DOES YOUR ADVISOR HATE ANNUITIES? IF SO, YOU MAY NOT BE GETTING THE WHOLE STORY...
Before we get started, I want to state that I am a professional licensed to sell both securities and annuities. This article is for educational purposes and is not intended to be individual advice. Annuities have a time and place when they’re appropriate for clients, yet I see an overwhelming amount of articles on why annuities are bad for clients. I’m hoping to even the playing field with this writeup.
I believe that annuities get most of their bad reputation by advisors that strictly sell securities and only want to keep you invested in things they offer. I’m sure that’s not always that case, however, in my personal experience, it does seem to be quite common. I will do my best to explain why advisors tell you to hate annuities and inform you of all the details they’re conveniently leaving out. This will be an educational piece, I want to give as much information, good or bad, on annuities as possible. I want you understand the basics of what they are, how they work, and fully explain the reasoning behind the negative connotation. This will be a bit lengthy compared to our usual blog…
We’re going to lead off with the first widely misunderstood concept of annuities and that when advisors speak about “annuities” they’re using it as a blanket term. There are many types of annuities, but the two major subsections of the term are fixed annuities and variable annuities. The difference between these two in terms of functionality are almost a complete 180, so when you hear anyone talk about annuities your first question should be, fixed or variable? If you’re told it doesn’t matter, they’re all the same, you’re being lied to or the person telling you this doesn’t know much, if anything about annuities.
Let’s talk about what commonality they both have, seeing as they are both annuities. Annuity, by definition is, “a fixed amount of money paid to somebody each year, usually for the rest of their life.”** That sounds incredibly similar to what we’re told about pensions. Isn’t a pension, in theory, a lifetime income paid out by an employer for years of service? I’d say the concept is very similar. Another lifetime income source we’re expecting as Americans in retirement is Social Security. Doesn’t a Social Security check sound eerily similar to “a fixed amount of money paid to somebody each year, usually for the rest of their life”?
Now my question to you, the reader, is wouldn’t you like to have a pension from your employer? Do you hope to get a Social Security check one day? If lifetime income from an employer or the government is viewed as good, then why is self-funding lifetime income so terrible? Well let’s return to the original topic at hand, “I was told by someone else that annuities are bad.”
So, what we’ve discussed so far is called “annuitization”. “Annuitization” is the act of turning an annuity into an income stream. If you’re on board so far and you believe that lifetime income sounds pretty good and is something you would want to have then let’s looks at how annuities work leading up to that point of annuitization. Before we get into that though, I have to remind you that there are different types of annuities and before we can dig any further into that, you need to learn about one specific type of annuity. That type is called a Single Premium Immediate Annuity, or SPIA for short.
SPIAs are important to mention at this point in the story because there isn’t any sort of wait time that leads up to these becoming an income stream. When we discuss the differences between fixed and variable annuities, technically SPIAs are fixed annuities, but most attributes associated to fixed annuities aren’t applicable to SPIAs. The reason they’re not applicable to other annuities are because other fixed or variable annuities have deferred annuitization. Meaning your money can earn tax deferred interest first, then is turned into income later. SPIAs, as stated in their name, are immediate income streams. How they work, is a client gives an insurance company a set amount of money, and in return, “a fixed amount of money paid to somebody (typically the one funding the SPIA) each year, usually for the rest of their life.” No bells or whistles, you trade a lumpsum to be paid overtime. That payment overtime is typically for life, but can be set to a specific amount of time too.
Let’s talk about pros and cons now, starting with the cons. I mean, the headline didn’t lure you in with knowing about the pros did it? If you already knew the positives of annuities then you’re not researching why they’re so bad, are you?
The biggest concern over SPIAs is you’re trading a large sum of money for smaller sums of money over time. Which, if you outlive their projections, that’s free money for life! However, if you don’t outlive their projections then what happens to that money? This is where the backlash on annuities starts to set in without full disclosure being presented.
I was told that with an annuity the insurance company keeps my money after I die, and my family gets nothing!
Now, here’s what isn’t always explained in full. Is that statement correct? The answer is yes, BUT only if you (the purchaser of said annuity) elect for it to happen. This would be called a “life only” SPIA.
That sounds like a huge rip-off, I would never agree to a “life only” SPIA!
