by Steve Goodman
CPA, MBA – President & Chief Executive Officer
Contact Steve today for more info.
In its simplest form, an annuity is a contract between the annuitant (the person who owns the annuity) and an insurance company. In exchange for the company’s promise to pay later, the annuitant agrees to pay now.As a financial tool, the annuity is as important in retirement planning as a hammer is to a handyman. While clearly a useful tool, the hammer is not the answer to every repair situation. And neither is the annuity.
Annuities get a lot of bad press, some of which is deserved. The industry has added so many bells and whistles to the simple annuity that it has become a very complicated product. These bells and whistles have also made annuities highly profitable for the insurance companies and those who sell them.Every variation beyond the most basic annuity comes at a cost. Either the buyer pays an extra fee, incurs an extra annual cost, or receives a lower payout.
By adding options, riders, and subaccounts, the industry has attempted to expand the target market for this product.The effect has been to create confusion for the buying public.With all the features and options now available, many annuities no longer serve as principally retirement income vehicles.
This article will look at reasons to consider annuities and reasons to avoid them.When relevant, specific types of annuities will be identified.
Reasons to Like Annuities
- Immediate annuities offer a ‘guaranteed’ monthly payout for life that is easy to compare among companies.Immediate annuities are relatively simple products offering a minimum of product options.The lack of options makes it easy to compare multiple annuities.Be sure to check the financial health of the insurance company with the major credit agencies. Look to see if the contract allows for accelerated or emergency withdrawals.If so, identify the costs and/or penalties incurred.
- Only an annuity can provide a guarantee of lifetime income.Immediate annuities begin their payout phase immediately. Assuming the annuitant lives to the payout phase, all deferred annuities present the annuitant with the opportunity to receive lifetime income. No other investment vehicle can make this claim.
- Annuities can reduce market risk in retirement planning. Index annuities typically include a cap and a floor to scale down market risk.Some variable annuities also offer a floor. While neither annuity will eliminate market risk, the annuitant presumably purchased either an index or variable annuity to acquire the potential of market upside. Floors help to reduce market risk, but add costs to the annuity. Many annuities with floors require the annuitant to eventually annuitize (transition to the pay-out phase) to take advantage of these favorable clauses.
- Fixed annuities can simplify retirement planning.Fixed deferred annuities typically offer two guarantees: a guaranteed minimum interest rate valid for either the surrender period or the life of the annuity (check your specific contract), and a guaranteed initial interest rate. The common guaranteed initial interest rate is effective for one to three years. Often a one-year teaser rate is offered to entice potential annuitants. Insurance companies reserve the right to change interest rates, usually annually, based on market conditions.Termination of the annuity during the accumulation phase can result in surrender charges, subject the annuitant to a market value adjustment (MVA – see Reasons to Avoid Annuities Item #2), and possibly a tax penalty if not rolled into another annuity or a qualified retirement plan.
- Tax free income for many years.Most annuities are paid with after-tax money. Payouts begin with a mix of principal and interest.When the cumulative principal amount has been returned to the annuitant, the entire payout will be interest. The principal returned in the payouts is not taxable if the payment was made with after tax money.If the annuity principal was paid with pre-tax money, the entire payout is taxable at ordinary rates.
- Annuities offer tax deferral of interest and gains until paid out.People who have maxed out their qualified retirement options will often turn to annuities for tax deferred treatment of interest (fixed annuities) and gains (index and variable annuities). During the accumulation phase, withdrawals from annuities are paid out on an interest or gains first basis.Withdrawals are subject to ordinary income taxes and may be subject to penalties if withdrawals occur before age 59½.
If the annuity is annuitized, the initial payouts will include a return of principal plus interest or gains.This combination of returned principal and gains will continue until all the principal has been paid out. All future payments will then be gains or interest only. The return of after-tax principal payment through payouts is not taxed again.
- Annuities can offer long term care (LTC) protection, if needed. Some companies offer hybrid policies.These annuities offer additional withdrawals should the annuitant enter a long-term care facility.These annuities are not designed to cover all LTC costs. They will help pay for a portion of the costs, but only for a set number of years. Unlike use-it-or-lose-it LTC policies, these annuities still function as annuities if the annuitant never enters a LTC facility.
