Written by Thomas A. Lane, Jr., ChFC®, CFP®
“I HATE annuities, and you should too” is a popular marketing campaign utilized by a national investment advisory firm to create uncertainty and fear among annuity owners with the hope they will seek out their firm who will then “rescue” them from these “horrific” products.
Is there any basis or truth to such a comment? I can only assume that the owner of that firm probably does hate annuities. That said, he is making a very broad statement inferring that ALL annuities are bad, which, of course, is not the case. Annuities receive a lot of press, some good, some bad, some ugly, and deservedly so. Annuities are pushed very hard by insurance salesmen and brokers who are paid, often times, excessive commissions, by the insurance companies to peddle their products, without consideration to the needs of the individual or couple to whom they are selling the annuity. The truth of the matter is that not all annuities are bad and not all annuities are great. In my many years of practice as a CFP® professional, I have seen all types of annuities. Some of which have been a nightmare for clients in terms of fees, expenses, and poor performance; and some that have worked extremely well.
The problem with annuities is that they are often painted with a broad brush by the uninformed media as being “bad”. It is this overwhelming belief by consumers that prevents them from enjoying the benefits the right annuity can offer. As a result, when an annuity is recommended to a client by an experienced advisor who clearly has his client’s best interest at heart, the client will often react defensively and may miss out on a perfectly reasonable solution to their specific financial need. As with any solution to a specific planning need, annuities are not an elixir, and there is no “one size fits all”.
Types of Annuities:
Fixed, Variable, Indexed, Deferred, Immediate, Longevity. What to do these terms have in common? They all describe different types of annuities that are as different as their names imply. Unfortunately for the consumer, it is very difficult to understand the differences between the several types of annuities and, more specifically, how they work before making a determination as to whether or not they have a need for an annuity.
It is beyond the scope of this article to provide an in-depth description of each product, so I will provide a brief overview of each and will keep the description of each as generic and simple as possible so as to provide the reader with a basic understanding of various types of annuities.
Fixed Annuity: The simplest way to describe a fixed annuity is to imagine a tax-deferred CD. This is not to imply that a fixed annuity is a bank product that offers the guarantees associated with FDIC insured products. For example, if you purchase a five-year fixed annuity, a pre-determined fixed rate of interest is credited annually for five years. Interest is not taxable during the deferral period unless withdrawn from the contract. After five years, the annuity can be 1) “cashed in”, at which time tax would be due on the accrued interest, 2) left with the insurance company for an additional five years, or 3) exchanged (without tax¹) for a new annuity at a different insurance company if more competitive rates are available. Barring cashing in the annuity during the “penalty” period, you can’t “lose” money in this type of annuity².
Indexed Annuity: Indexed annuities are similar to a fixed-rate annuity, with the exception of how the insurance company credits interest. Rather than a “declared” or fixed rate, the interest credited to the annuity is linked to an index, i.e., the S&P 500, subject to a cap. For example, if the annual cap is set at 5%, and the index earned 9%, the interest credit would be 5% for that contract year. However, if the index is negative for the year, regardless of how steep the decline, there is simply no interest credit. The annuity does not lose value. Indexed annuities also offer additional benefits, for a fee, including enhanced income and death benefits that are beyond the scope of this article.
Variable Annuity: A variable annuity (VA) is considered a “security” and can only be sold by a registered representative. A VA might be viewed as a tax-deferred mutual fund account, however, with much greater fees. VAs historically have very high fees, which eat into the returns offered by these contracts. Some VAs offer “enhanced” income or death benefits that can justify paying high fees if real value is created by protecting the annuity owner and/or beneficiaries against market risk. VAs are very complex products and should be considered only when enhanced benefits are offered that are desired by the consumer. It is important to note that money can be lost in a VA, as the funds are invested in sub-accounts/mutual funds that are directly invested in the equity and bond markets.
Immediate Annuity: A single premium immediate annuity (SPIA) is a contract between an insurance company and the annuitant where, in exchange for a lump-sum of capital, the annuitant receives a guaranteed stream of income, often times payable for life, or joint lives. A SPIA can maximize the amount of income the annuitant can receive from a lump-sum of capital since the payments consist of both principal and interest. A SPIA is appropriate for someone who is concerned about spending down assets during their lifetime. A good financial planner can help a client determine when an immediate annuity is appropriate, and if so, which type of payout structure is optimal to meet their needs.
Longevity Annuities: These products are similar to the above-referenced SPIA and were brought to market by the insurance industry as a solution for the client who fears “living too long” and running out of money. These products, while much more complex in how payments are calculated, provide guaranteed income starting at a pre-determined age, typically as late as ages 80 or 85. The amount of income that can be generated at a pre-determined point in time can be substantial when compared to more traditional options; not due to unreasonably high rates of returns, but for the simple concept of “surviving” to the specific age when the payments commence. Mortality credits are applied to the annuitant who attains a certain age, at which time the payments commence and greatly enhance the amount of income paid.
As with any of the aforementioned annuity products, careful thought and consideration must be given before purchasing any type of annuity contract, as they are very complex and there are “the Good, the Bad, and the Ugly” in terms of product choices for every type of annuity. I suggest that you consult with a qualified advisor who understands how annuities work and will act in your best interest when recommending an annuity product to meet your specific needs.
An excellent resource for information about all types of annuities can be found at http://www.annuityfyi.com. I have often used this site during my career when researching various annuity products for our clients.
¹ via a 1035 Exchange, which if done properly allows an annuity owner to “exchange” on annuity for another company’s annuity without paying tax on the accrued interest.
² Principal is guaranteed by the issuing life insurance company. Losses may be suffered if the annuity contract is surrendered during the first five years.