Few words in the financial world will elicit such a passionate response as the word “annuity.”
Some customers swear by them, others detest them, and the financial industry itself is split on the worthiness of annuities as investment products.
Why such a passionate response from both sides? Do advisors who push annuities do so with pernicious intent and are advisors who swear them off committing a fallacy in their reasoning? Let’s explore what annuities are and separate the good from the bad and everything in between.
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What Is an Annuity?
An annuity is a specified income payable at declared intervals for either a fixed or contingent period of time. They are issued via an insurance contract and are purchased by investors seeking either monthly premiums or lump-sum payments. Popular with retirees, annuities aid individuals seeking to mitigate the risk of them outliving their savings.
These products offer a guaranteed income stream, which the annuitant begins receiving after a stated annuitization period, either for a set period of time or for the rest of their lives.
The first stage of an annuity is the accumulation period, where the investor funds the annuity with either lump-sum payments or periodic payments.
There is plenty of nuance amongst annuities, which may be classified as either immediate or deferred, and may be structured as either fixed or variable.
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What Attracts People to Annuities? Why Do Advisors Pitch Them?
For some retirees, their retirement accounts may not be sufficient enough to cover their cost of living and monthly expenses in retirement. Insurance companies and other financial institutions provide these prospective annuitants with an annuity contract that provides regular fixed income in retirement, which is guaranteed by the company.
There are disparities in withdrawal stipulations for each annuity product, although for all annuities the cash is illiquid. There are withdrawal penalties should an annuitant withdraw more than is permitted in their contract. Because of these characteristics, annuities are not typically recommended for investors who have a strong liquidity need.
Advisors and sales representatives pitching fixed annuities typically market them as safe investments where you are guaranteed that your principal investment amount will not go down, regardless of what the stock market does. These fixed annuities allow the annuitant to take a part in a portion of any market upside, although it is typically low—usually under five percent.
The tradeoff the annuitant is making is decreased upside potential for guaranteed protection from any downside losses. So, if the market were to return a lucrative 15 percent, the annuitant would only get a fraction of that gain. However, should the market drop 38 percent like the S&P 500 did in 2008, the annuitant’s principal amount would be protected against any market losses.
Many individuals that are either retired or close to retirement have a proclivity to lean toward safety over risk. They are in their golden years and the time spent accumulating capital in their accounts has come to an end. Because of this reason, many advisors may believe that an annuity is suitable for their client, and they pitch it as an investment that sacrifices potential growth for guaranteed safety.
While an advisor may genuinely believe a client is suitable, and this certainly may be the case, it would not be painting the entire picture if commissions were left out of the equation. Annuities pay excessive commissions, often surpassing six percent or higher of the principal amount. For example, an advisor earning six percent on a $250,000 annuity would take home $15,000 upfront.
While this amount does not necessarily come out of the annuitant’s principal amount, it is a lucrative sum that certainly adds extra incentive for the sales rep to sell their product.
There was a fiduciary law passed in 2016 which tightened the rules around selling annuities. After this law went into effect, annuity sales dropped by eight percent. They fell an additional 18 percent in the first quarter of 2017. Variable annuities felt the impact the most, and sales dropped a staggering 22 percent in 2016.
When an Annuity Might Be the Right Fit
Being suitable for an annuity is not a black and white situation, and should be approached as such. Both fixed and variable annuities are tax-deferred products, and the tax benefits are an attractive attribute.
Fixed annuities, which are traditionally better reviewed and respected than their variable counterparts, are popular because of their guaranteed income. This does not change when the market shifts or when interest rates fluctuate.
The only scenario which would prevent this is if the insurance company went out of business, although this is unlikely. While these companies are not insured by the FDIC, they are regulated by individual states, who require them to keep cash on hand to pay their liabilities.
This is far more than what is required of bank reserves. For example, an investment bank may leverage $10 for every $1 they have. An insurance company can only leverage $1 for every $1 that they have.
Fixed annuities can provide annuitants with a steady income stream that is guaranteed, and is an attractive option for any individual who does not have an exorbitant liquidity need. Retirees who vehemently value safety over growth and more liquidity, and who do not plan on withdrawing more from the stated parameters may find fixed annuities quite suitable.
The lion’s share of annuities that are scrutinized tend to be variable annuities, but they are not without their selling points. There is no limit on the amount of money allowed in a variable annuity, which is why they tend to be popular with affluent investors seeking tax shelters. While most providers put a cap on initial purchases, there are unlimited contributions.
Both living and death benefit riders (which often pay additional commissions to the agent) appeal to prospective annuitants seeking a guaranteed stream of income.
For the living benefit rider, the payout is based on speculative rates of growth from additional sub-accounts. Regardless of whether or not these sub-accounts reach this rate of growth, the annuitant will be paid out.
For the death benefit rider, the beneficiary is guaranteed the largest of these options: the current value of the contract, the highest value on the contract anniversary, or a value which is attributed based off of a guaranteed hypothetical rate of growth.
In comparison to their fixed counterparts, variable annuities tend to have far higher rates of return.
Fees are an attribute as well as a deterrent when it comes to annuities. If the math adds up, an annuity can be more attractive to an investor than having an advisor manage their money. Let’s say a prospective annuitant does not anticipate withdrawing more than their withdrawal limit. They calculate the penalties if they do under extreme circumstances, and it comes out being less than what an advisor would charge annually. An annuity would appear to be the less expensive option.
Keep in mind that an advisor charging a one percent fee annually will not equate to 20 percent after 20 years. The power of compound interest will snowball from the amount taken out annually, regardless of whether the principal amount gains or loses.
The Bad and the Ugly
While annuities certainly have favorable qualities (they would not be so popular if not), they are hardly without criticism.
Annuities provide guaranteed income, which is great, especially in retirement. However, with this guarantee comes a lack of flexibility. Once you have invested in an annuity, control is given to the insurance company and their contract.
Should your situation or lifestyle change drastically and you need more money, the cost of fees and withdrawals can get hefty. Liquidity needs change, particularly when you are talking about a period of time that may span decades. Flexibility in liquidity is not a strong trait for annuities.
While withdrawal fees can get expensive, they are not the only fees that investors should be wary of. Riders, both living benefit and death benefit, are notorious for being high in fees. Agents are incentivized to pitch them along with the contract due to lucrative commissions. These high commissions are paid in addition to the already exorbitant commissions paid for selling annuities. Critics of annuities have surmised that some agents choose products for their high commissions rather than because they are suitable for their clients.
Variable annuities are some of the most complex financial products on the market today. Due to their complicated nature, they are often misunderstood by both sales reps and potential investors. They are subsequently marketed and sold poorly.
Variable annuities buy both stock and bond funds, which tend to fluctuate with volatile markets. These types of funds generally charge higher-than-normal fees. Due to the intricate nature of variable annuities, it is unlikely that the annuitant or agent will fully understand the total amount of fees.
The Epoch Times Copyright © 2022 The views and opinions expressed are only those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.