- Fixed annuities are ‘guaranteed’ by a state insurance fund. Unlike banks, which are usually federally insured, every state maintains an insurance guarantee fund to insure insurance company accounts located in the state.Like federal bank insurance, each state sets maximums for account guarantees.Most state insurance regulations only cover fixed and index annuities. Immediate annuities are also insured subject to a state maximum.The fund may not offer the same terms and conditions as your insurance company in the event the insurance company is declared insolvent. In almost every state, insurance companies are prohibited from advertising this insurance protection.
- Sub Accounts in variable annuities are securities.As such, they are insured by the SPIC. The insurance company does not own the subaccounts. They are not assets of the insurance company to be used to pay any debts the company may have.
- Annuities can offer legal protections. Each state is different and not all states provide the same legal protections for annuities that life insurance enjoys.State regulations may impose a dollar value cap on legal protections so check with your state of residence if this is a concern.Legal protections are typically limited to fixed annuities and annuities in their payout phases (immediate annuities).Many professionals, especially doctors, accountants, and others who chose to forego professional liability insurance, purchase annuities.They employ annuities after they have maxed out their ability to protect assets in life insurance policies and retirement accounts.
Reasons to Avoid Annuities
- Annuity payments do not keep pace with inflation. Once an annuity enters the payout phase, the dollar amount of the payment is fixed. If the annuitant lives for 30 years receiving payments, the first and last payment will be the same. Many companies offer a cost-of-living rider at an extra cost.The rider may have the effect of reducing early year payouts in favor of later year payouts.
- Annuities contain multiple costs.Annuities are complex and laden with expenses. In their accumulation phases, there are three kinds of expenses; fees, opportunity costs, and taxes.Once annuitized, all annuities have some fees associated with their administration.
- Fees – fees come in multiple varieties.Some are explicitly stated in the contract while others are built into the costs associated with administering the contracts. There are surrender charges which one may incur if an annuitant cancels an annuity.(Direct annuities offered by some major mutual fund companies can mitigate most of the surrender charges.)Fixed annuities also incur a Market Value Adjustment (MVA), a fee based on interest rate changes.If one withdraws capital from, or terminates, a fix deferred annuity, the insurance company will assess a MVA. If interest rates have increased since the annuity was initiated, the MVA will result in a charge to the annuitant’s account. If rates have declined, the MVA may yield a payment to the annuitant.
There are management fees for administering the annuity.Some of these fees are identified in the contract, such as an annual administrative fee.
Variable annuities incur significant fees and investment restrictions.There are fees to manage the various portfolios. Variable annuities may also restrict an annuitant’s ability to place all his/her capital in the riskiest investments.Fees in a variable annuity can reach 3% to 3.5% of the typical account value annually.
Index annuities incur the same fees as fixed annuities.Additionally, index annuities are subject to annual return caps and participation rates.The annual return cap may limit a policy to 8% upside per year even if the underlying market index rose by 10%, after dividends are excluded. (Virtually all index annuities exclude dividends in their computation of index changes). This is a hidden cost. Also, many contracts limit gains to a percentage of the index change. An 80% participation rate is an implicit 20% fee.
Opportunity Costs – When one buys an annuity, one makes a long-term commitment with one’s capital. Assume interest rates are currently 2.5% and one owns a fixed annuity. If rates were to rise two years from now to 4%, the annuitant would be locked in at 2.5%.The insurance company may adjust the rate over time, but there will always be a lag.Long term domestic rates have been trending downward for the last 30 years. If there is a bias in rate setting, it will logically err on the side of remaining very conservative. The compounding difference of the lag time and conservative rate adjustments could be substantial over many years.
Another opportunity cost is the loss of investment flexibility. Within a variable policy, one has a limited number of investment options. One may not find an investment option that is optimally positioned to take advantage of an investment trend. Once annuitized, annuitants have no control over their money. Annuitants lose all capability to take advantage of a changing financial landscape.
Tax Costs – There are three major tax costs with annuities:
- All interest and gains earned in an annuity are taxed as ordinary income when paid out. They may be long term capital gains, but they will be taxed as ordinary income.
- When an annuitant dies, the heirs receive no step-up in tax basis. Consider an annuity in which the annuitant has invested $100,000.Through judicious investing, the value of the annuity is valued at $150,000 when the annuitant dies. The heirs will inherit this policy at a tax basis of $100,000. If this was a portfolio of stocks, they would have been ‘stepped-up’ as part of the inheritance process.The heirs would have a cost basis of $150,000 resulting in less taxes when sold.
