What You Should Actually Know About Annuities
Background:
Annuities often get a bad reputation in the financial services industry. Why? In the past, annuities have been known to be both very confusing and complicated. Additionally, some financial professionals made steep commissions on the sale of these products and regulators found that these professionals did not always have their clients' best interests in mind when doing so. Unfortunately, an annuity is only as good as the company that issues it and some companies have poor product offerings and some advisors are poorly trained on the product or have simply misused them. Some annuities have long been known for their high fees which is, of course something, investors should be aware of when considering purchasing an annuity. It is important to understand what you want to use the product for, what bells and whistles it offers and what is the cost. With that said, annuities have come a long way over the past decade or two and can be a great choice for certain individuals. How do you know if an annuity is right for you?
What is an Annuity?
An annuity is a contract between you and an issuing insurance company. You can pay a lump sum of money for guaranteed regular payments that can last your lifetime. Annuities are sold to clients through various financial institutions.
In the accumulation phase, the annuity is being funded and payouts have not yet begun.
Once fixed payments begin, the contract has entered the annuitization phase or if the contract has a life income rider, payments can begin without annuitization.
Some annuities may pay the annuitant for a fixed period of time while others may pay for the remainder of their life.
There are many different kinds of annuities- fixed, variable, immediate income, deferred income, and more. The image below from NapkinFinance.com helps us to better understand annuities by providing a very basic visual explanation as to what annuities are and what the process looks like.
Who are they best for?
Annuities, like any investment vehicle, are not for everyone. Whether an annuity is right for you will ultimately depend on your risk tolerance, your desired retirement age, how much you have saved, and your personal circumstances. Ultimately, an annuity can be a good vehicle for someone who is very fearful of running out of money in retirement, whatever the reason might be. In some cases, an annuity can help to eliminate this risk, almost entirely.
Annuities are sometimes used to turn substantial lump sum payments into steady cash flows over the course of a lifetime. This might be seen in cases where someone wins the lottery, receives a large cash settlement from a lawsuit, or receives a generous inheritance. Many may think of an annuity similarly to a “pension:” where you receive a guaranteed amount of money each year for the rest of your life, often regardless of how the stock or bond market is performing.
Most commonly, annuities are used for anyone who fears outliving their assets as they help to alleviate fears associated with longevity risk and market risk. Often, we see soon-to-be retirees purchasing annuities. While some retirees are comfortable with their assets remaining fully invested—albeit usually increasing the percentage in fixed income products to mitigate market risk—some retirees are not satisfied with this solution. Annuities can be particularly comforting for retirees who are single or recently widowed. These individuals know they must have enough money to pay for their expenses for the remainder of their life as they often do not have someone else’s financial support or assets to fall back on.
Who are they not for?
Generally speaking, annuities are not for people with liquidity needs or young individuals, although there are exceptions to every rule. Annuities are not right for someone who is seeking liquidity and may need to access these funds in the near future, as the penalty—i.e. surrender fees –to do so can be quite steep. Annuity distributions are taxed as ordinary income rather than at capital gains rates as is often the case with other retirement saving vehicles. With that said, annuities are not right for every investor, hence why it can be crucial to work with a financial professional when assessing if an annuity could work for you.
Drawbacks of Annuities:
We are very upfront with our clients about the potential downsides associated with different investment products and vehicles. One major criticism of annuities is that they are illiquid. Once deposits are made into annuity contracts, it is common for those funds to be “tied up” for a predetermined period. This is known as the surrender period and the annuitant would need to pay a penalty if any part of these funds were to be withdrawn. Typically, surrender periods last from 2-10 years and will largely depend on the terms of the particular product. It is not uncommon to see a surrender fee of 10% or more, but the penalty will usually decline annually as the surrender period progresses.
Additionally, annuities can sometimes have steep fees for underwriting, fund management, and penalties. The fee will ultimately depend entirely on the specific annuity and should be looked at on a case-by-case basis. With that said, all investments have a cost. You pay a fee for ETFs and Mutual Funds and you pay an advisor for consulting on asset management and financial planning. Clients are encouraged not to cast aside annuities entirely but rather let an advisor help you to analyze your personal circumstances, financial goals and needs, and what makes sense for you. Ultimately, paying a fee might make sense if it provides the ability to enjoy your retirement.
Benefits of Annuities:
Despite these drawbacks, annuities do of course have several benefits.
Guaranteed lifetime income in the form of fixed payments
A lack of heavy record-keeping requirements Deferred taxes on your investment
Tax-free transfers amidst annuity companies
No annual contribution limits (which other tax-deferred retirement accounts have)
401(k)s with in-plan annuity opportunities *
Good for those close to retirement who need to “catch-up”
*As a result of the recent SECURE Act, individuals can now invest in annuities through their 401(k)s. It is likely we will see more and more annuities showing up I 401(k) plans over time.
Conclusion
Overall, annuities offer financial advisors another potential tool in helping clients to reach their personal financial goals. Like any investment vehicle, annuities are not the right choice for everyone but, for someone who is looking for stable, lifetime income, they provide a very powerful option. There are many different types of annuities, each of which comes with unique benefits and characteristics. If an annuity is something that sounds appealing to you, your financial advisor can provide more information about the specific costs and benefits as they relate to your personal financial situation.
Disclosure: Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Guarantees are based on the claims-paying ability of the issuer. Withdrawals made prior to age 59½ are subject to a 10-percent IRS penalty tax, and surrender charges may apply. The investment returns and principal value of the available subaccount portfolios will fluctuate so that the value of an investor’s unit, when redeemed, may be worth more or less than the original value. Optional features available may involve additional fees.
Written by Kaitlyn Keeler
Kaitlyn is an enthusiastic client service intern that assists our advisors with your accounts. She is an attentive business student with a concentration in finance.
