There seems to be a lot of confusion about whether annuities are good or bad. Some of it stems from viewing the product as complex and too time-consuming to study and understand. But I don’t see annuities being any more complicated than other financial products. For example, one type of annuity is simply like a pension, and there’s almost no one who thinks a pension is bad.
Annuities are a type of insurance product. By purchasing one, you’re transferring risk to the insurance company just as you do with home, auto, or life insurance coverage. With annuity products, the insurer is assuming some, if not all, of the longevity or market risk and charging a fee doing so. Risk mitigation is common to all types of annuity products, yet they differ markedly in other ways.
Variable Annuities
When people talk about contract complexity and high fees, they’re usually referring to variable annuities. I find these products are best explained as mutual funds wrapped in an insurance contract.
For example, I can purchase an annuity with the following features. If I put $1,000,000 into a variable annuity and its value drops to $800,000 when I die, the insurance company will still pay my beneficiary $1,000,000. If I’m drawing income of 5% from that million dollars every year, and the annuity declines in value, the insurer will continue to pay me 5% of the original sum even if the value of the account goes to zero if I have purchased the proper rider on the policy. In both these cases, the insurance company has assumed the market risk.
Of course, all this comes at a price. I’ll pay fees for the insurer’s assumption of the risk plus fees charged by the sub accounts (mutual funds). The combination of fees is generally between 2 and 4% per year.
Variable annuities don’t look attractive right now because the fees are relatively high compared to the low interest rate guarantees. When interest rates rise and companies can offer higher minimum guaranteed interest rates (think of the early 2000’s), then it may be a whole different ballgame.
Immediate Annuities
An immediate annuity enables a person to deposit a lump sum of money with an insurance company and receive an income right away. This is the annuity that I mentioned earlier, that is like a pension. The product usually offers several payout options, including a guaranteed lifetime income benefit where the insurer assumes all the longevity risk plus the market risk. What if you die shortly after making the purchase? Well, some payout options allow you to designate a beneficiary who will receive a stream of payments.
Immediate annuities that provide regular, guaranteed income can be a good substitute for traditional pension plans that are no longer widely available. They can fill a big gap in retirement income plans.
Fixed Annuities
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A fixed annuity isn’t a CD, but it sure looks like one. For example, let’s say a fixed annuity and a CD pay interest of 3% for 3 years. If you remain invested for the 3-year period, there’s no risk to your principal. If you withdraw your money before the 3-year term ends, you’ll pay a penalty.
CDs, of course, are insured by the FDIC or NCUA. An annuity’s guarantees are backed by the insurance company that issues them. It’s important to purchase the product from insurers who get high marks for financial strength and stability from the major third-party credit rating agencies.
Annuities typically pay higher interest rates than CDs due to differences in their underlying investments. Annuity rates are based on long-term, illiquid investments – bonds, mortgages, private equity, private credit and real estate, for example. The premium from illiquidity is higher rates of return without higher risk.
Fixed Index Annuities
Fixed Index Annuity is a form of fixed annuity that doesn’t guarantee an interest rate, but lets you participate in an index, such as the S&P 500. Most contracts are designed to guarantee against any loss while participating in some of the upside gain. For example, a contract might protect against losses in a year when the index declines and credit 50% of any increases in the years that the index increases. Assets in these annuity products have the potential to grow yet have protection from downside loss. They are not securities, which causes some confusion because many people that are “Anti-Annuity” analyze them as if they are securities.
Annuities can shine in volatile markets
A volatile and unpredictable market environment like we have today tends to increase people’s interest in the principal guarantees and downside protection of fixed or fixed index annuities. You may gravitate to bonds as an alternative to annuities, yet bonds are poised to fall in value as interest rates rise.
If you’re newly retired, you may be particularly vulnerable to wide market swings. Some advisors attempt to mitigate market risk, especially sequence of return risk, by allocating 35% of a portfolio to an annuity with principal guarantees and the other 65% to equities. This strategy offers flexibility in choosing the source of income. When the market is rising, income can be taken from the equity component of the portfolio. When the market is dropping, the fixed annuity can provide income while the equities have time to recover.
More and more 401(k) plans are making annuities available, giving participants a way to get a guaranteed income for life without moving their money out of the plan. Participants who aren’t in need of income now can use the annuity as a type of stable value account. It can allow them to lock in gains from the bull market and move money off the table, knowing the interest rate and their principal is guaranteed.
Don’t approach annuities with a closed mind. Open your eyes to how effective they can be in protecting assets, providing guaranteed lifelong income, and building a secure financial future.