So, are annuities a good investment in this particular case? Unequivocally no. As I've mentioned, they're a tool in the toolbox, to be used at the correct time, in the correct way. The salesman pushed unsuitable annuities for too much of her total assets, while ignoring that the annuities didn't fit her specific goals.
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