Written by: Corey Janoff
This post was originally published on our previous blog website on September 19, 2017 and has since not been revised and/or updated.
I occasionally get asked about annuities. Are they worth it? Should I invest in one? In this post, I will look at some reasons why people might consider investing in an annuity. I will also discuss drawbacks to annuities and why one might want to avoid them.
What is an Annuity?
In its most basic definition, an annuity is a set payment made to someone over a certain period of time; often over the person’s entire remaining life. There are many different forms of annuities – we won’t go in-depth on all the different types today, because I don’t want to put anyone to sleep. Some annuities allow you to withdraw money immediately. Some require you to wait until a certain age. Some require a lump sum contribution. Others allow you to contribute over time. Some enable you to receive a larger benefit the older you are. Some have the possibility of growing the benefit amount by investing the money within the annuity. Some allow a surviving spouse to receive your benefit after you die. There is an annuity for pretty much any scenario/concept/payout you can think of.
Every working American has an annuity. It’s called Social Security. Every year, we currently pay 6.2% of our income into Social Security (our employer matches that) on earnings up to $127,200 in 2017. The income limit typically rises each year. Once we reach a certain age (minimum age 62 for most people) we can begin drawing a set payment each month for the rest of our lives. A surviving spouse can even collect our benefits after we die. Pretty cool.
Many Americans rely heavily on Social Security for their retirement income. So without the Social Security annuity, a lot of people would be in big trouble. Some people like the idea of a guaranteed income stream so much that they elect to purchase annuities to supplement Social Security and their other retirement sources.
So what type of people should consider an annuity?
There are several categories of people who should consider an annuity, and they are not mutually exclusive. The more boxes you check, the better.
- People who want guaranteed income in retirement.
- People who expect to live a long time.
- People who are scared of investing in stocks, real estate, or other investments that have a potential for losses.
People Who Want Guaranteed Income In Retirement
The idea of having a set income stream that you can depend on is attractive for many people. After you stop working, your normal income shuts off, so you need to support your lifestyle with your savings and investments. Structuring a plan to enable your money to last at least as long as you do is a daunting challenge for many people. That’s where an annuity can help alleviate concerns.
With an annuity, as long as the company you purchase the annuity from stays in business, you will have a guaranteed income stream for life. Hold on, the annuity companies can go out of business? Absolutely. Just like the US government could default on their debt obligations and Social Security could disappear. Not to scare anyone, possible and probable are two different things. Many annuities are sold by large insurance companies that have been around for a long time. You will want to do your due diligence and only purchase from a financially sound company.
People Who Expect to Live a Long Time
Annuity payouts are based on life expectancy mortality tables. The companies that sell them understand that some people will die early, meaning the company doesn’t have to pay out a benefit for very long. Other people will live beyond life expectancy, causing the annuity company to pay out more in benefits, leading annuity investors to feel like they came out ahead.
If you have longevity in your genes, are in good health, have access to quality healthcare, and don’t smoke, there is a decent chance you could live longer than life expectancy. In that case, it could be worth considering an annuity.
If you don’t check the above boxes, then an annuity may not be right for you. However, if your spouse falls into the above category, investing in an annuity with a survivor benefit could make sense. That way, your spouse will continue to receive your benefit if your spouse outlives you.
People Who Are Nervous About Investing in Stocks/Real Estate/Etc.
Seeing the ups and downs of stocks can give people heartburn. Especially when it is in your portfolio and you are nearing retirement. At the beginning of the year, I received numerous calls and emails from clients who were concerned about how the new president would affect their investment portfolios. Some clients in or near retirement were especially concerned and wanted to take a serious look at their investments and see if they should consider alternative options.
For any investment strategy to work, the investor has to be able to withstand the turbulence. Stocks are an easy example. Everybody knows that stocks can and will go down in value from time to time. No stock ever only goes up in value. All stocks have days/weeks/years where their value declines. Some even go out of business completely! However if the company you invest in is successful, they will likely grow in value over time. If we look at large US companies as a whole, measured by the S&P 500 index on a year-to-year basis, 75% of the time we see the aggregate values rise. 25% of the time we see it decline. Historically we have seen three positive years for every negative year. Past performance is no indicator of the future and there is no guarantee that trend will continue. However, every investor that invests in stocks understands that there will be the occasional down year mixed in with the positive years.
That being said, when you are in or nearing retirement, the idea of those down years can be terrifying. Let’s say you have determined that a balance of $2,000,000 in your investment portfolio by age 65 will enable you to afford your lifestyle in retirement. You are 63 years old now. You have $2.1 million. You’re ahead of schedule. Another couple of years of working to give you some extra cushion and life will be good. What if we go into a recession and your investment portfolio declines by 30% over the next two years. Now you only have $1.5 million at age 65. Can you still afford to retire?
