Someone recently told me annuities were the worst thing to put your money into. He said a ‘salesman’ talked him into it and he was not satisfied with the growth, so he pulled his money out only to be hit with a big fee. Yet others have said their annuity provides reasonable growth and principal protection.
Another person warned that when you die your beneficiaries don’t get a dime. I’ve also had someone say be careful because annuities have fees. Then there was one that said because of her annuity she no longer worries about running out of money in retirement. Maybe you’ve heard something similar? So, are annuities bad? Well…it just depends!
Without question annuities are one of the most hotly debated financial strategies in the marketplace today. It seems financial professionals are either spending their marketing dollars praising the virtues of annuities or trying to scare people away.
First, what is an annuity? An annuity is defined as a fixed sum of money paid to someone each year, typically for the rest of their life. Well known examples of annuities would be Social Security and pension benefits.
Of course, the advantage of this type of financial arrangement is you will receive a monthly payment usually for the rest of your life no matter how long you live. What a great deal! If you’re receiving Social Security or a pension benefit and you live a long life your monthly benefit will never end. However, with these benefits the payments stop when the ‘annuitant’ dies. If you get hit by a bus early in retirement the payment stops with no lump-sum payment to beneficiaries. Not a good deal!
Insurance companies also provide annuities. It is these insurance-based strategies where we hear the good and bad. To understand the role insurance company’s play in this arena we need to first understand the history of insurance companies with this type of product.
Years ago, like today, people were arriving at retirement and were worried about outliving their savings. To address this concern the insurance companies began to provide what I call the ‘old-style’ annuities. You could give the insurance company your hard-earned retirement savings and in-return you were promised a guaranteed lifetime payment you could not outlive.
The attractive feature of these annuities was that if you lived a long life (past average mortality) you likely would receive more money from the insurance company than you gave them. The conversion of your savings into this type of guaranteed lifetime payment is called ‘annuitization’. By ‘annuitizing’ your savings you could transfer the risk of outliving your money to an insurance company. However, if you and your spouse got hit by a bus early in retirement the payment stopped with nothing to go to the kids.
Just like Social Security the insurance companies built these annuity products around mortality tables. They know that the average person is going to die at average mortality. They also know that half will die before, and half will die after. By pooling the risk with so many people they can confidently meet their annuity obligations no matter how long you live.
Of course, with the ‘old style’ annuities if you died and your kids went to the insurance company looking for their remaining inheritance the company would have told them there was no money because you annuitized the annuity. You converted your liquid and available money into a lifetime payment. You essentially bought a pension. While the lifetime income guaranty was an attractive feature of annuitization, the idea that there was no residual lump-sum available to beneficiaries was a negative.
To remain competitive the structure of annuities began to evolve. Today’s annuities can have a lifetime income guaranty feature without annuitizing. Therefore, the annuity owner can remain in control of their money and enjoy lifetime income. Basically, the company agrees to pay a certain monthly amount for the rest of your life. They withdrawal this monthly payment from your annuity account. However, if you outlive the money in your account the insurance company is obligated to continue to make this guaranteed payment until you die, but if you die early or change your mind the remaining balance is for you or your beneficiaries to keep.
This sounds to good to be true, but it’s not. As always, insurance companies get paid for the risks they take. For this added feature, known as a ‘living benefit rider’, the insurance company charges a fee, which is usually about 1% of the initial amount the income is based off of. The fee is for your longevity insurance.
So, in addition to withdrawing your guaranteed lifetime payment from your account, the insurance company will withdrawal their fee each year. If you live a long life and as a result your account balance goes to zero you will continue to receive your promised lifetime payments, but their fee will stop because you’re now receiving the benefits.
How do insurance companies do this? Well, they know mortality tables cold. They believe you will die at average mortality and they project that even with your guaranteed lifetime withdrawals there will likely still be a little bit of money in your annuity account and this remaining lump-sum will be paid to your beneficiaries.
But think about that for a minute, they got to charge your account a fee each year for the protection that if your account goes to zero they will continue to make the lifetime payment, but you died before that happened. They owe your beneficiaries nothing except the remaining account balance. One could argue in that instance that the insurance company ‘won’. However, half the population will live past average mortality and continue to enjoy the same income even though they outlived their money.
Wouldn’t you agree that an annual fee charged against your account balance is acceptable if you’re getting a valued benefit? The real question is is the lifetime income guaranty worth the fee? For those worried about running out of money the fee is a small price to pay to eliminate that fear.
Fees and benefits do vary depending on the type of annuity you’re considering. Some annuities have no fees and others have more than just the living benefit rider fee.
As mentioned, modern annuities allow you, the account owner, to remain in control of your money while receiving guaranteed lifetime income. If at any point you decide to withdrawal all your money the lifetime payments will stop. Alternatively, if you withdrew a portion the lifetime monthly payment will continue but will be reduced because you took more than the annual guaranteed withdrawal amount.
While the account value is accessible it’s important to know that annuities are often structured with a surrender charge for early withdrawals. The surrender charge period generally can be anywhere between six to twelve years. This means that if you purchase an annuity and decide at some point during the surrender charge period you want to withdrawal all your money you will be assessed a surrender charge. The surrender charge is stated upfront and the percent charged typically declines throughout the surrender period. After the surrender period has ended your money is fully accessible with no penalty for withdrawal.
