Much of the information about annuities found on the internet, in books, and on the radio seems contradictory and downright confusing to the public. Why all the controversy? The answer, as is often the case, is marketing.
The information we get on annuities is usually tied to the sale of a product, and so it’s hard to get an objective point of view. I’ve even heard finance professors disagree on the use and efficacy of annuities in coursework. It’s a complicated subject, but I’ll do my best to sort out the issues and help you make informed decisions regarding this complex product.
What is an annuity?
The first record we have for an annuity goes back to 225 AD when a Roman judge produced a mortality table to help calculate a stipend in exchange for a lump sum payment. It was called an “annua,” so we can see where the name came from.
Today, annuities come in all varieties. There are fixed annuities, indexed annuities, immediate annuities, deferred annuities, variable annuities… Not only are there an endless variety, there are also myriad variations within each class. It’s like the canine world. You have your breeds, but then you have the mixes. That’s the cause of all the confusion!
Let’s get basic.
The concept of an annuity is simple. Annuities were initially invented as a risk management tool using the “law of large numbers.” Individually, no one knows how long they will live. But with a large enough sample of people, we can estimate average life expectancy. For instance, based on historical data, I can estimate that the average 65-year-old American male will live another eighteen years. But that’s just an average. Some may live only a couple of years and some may live well over thirty more years.
You can think of an annuity as the flipside of a life insurance contract. With life insurance, a thirty-year old would pay a small premium, but their heirs would get a lot of money if they died prematurely. The life insurance actuaries know exactly how much to charge each thirty-year old so that the collective premiums paid by all thirty-year-old’s would be enough to cover the claims for the few that die early, plus a little for profit. In other words, if you die young you—well, your heirs—win financially. If you live up to or past your life expectancy, the money you paid for the insurance was (thankfully) wasted money.
With annuities, the situation is reversed. Here’s why. With the simplest annuity, a life-only immediate annuity, I pay the insurance company a lump sum and they agree to pay me a little each year until I can no longer fog a mirror. When I die, their obligation to pay ends. So, I could make a huge payment to the annuity company, get one small payment from them, and then it’s over. They win. Therefore, I lose if I don’t live a long time—in more ways than one.
But if I live far past my life expectancy, they would have paid me more than I gave them; and more than they earned in interest by reinvesting my initial payment. I win. I’ll use a simple example to illustrate.
Let’s say interest rates are zero, and to make the math easy, the insurer isn’t interested in profits. If a 77-year-old male with a 10-year life expectancy takes out an immediate annuity, he pays a single premium up front, and then each year after the insurer would send him 1/10th of the first premium. If he gives them $100,000, then they would pay $10,000 each year, for life. In ten years, he would have gotten back everything he paid. If, however, he dies in two years, he only got $20,000 and they get to keep the rest. Technically they wouldn’t keep it, though. (Remember, this company isn’t into profits.) Some other person who lived 8-years past life expectancy may end up with the payments that the first guy didn’t live to get.
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Annuity pay-out options
There are all kinds of variables with how immediate annuities are paid out. I can choose a “life only option” where the payment is calculated on my life expectancy alone. That gives the largest payout since only one death stops the payments—mine.
I can choose a “period certain” option. For example, if it is a “10-year period certain” then the first 10-years of payments are guaranteed, as the name implies, and then after the 10-year period is over, they continue to pay until I die. If I die in two years, they will have to continue to make payments to my heirs for another eight years. If I live for eleven years, then their job is over.
I might have a “return of premium” option where they make payments until I, or my heirs at least, get back what they paid to the company. That would, of course, reduce what the insurance company will pay me since the insurer doesn’t have the ability to get a windfall with an early death.
Another option is to add an additional life to the mix. As you can imagine, two people would have a longer life expectancy than one. For instance, the life expectancy for a 65-year-old couple may be four to seven years longer than either of them individually.
