There is a gentleman in my shul who has been encouraging me to purchase an annuity from him for the past year or so. He tells me that annuities have many benefits such as having guarantees, tax free growth, and not running out of money. He also said that this opportunity will not be around forever. My question is: Are annuities a good investment?
Annuities have a bad reputation, and rightfully so. In my opinion, they are a jungle of high fees, moving parts, and lack of transparency. In short, they are not usually the best choice. However, for the right investor, an appropriate annuity can be incredibly beneficial and lower stress levels. It’s important for each investor to do their own due diligence to ensure that an annuity is the right fit for their specific circumstances. Hopefully this article can serve as a good starting point for your research. Let’s break down your question and give annuities a bit more context.
Don’t rush: Annuities have been around for a long time, and, despite what you’ve been told, they are not going anywhere. Furthermore, while annuity yields may be a bit higher now through some insurance companies, that is not a reason to rush into purchasing one today. So, take a deep breath and fully evaluate your options. It’s imperative that you take the time to complete your own due diligence before purchasing anything. Frankly, annuities are not the right answer for some investors. It is very difficult or impossible to “undo” a bad annuity decision, so take your time deciding if it is right for you.
Not an investment: Next, it’s important to point out that annuities are not actually an investment. They are long-term policy contracts with an insurance company to provide you with a stream of income, or possibly a certain minimum rate of growth, for a set period of time, in exchange for a hefty fee and lack of liquidity.
When your fellow shul congregant mentioned that there are guarantees, he is referring to the contractual obligation of the insurance company from which you are buying the annuity. If the insurance company remains solvent, they should be able to fulfill their end of the contract. If the insurance company is not on solid financial footing, now or down the road, they may have a hard time holding up their end of the contract. There are no guarantees in life, just probabilities. When you view annuities from this vantage point, it can help you assess whether they are a good fit for your personal circumstances.
Tax benefits: Money within an annuity does grow tax deferred. This may be a nice perk. However, never let favorable tax treatment drive an investment or financial planning decision. As I frequently tell my clients and their tax advisors: “Don’t let the tax tail wag the investment dog.” You must first determine if an annuity makes sense independent of the tax benefits.
Many options: Annuities come in many shapes and sizes, all of which fall into one of three general buckets:
Fixed annuities: Fixed annuities are when an insurance company guarantees both the rate of return and the payout to the investor. The interest rate on a fixed annuity can change over time. Often the interest rate is fixed for a number of years and then changes based on current rates. Payouts can be for an entire lifetime, or you can choose another time period.
Variable Annuities: Variable annuities offer investors choices among a number of complex contract features and options. With variable annuities, the rate of return might go up or down depending on the performance of the stock, bond, and money market funds that you choose as investment options. Variable annuities may be compared to mutual funds because of the fluctuating value of your investment choices held in the “subaccounts.” The three things that variable annuities have that mutual funds do not are 1. tax-deferred treatment of earnings 2. a death benefit and 3. annuity payout options that can provide guaranteed income for life.
Indexed Annuities: Indexed annuities are complex financial instruments that have characteristics of both fixed and variable annuities. They typically offer a minimum guaranteed interest rate combined with an interest rate linked to a market index. Many indexed annuities are tied to well-known indexes like the S&P 500. However, some use other indexes that represent other segments of the market. There are also several methods insurance companies use to calculate gains. The features of an indexed annuity can be confusing for many investors.
Indexed annuities are generally categorized as either Equity-Indexed Annuities (EIAs) or Registered Index-Linked Annuities (RILAs). More can be said about each of these products, but that is beyond the scope of this article. In short, indexed annuities expose you to more risk than a fixed annuity, but less risk than a variable annuity.
Complex: As the previous paragraph illustrates, there are many options and moving parts when it comes to annuities. A good rule of thumb is if you do not understand it, then stay away from it! Oftentimes, folks don’t give themselves enough credit. If you are a Jewish Press reader, you are likely thoughtful, well informed, and intelligent. If something doesn’t feel right to you, then trust your judgment and stay away from it. Don’t assume it must make sense simply because other smart people are doing it!
Scenario where an annuity might make sense: For most people, most annuities are expensive, unnecessary, and confusing. Folks should consider, and probably pursue, alternative solutions to meet their goals. That being said, I have come across one specific scenario in my own practice where annuities were an appropriate solution.
Scenario: A client is terrified of the market, they are retired and already collecting social security. They may want to consider taking a maximum of 15-20% of their portfolio and putting it into an annuity called a Single Premium Immediate Annuity (SPIA). SPIAs are relatively straight forward and easy to understand. They provide a relatively high rate of income that is guaranteed by the insurance company for the rest of the client’s life. They are used to help clients meet their cash flow needs while sleeping better at night because this stream of income is not tied to the gyrations of the market. They are somewhat similar to an old school pension where an income is provided and the onus for producing that income does not fall on the shoulders of the investor.
The remaining 80% (or more) of the client’s liquid assets should be diversified elsewhere, not in annuities, so they have liquidity. I would also encourage all clients considering this option to include a rider on the annuity that pays out for at least 15 years in case the annuitant dies early. While this rider costs additional money, it also ensures that if the annuitant were to die before this 15-year period, the insurance company is on the hook to make payments to the beneficiaries for the duration of this 15-year period. I will also note that this scenario comes up infrequently.
It’s important to reiterate the downside of this product, as well. This includes the required lump-sum payment, which is irrevocable. Additionally, income payments to the annuitant may be adversely impacted by inflation.
Final thought: The biggest determinant of whether an annuity makes sense is your own personal situation. For some people the right annuity can improve their lifestyle. For many others it is a big financial mistake.
If a salesman encourages you to buy an annuity as their first suggestion, I would be quite wary. They are likely putting their desire for a juicy commission above your own needs. Avoid these people at all costs! A financial professional should caveat the purchase of an annuity by encouraging you to take your time, do your own extensive research, and proceed cautiously.