You should know though that during the surrender charge period most annuities have a ‘free withdrawal’ allowance you can take each year with no penalty. The free withdrawal amount varies but is usually between seven to ten percent of the account value.
Because insurance companies know you can’t predict death, surrender charges are waived if you die. Therefore, the remaining account balance would go to beneficiaries without penalty. Also, many annuities waive surrender charges for terminal illness and a long-term care need. Again, the insurance companies know you cannot predict these events and don’t want to penalize you in these situations. Annuities do vary so you want to be sure that yours waives penalties for these life events.
Why do insurance companies have surrender charges? Are they just trying to lock you in? No, the company has expenses related to issuing the annuity including administrative expenses and the compensation earned by the financial advisor. To re-coop their up-front costs the money must remain in the annuity for a period of time or a fee is charged.
The way your money is invested in an annuity depends on the type of annuity you’re considering. With some annuities you simply earn a fixed rate of interest similar to or better than CD rates. Some annuities let you tie your money to the stock market in a limited way, but you’re protected against market losses allowing you to maintain principal protection with the potential of even better growth than the fixed rate kind. Other annuities let you fully invest in the market but offer certain protections against the potential harm of stock market declines.
Is it possible to get reasonable growth with an annuity? The response to that question should be ‘As compared to what?’. As you near retirement or if you’re in retirement and withdrawing from your savings to supplement income how would you invest that money if not in an annuity?
By investing aggressively, you might get good growth, but your account value will likely bounce around with the stock market and you’ll be subject to market declines, both of which can be devastating if you’re systematically withdrawing your money. If the stock market declines, and you’re trying to offset your account losses, you may be forced to reduce your spending needs or cancel an anticipated vacation.
So, to prevent this from happening you might invest more conservatively in the stock market thereby sacrificing some growth, but by doing so reducing the level of volatility and the risk of significant market declines. However, even in a more conservatively managed account you can’t completely eliminate the risk of market losses and volatility.
The only way to avoid market losses and volatility is to position your money in some sort of principal protected strategy like certificates of deposit, money market accounts and the like. The problem with these strategies is the interest earned may not even keep up with inflation. However, by sacrificing growth these types of accounts offer stability for systematically withdrawing money.
Of course, with all these strategies the risk of outliving your money remains.
When you consider how to invest your money, you must first ask yourself what is the reason for wanting to invest the money. If your intent is retirement income, annuities should be considered as they offer the potential for reasonable growth, guaranties of lifetime income and with some annuities principal protection from market losses.
Let me tell you a story about one of my favorite clients. When she retired, she rolled her 401(k) into CD’s and began living off of a pension, Social Security and interest from her CD’s. She also had some money in mutual funds but wanted most of her money to remain in CD’s because she needed the interest income and was afraid stock market declines could negatively impact her retirement income. She feared running out of money.
Recognizing her concern, I mentioned the idea of annuities. I explained if she rolled the CD’s into three different annuities it would significantly increase her income and it would never end. She liked the idea, but she didn’t need that much income. I told her we could turn on one annuity and that the other two could be used for future pay raises. Every year she waited to turn-on the other annuities the income was guaranteed to increase. She liked the concept and agreed to proceed.
It wasn’t long and she called requesting to turn on the second annuity. She told me she’d always been a saver, but since retirement she didn’t have the income to save. She thought by turning on the second annuity she could start saving again. I smiled and said if she did that she would be ‘saving her savings’. She didn’t need to save anymore and if she didn’t turn on the other annuities the money would end up as part of her legacy. I suggested that by turning on the annuities she could either increase her standard of living or start giving money to her grandkids while she was living instead of after she was gone. Wouldn’t that be more fun especially if the income never ended?
To make a long story short she began to enjoy the income from all the annuities. The best part of the story is the updates I’ve received from her since then. She is taking more vacations, updating her home more often and even making generous contributions to her grandkid’s college savings. She’s now truly enjoying her money in the way she always wanted to.
The point of the story is she’s spending money she’d never have spent because of the fear of running out of it. The annuities changed everything. It increased her income and eliminated the fear.
By the way, this wonderful lady is my mother. It’s meant a great deal to have had such an impact on changing the course of her retirement. I hope that my mom lives a long life and continues to enjoy the added income, but if she doesn’t there will be plenty of money remaining in the annuities for her legacy.
So, are annuities bad?
Doesn’t it depend on what your money is intended for and your current circumstance? If you’re still willing to be aggressive in the stock market or if you have more short-term goals like saving for a new car or a vacation home an annuity shouldn’t be considered. Why? Because it’s not designed for those purposes.
Alternatively, have you reached an age where you’re trying to grow your money, but have concerns about the impact market losses could have on your retirement? Are you concerned about outliving your money? Are you seeking certainty and predictability with your retirement income, which won’t be adversely impacted by the ebbs and flows of the stock market? If that’s you, you owe it to yourself to explore these insurance-based strategies.
So, are annuities right for you? It just depends!