You may also wonder about cost of living increases. If you keep receiving the same amount of money each year, your budget may get tight over time. In the 1970s you could buy an average house for around $30,000. Now you’d be lucky to get a travel trailer for that. When an annuity has a COLA, or cost of living rider, the payments will start out lower than a straight life annuity, and then increase a little each year. Also, keep in mind that the annual cost of living increases are capped with these products. They aren’t designed to protect against runaway inflation since the insurer can’t protect themselves from it. They can’t spread that risk, so they must avoid it through product design.
How to use (or how not to use) annuities
Annuities were designed to insure against living too long. Surprisingly, however, they are rarely used for this function. In fact, according to LIMRA (Life Insurance Marketing and Research Association), only 5% of annuities were “annuitized”—actually making payments to the insured—in 2018. Why so few? One big reason is that people don’t easily give up control of their money.
When you’ve spent your life accumulating a nest egg, it’s hard to hand it to an insurance company knowing the money could evaporate if you die early. While there are countless plan designs that attempt to alleviate this objection, the simple math of annuities makes it impossible to give people what they would like—a high payout with no loss if they die young.
What about the other 95% percent of annuity contracts? Many are used as accumulation vehicles. Let’s say you have $100,000 in a CD and you want to avoid paying taxes on the interest. You could deposit that money in an annuity contract and, since annuities grow tax-deferred, you won’t have to pay taxes on the growth each year.
Annuities are taxed “last in-first out.” That means if the account grows to $120,000 and I start taking withdrawals, then first $20,000 would be 100% taxable since it was the gain and it went into the account last. If you annuitize, you may be able to spread the gain over several years. If the money comes out due to a death, it gets even more complicated. This is why it is important to get professional counsel in dealing with these tax issues.
Unfortunately, annuities are also commonly used in IRAs and other qualified retirement plans. (Technically IRAs aren’t qualified plans, but I’ll put them together here since the tax treatment is often the same.) This is a questionable use of annuities. In fact, some of the investment regulators have warnings regarding this practice. Why? IRAs and other pretax retirement plans already benefit from tax-deferred growth, so there is no need to have an insurance company involved in the process.
Think of it this way. The insurance company is an “intermediary” between you and where your money is invested. You give them money and they invest it on your behalf. Besides the profit that the insurer skims off the money, they also often must pay commissions to the financial person who sold the annuity. These commissions can be quite high on some products, upwards of 10% or even more of the deposit amount.
When I was in the insurance business, we were under a lot of pressure—and given great financial incentives—to sell as many annuities as we could. We were told to do a hard sell on the guarantee features. These guarantees are often used to justify using an annuity in an IRA. I won’t go so far to say that you should never put an annuity in an IRA, but I will say that the decision should be made with significant thought.
I recommend getting advice on these types of decisions from fee-only planners—because they don’t have an incentive to sell the product. There is a built-in potential for conflict of interest when the advisor only gets paid if the annuity is purchased. This is one of the reasons I only recommend “no-load” or non-commission-based annuities in my practice.
There can be circumstances where annuities may make sense in non-qualified (non-retirement plan) uses. Annuities can have some protections from creditors, where a regular, non-qualified, account may not. If someone is in an occupation with a high-risk for lawsuits it may make sense to use an annuity for protection. Again, this is another area where getting proper counsel is critical. It’s wise to weigh all the pros and cons and look at other possible methods of accomplishing the same goals in the planning process.
Types of Annuities
How annuities are actually invested can vary. I’ll walk through the basic types to give you an idea of the variety and help you understand some of the terminology.
The most basic type is the “fixed annuity.” Fixed annuities are often marketed as paying a set interest rate for a period of time, almost like a CD. The key selling point is the safety and guaranteed income. But the problem is, there are several schemes the insurance company uses to eke out a profit. For example, the interest rate may vary each year, or it could stay the same for a guaranteed period then change to anything the insurance company wants after the period is up. The rate the insurance company pays you is driven by the returns they make on your money as they reinvest it. Therefore, it is important to remember that the guarantee is only as good as the company that is backing it. You can suffer losses if something goes wrong with the company or the industry as a whole. There is no FDIC insurance at work with these products.
