Annuities have become a somewhat popular topic in financial services and often are associated with polarizing views of their effectiveness. I intend to debunk the confusion by providing clarity about the product itself, its uses, and its risks.
At the end of the day, an annuity is just a product, but before investing OR avoiding, it’s important to know what an annuity is and what is isn’t.
A Product Metaphor: Peloton
Take Peloton for example; it released its hugely popular bike and membership which defied the old-fashioned workout routine a few years ago. Is Peloton a better way to get fit? Well…it depends. For a woman who wants to have a class-like experience but doesn't have time to travel to and from a gym and who has the financial means, Peloton could be life changing. For the guy who has a gym and free classes offered at his start-up tech firm’s campus for free, it probably doesn’t make sense. Bottom line: one size never fits all.
What is an Annuity?
An annuity is a contract with an insurance company in which an individual (or two) pay the company either in a lump sum or through multiple payments to ultimately get a promised stream of income. Why would that be important? Not everyone is great at managing their day to day expenses and once you bring in the behemoth called retirement, it makes things even more difficult. With an annuity, a stream of income either by length of time or by amount, can be protected by “annuitizing” the contract. This doesn’t always solve for having enough money but it certainly helps with providing more control of that income.
What types of annuities are there?
There are two basic types of annuities; deferred and immediate.
A deferred annuity is one that literally gets deferred to a later time in your life. It can be funded all at once or throughout a period called the “accumulation period” and then those funds would be accessible after this period is up in which the contract could be annuitized, taken as a lump sum, or simply kept there until needed.
An immediate annuity is an annuity that is paid for up-front a lump sum and it begins paying out immediately. This may be used, for example, if someone retires with a large 401k account at their company and they want to secure a monthly income from retirement through the rest of their life.
Fixed vs. Variable Annuity?
There is a major difference between fixed and variable annuities that folks absolutely need to understand, especially those nearing retirement needing access to funds. Fixed or Fixed Indexed annuities are insurance products that protect your principle investment and offer opportunities to gain interest. They are not exposed to market risk themselves and the investment can’t be lost (aside from the actual fees assessed based on the product). Variable annuities are not guaranteed and are invested in the market (called subaccounts), meaning there is more associated risk and someone could lose principle.
How do Annuities Operate with Certain Retirement Accounts?
An annuity is the contract which provides the benefits mentioned above; stream of income, potential interest/market gain, and potential riders that will be discussed later. The registration of your annuity can vary depending on what type of account elected. For example, the annuity could be a Roth IRA, a Traditional IRA, or simply a “non-qualified.”. All of these factors are important to consider when looking at individual’s own financial picture and the tax implications of such.
What About Riders?
There are often what are called “riders” that can be either purchased (usually through annual fees) or in some cases, may actually come with the annuity purchased. They can provide options like turning on and off income through a period of time or providing double the typical income during times where an annuitant is in a nursing home. There are a variety of riders that differ based on the annuity company and is something to consider and learn about to maximize the benefits of the annuity.
So Why the Bad Rap?
After providing a little context, you can see that annuities DO offer benefits and some of the annuity products I’ve seen are pretty damn good. So why the bad name?
If we examine the example provided at the beginning of this article, I’m trying to make clear that the product itself isn’t always bad; the advice is often bad. Annuities are for very specific people in very specific situations that need to be looked at before an investment is made.
As with any industry, there are unfortunately professionals who don’t have your best interest in mind and may only be focused on the commission they get by selling you a product. Due to these horror stories of being sold expensive products that aren't needed, annuities are sometimes unfairly given a bad name.
A Personal Reflection
The benefits and pitfalls of annuities are sometimes tossed around irresponsibly. Are annuities bad? No. Do I often recommended them for the clients I work with? No. It all comes down to identifying the situation and making the right decision based on the individual. Many of my close friends have been recklessly sold annuities and are now trying to get out of them (which by the way can be VERY costly). They’ve been “sold” by a salesperson who only considers whether the annuity could be “suitable” for them…not what is in their best interest. Before you determine whether to invest in an annuity, please consult with a financial planner/adviser who is a fiduciary and has your individual needs in mind.