Great news! In that case then no, the insurance company, doesn’t keep the premium you put in if it’s not all paid out before you die.
Why would anyone elect for that to happen?
Well it has to do with the amount of income needed or wanted by the client. An insurance company will offer someone more money if it knows it would receive their death benefit. There’s less incentive for the insurance company to offer you a higher rate of lifetime income if you die after the first payment and now they’re paying all that premium received back out to your beneficiary. Seems logical. In my opinion, I think “life only” SPIAs are unwise, but remember that everyone’s situation is different. In some cases, this can be a client’s best option. Sometimes that little extra is needed by clients with no legacy and who don’t care where their money goes after passing. Again, in my experience, this is not common, but it can happen. Folks usually have relatives or passionate causes (Cancer society, Humane Society, Alzheimer’s Association, Salvation Army, etc.) that they would certainly prefer to be the beneficiary.
That’s the simplified picture of SPIAs. Know that with everything in this article of course there are going to be some details missing. This is meant to be an overview and generalization of the good and bad in annuities. This isn’t meant to the be the definitive article on the deep inner workings of them. If you want more detailed information, we’re always eager to provide that too!
So, if an annuity isn’t immediate then that means it’s deferred. All that means is that the annuity has the opportunity in grow in value before being turned into an income stream. The way in which annuities grow during the deferral period is where the distinction between fixed and variable becomes clear.
Fixed annuities are the safer of the two, in the sense that they only increase in value because they’re not directly tied to the stock market. Under the umbrella of deferred fixed annuities are fixed, typically referred to as multi year guaranteed annuities or MYGA for short, and fixed indexed annuities or FIAs.
MYGAs are very simple and have the functionality of a bank CD when it comes to set rates and guarantee terms. With MYGAs a company will offer you a set interest rate for a set amount of time. During that time, typically you can withdraw either 5-10% of the value after year one or your interest (even within the first year) depending on how the MYGA is setup. Or if you don’t touch it at all you receive the premium plus interest at maturity. We prefer MYGAs over bank CDs for a few reasons, but typically because we tend to find better rates with MYGAs than bank CDs. On top of that annuities, by design, are tax-deferred investments meaning if you invest in a CD with non-qualified money (which just means money not in a retirement tax code like IRA or Roth) you pay taxes on the interest every year. If you use non-qualified money to purchase a MYGA your taxes are deferred until you cash the money out.
Now the negatives to using MYGAs over bank CDs. Annuities are meant to be used for retirement, meaning that accessing your money from them without penalty you have to be over 59.5 years old. If you’re in your 40s and want to change your CD ladder to a MYGA ladder, but you plan on spending that money in the near future you’re going to run into some complications. If you’re over 60, then I typically don’t see a downside to using MYGAs over CDs. There are some IRS rules allowing younger folks to use a MYGA as an income stream prior to age 59 ½, but we won’t delve into that in this article.
The next fixed annuity we’ll discuss is the fixed indexed annuity, or FIA. An FIA has allocation options that mirror the market, but not in a sense that puts your money at risk. Behind the scenes of these allocations, the way the insurance company handles their options, is overly complicated and not relevant to the point of this particular article. What is important is how they work for you as an individual. These options can be a fixed interest rate or more commonly mirrored to a market index like mentioned earlier. Say the allocation mirrors the S&P 500 and the S&P goes up 10%, does your annuity make 10%? No, it makes a fraction of that, let’s say 3-5%.
Well that means the insurance company keeps the rest of my money? That doesn’t seem fair at all!
Again, when information is presented this way without all the facts, this does sound like a negative, but it’s not and here’s why. What you’re trading for restricted upside potential is the protection of the downside risk. Let’s go back to the previous example and say the S&P now goes down 10%, how much interest does my annuity lose? Well with a fixed index annuity, the answer is 0%. Fixed index annuities only go up! Granted, it’s at a lesser rate than the market, but when the market drops, your investment stays the same. I can’t stress this enough. The negatives you’re told about annuities aren’t always false, but they are typically out of context.
I’ve heard annuities are expensive!
With fixed annuities there are no annual fees unless you elect to add on an optional rider. There are times when this can be beneficial, however, the majority the time you would invest in fixed annuities without them. That’s typically my suggestion, but again, every case is different.