- Distributions from annuities in non-IRA accounts by annuitants under 59½ years old may be subject to a 10% tax surcharge.
3.Variable and Index annuities contain market risk. Variable and index annuities offer returns based on the market’s performance. In times of a rising market, the policies can offer significantly greater returns than fixed annuities. This upside potential comes with significant annual fees.With a vanilla index or variable account, there is no guarantee that the annuity will provide the income required when the time comes to begin receiving payouts. Most index and many variable annuities offer guarantees that you will not lose money in any given year.There is a cost to this feature that the annuitant pays for in fees and restrictions.
- Withdrawals during the accumulation phase may be taxable.Tax laws require that withdrawals during an annuity’s accumulation phase be taxed on a LIFO basis.Gains, be they interest or portfolio increases, are distributed first with the principal paid out last. Additionally, withdrawals before age 59½ may incur a 10% tax penalty.
- Your money is locked in to a single investment and/or investment management company.Annuities are financial products designed for decades of use. Over the course of time, economic conditions can change significantly. Once committed to a deferred annuity, the cost to change can be substantial.Surrender charges can be in effect for 10 years.Terminated fixed deferred annuities are subject to a market value adjustment (MVA).If interest rates have risen since the annuity was initiated, the MVA will cost the annuitant. If interest rates have declined, the MVA may result in payment to the annuitant.Once committed to the payout phase, all deferred annuities and immediate annuities cannot be cancelled.
There is also a recent trend in which private equity companies have been acquiring fixed index annuities. The company that issued the annuity may no longer be the administrator a few years later. It is unclear how PE firms will act if conditions turn unfavorable for issuers.
- If longevity is not a concern, there are better investment vehicles for generating retirement income and passing along capital to your heirs after you pass on. A portfolio of stocks and bonds can be constructed to yield sufficient dividends and interest to meet long-term cash needs projections. Many companies have a history of increasing dividends over time. Bond durations can be laddered to trade-off opportunity risk and cash income requirements. Capital gains and qualified dividends are taxed at preferential rates. When the owner dies, the heirs not only benefit from the full transfer of wealth but also benefit from a potential step-up in cost basis due to price appreciation. With an annuity, the heirs may receive a limited stream of income or nothing at all. Any interest or gains they receive will be taxed as ordinary income.Returned principal remains non-taxable.
- Timing.As this article is being written, stock markets across the world are hitting new highs. Interest rates are low by historical standards, inflation is relatively low in most developed countries, and developed world debt is growing in relative and absolute terms. When one buys an annuity, one effectively locks into a financial environment at the moment of purchase. What if we are in a market bubble and markets decline or trade sideways for many years?What if interest rates were to rise, even modestly over the next few years?The insurance company is unlikely to increase their rates quickly given the history of declining rates over the last 30 years.
While it is possible to do, few people own a handful or more annuities.Annuity purchases tend to be large dollar amounts, relative to the capital availability of the annuitant. When investing in equities or other liquid investments, one can dollar cost average over time. While possible in a variable or index annuity, caps, participation rates and fees will diminish the strategy’s effectiveness.
- You are highly unlikely to receive the guarantees advertised by the company.Insurance companies have been known to advertise benefits and highly competitive financial returns that few annuitants will ever realize. Unfortunately, it is an all too common industry practice. A company will advertise an attractive annual guaranteed yield on invested capital.Known as a Guaranteed Minimum Benefit Rider, these guarantees come with high fees for the rider, required annuitization, and limited payouts.Unless you live to a minimum of 85, you will not realize the advertised return. Some companies have recently incurred significant fines for misleading advertising.There is a cost for every benefit.You need to find the costs and see how they will affect you.
Annuities ensure that people do not outlive their savings. They continue to perform this function well. There are many people for whom an annuity is the right investment vehicle for all or part of their retirement program.
As one moves beyond the lifetime income requirement, the appropriateness of an annuity become less clear. There may be instances in which an annuity product is the best vehicle for a client for other reasons. But all too often, people who purchase annuity products have little idea concerning the details in the contract they are buying.It may the best product for the salesman, but not the client. Annuities are big dollar, long term investments.Educate yourself, read the contract, and get a second opinion if necessary.
CPA, MBA – President & Chief Executive Officer
About Steve Goodman
For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.
He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.