This is a real concern that hundreds of thousands of people currently face. It looks like I’m on track, but what if ________ happens? Then what?
If you can move some of that investment portfolio into a vehicle that won’t go down in value and give you a set payout for the rest of your life, that could enable you to sleep a lot better at night.
Why Shouldn’t I Invest in an Annuity?
Up to this point, we have looked at all the potential benefits of annuities and why someone might consider investing in one. There has to be a downside though, right? Of course! With every investment there are drawbacks. Let’s take a look!
Lack of Flexibility
Most annuities have restrictions on how and when you can access your money. Depending on the particular annuity, the terms can vary.
Annuities often let you withdraw the amount you invested, but you can only do it after a certain point. There is a “surrender period” from when you initially invest until a set number of years later (usually 5-10 years). If you want to withdraw your money during that surrender period you pay a penalty. For example, if you deposit $100,000 and there is a 10% surrender charge, if you wanted to withdraw your money you would only receive $90,000.
Once you pull the trigger and “annuitize” the annuity – meaning you begin taking an income stream, you are stuck. You can’t decide you want to liquidate the whole thing. You have to continue taking that income stream. There is no turning back.
The income steam is typically a pre-determined rate that is written into the contract at the time of purchase. It might say, if you annuitize after age 65, you can receive 4.5% of the balance each year. So a $100,000 annuity would pay out $4,500 per year. If you annuitize after age 70, you can receive 5% of the balance. If you wait until after age 75, it’s 5.5%.
Because of the lack of flexibility, it is rarely a good idea to invest all of your money into an annuity.
Expenses
Annuities can be quite expensive. This is particularly true of variable annuities. A variable annuity is one where you can invest your money within the annuity into these things called “sub-accounts.” The sub-accounts are basically mutual funds. You can usually pick which ones to invest in. The annuity company will give you the better of the guaranteed account, or the performance of the sub-accounts that you invest in. However, the fees act like a weight attached to the money in those sub-accounts.
For example, your annuity might provide a guaranteed 5% rate of return per year if you leave the money invested for at least ten years before annuitizing. If the sub-accounts perform better than the 5% per year guarantee, the annuity company will give you the better return of the two. However, the fees come out of the bucket with the sub-accounts. So if the annual fees are to 3%, your sub-accounts really need to grow by over 8% per year before expenses in order for you to realize a growth rate better than the guaranteed 5% amount.
Now, people investing in an annuity should not be going into it thinking they will do better than the baseline amount. The whole reason you are investing in an annuity in the first place is for the guarantees. Anything above that is icing on top of the cake. However, annuity salesmen often try to sell the product with the implication that the guarantee is the worst case scenario and it is much more likely that you will do better. It’s a big case of over-promising and under-delivering. In reality, they should do the opposite. Position the worst case scenario as the realistic scenario (because that’s what it is) and if you do better than that, consider yourself fortunate.
Taxes
The money invested in an annuity grows tax-deferred (similar to a qualified retirement account). This is attractive for most people. However, you have to pay ordinary income taxes on the growth when you withdraw the money, as opposed to the historically lower capital gains tax on investments outside of retirement plans. If you’re investing your IRA money in an annuity, this isn’t an issue. But if you invest non-qualified money, it could result in higher taxes over time, depending on your financial circumstances.
If You Have More Than Enough to Support Your Life in Retirement
If you have done a great job saving and investing and built yourself a substantial nest egg where there is a good chance money will be left over when you pass, congratulations! You probably don’t need to invest in an annuity. You could if you want to. Create some guaranteed income streams for yourself and give the rest of your money away to heirs or charities. But you are in the position all of us dream to be in.
Summary
Annuities serve a purpose in our world. They are one of the oldest investment vehicles known to man. While the idea of guaranteed income for life sounds like it could be too good to be true, it’s not. However, it’s too good to be free. There are costs and drawbacks to annuities that one should heavily consider before investing.
Disclosures:
Annuities are designed for long-term retirement investing. Early withdrawals may be subject to withdrawal charges. Partial withdrawals may reduce benefits available under the contract, as well as the amount available upon a full surrender. Withdrawals of taxable amounts are subject to ordinary income tax and, if taken prior to age 59 1/2, an additional 10 percent federal tax may apply. An investment in a variable annuity involves investment risk, including possible loss of principal. The contract, when redeemed, may be worth more or less than the total amount invested. Products and features may vary by state and may not be available in all states. The purchase of a variable annuity is not required for, and is not a term of, the provision of any banking service or activity. Variable annuities are sold by prospectus only. The prospectus contains the investment objectives, risks, fees, charges, expenses and other information regarding the contract and underlying funds, which should be considered carefully before investing. A prospectus may be obtained from a financial professional. Clients should read the prospectus carefully before investing. All product guarantees, including optional benefits, are based on the claims paying ability and financial strength of the issuing insurance company.