Usually when you’re told about how expensive annuities are, they’re referring to variable annuities. When you know the difference between fixed and variable and hear someone express distaste for annuities, if you notice they’re using annuity as a blanket term and not defining what type, it’s usually variable annuities.
We’ll come back to this point in a minute, but let’s talk about the costs involved in annuities, starting with fixed. When purchasing a fixed annuity every penny you put in actually goes into the annuity. The commissions are paid by the life insurance companies, not by you. There are no additional fees paid, unless you elect an option rider, and in a lot of cases those aren’t warranted. Even in those cases there’s no upfront fee, it gets subtracted annually at each anniversary date.
So, if there are no commissions or fees paid upfront by clients and typically no annual fees for fixed annuities, then why am I told they’re so expensive?
Again, most people are told annuities are expensive, not explicitly told variable annuities are expensive, so a lot of confusion comes from that. Another topic brought up, and this applies to fixed and variable annuities, is the surrender charge schedule. Insurance companies have to accomplish 3 things when it comes to offering annuities…
1) Make a profit- Obviously, this is something that’s important for a company to stay in business. If an insurance company is holding your money you want them to stay in business too! This is no different than buying stocks. If you own a stock you need that company to stay profitable and stay in business.
2) Give you a decent rate of return- If the company doesn’t offer you decent interest than why would you give them your money in the first place? They want you to be happy with your decision to move your money to them.
3) Pay agents to find you- Remember you don’t pay the agent’s commissions like you would to buy stocks/bonds through a broker dealer or an annual fee to an IAR. The company pays agents, so you don’t have to!
In order to accomplish these 3 things a company has to hold your money for a certain amount of time. They take your money, as well as, everyone else’s, hold it for as long as they can and reinvest it. Banks do a similar thing with your checking and savings accounts, but offer you less in return because those accounts are meant to be liquid. By holding your money for a longer period of time it takes away some of your liquidity, but allows the company to give you more in return. Annuities can range for 2-20 years and the longer you allow them to hold it, the more they typically offer you in interest or potential interest. During your surrender charge schedule, most companies offer some limited liquidity for example 5-10% each year after year 1 or interest as it accrues. Annuities are NOT meant for emergency funds. It’s up to you and your advisor to figure out that balance and what liquidity is needed if looking into investing in annuities. Once out of the surrender charge period though, annuities can be kept without starting a new surrender period and stay fully liquid. There are some exceptions, typically with MYGAs, but that’s a general rule of thumb.
Back to expenses and variable annuities. Annuities as a whole tend to get their bad reputation from how variable annuities act so let’s explore what a variable annuity is. A variable annuity at its base is the same as all the others in the sense that they’re meant to be turned into lifetime income. Unlike fixed annuities, variables are market sensitive. Unlike fixed where if the market goes down you don’t lose any value, with variable you can lose money year to year. Not only that, but there can be a considerable amount of fees charged annually to variable annuities. I’ve seen ranges between 2-5% annual. That means you have to make 2-5% just to break even.
On the flipside though, because they are tied to the market, they can earn considerably more interest than fixed annuities. They also allow you to invest non-qualified money in the market and let it grow tax deferred. These are the positives to variable annuities, however, between the market sensitivity, the annual costs, and the surrender charges, typically the downside outweighs the upside. We feel with fixed annuities and ETFs you can accomplish much of the same things you can with a variable annuity and at less cost.
When speaking of variable annuities, I completely understand why advisors would tend to say only negative things about them, because I personally don’t see much positive either. I do however, have issue with saying annuities have no merit being a part of your financial portfolio at all, when not all annuities are built the same. I disagree with “annuity” being used as an umbrella term and I strongly believe whenever statements on annuities are made that clarification be given as to whether or not the statement applies to all annuities, fixed annuities, or variable annuities.
I hope you have found this to be informative and has given you a better picture of what annuities are and how they work. If there is one take away from all of this, it’s that not all annuities are the same. When you’re being told how terrible they are, ask yourself, does the person telling me this have an agenda to sell me something else? Can I invest in annuity through them if I chose to, or do they not offer them at all? As a professional that offers managed money AND annuities, it’s important for me to help you to understand that there are pro and cons to everything. It’s not all as one sided as some advisors can make it seem.