On the other side of the spectrum is the “variable annuity.” In this product, the insurer typically allows the investor to choose how their money is invested by offering “subaccounts” which operate much like mutual funds. These accounts may invest in stocks, bonds, commodities, real estate, or other investments. While variable annuities often have a fixed account amongst the offerings, that does typically have some guaranteed features, these subaccounts normally have no protection against loss. Notice I said “normally.” Some of these products may have complicated riders that guarantee values.
With variable annuities, the guarantees are often on the “death benefits.” For example, let’s say that you put $100,000 into a variable annuity and choose an investment mix of mostly stocks. One of the things we know about the stock market is that it fluctuates in value, both up and down. Variable annuity contracts normally charge something called M&E, or “Mortality and Expense” charges. These expenses can be upwards of 2% per year in some contracts.
While there are many variations in contract design, M&E commonly provides a death benefit. Let’s say that I put my hard-earned money into the annuity, but then the stocks I own go down in value. Upon opening my statement at the mailbox, I see the horrifying numbers staring back at me—my $100,000 has dropped in value to $80,000. At that point I keel over and die. What happens then? Well, besides the beautiful funeral with hundreds of thousands of mourners, the insurance company may have a death benefit for my heirs that brings the account value back to the original deposit amount. It may even bring it up to the highest value that the investments ever reached, again, depending on contract design. These “bells and whistles” all come at a cost, though, so be careful to weigh all of them before investing.
Fixed indexed annuity
Another common variety of annuity is referred to as “fixed indexed annuity.” This product is often marketed as having the best of both worlds. They often have some kind of guarantee against losing principal while you are living, along with the ability to tie the returns, in some way, to the performance of a stock market index.
While the guarantees can be applied to the account value, these guarantees are often applied to the income features. This can get complicated, so hang on. (Note that the terminology can vary a bit between companies and is defined in the front portion of the annuity contract you receive when you buy the product.) You may see multiple account values on an indexed annuity statement: the cash out value, the account value, and the income rider value.
The “cash out value,” or “surrender value,” is the amount they will pay you if you close your account. It’s often the lowest number because the insurer will take their expenses out—which includes the commissions fronted to the financial salesperson—before giving you back your money. These expenses are called “back-end surrender charges.” Agents will often convince potential buyers that these expenses are paid by the insurance company and that no money will come out of pocket for the buyer. But as you can see, this can be very misleading.
The “account value” is the value that they credit your returns to. As time goes on, the back-end surrender charges will go down according to a pre-determined schedule. This is because the insurer holds your money long enough to recoup the business acquisition costs that they incurred to get you as a customer—like commissions, and possibly underwriting fees.
The third number is the “income value.” This number is used to determine what lifetime income they will pay you when you decide to start taking income or annuitize the contract. More often, the “income value” number is much higher than the “account value,” but the “income account value” number isn’t the money you can take and spend. That’s why this is often referred to as a “phantom account.”
The bottom-line with annuities
At the risk of being redundant, note that these contracts vary depending on the insurer and the specifics of the product. If you think that artists have a monopoly on creativity, you haven’t met the marketing and actuarial department of your local annuity provider. It seems that every time an objection to product design surfaces, they will go to the drawing board to try to eliminate the problem.
Here is where I’m going to ask you to apply some common sense and remember the acronym TNSTAAFL, “There’s No Such Thing As A Free Lunch.” Deep in our psyche, we all want safety. “I just want to make it safely to death,” I often joke. This is why we can be so vulnerable to the sales pitch of “guarantees.” Think about this: If someone tells you that you can get high returns with no risk, I would simply ask why someone wants to pay me so much to use my money if there’s no risk. It doesn’t make sense.
If you’ve ever had a mortgage, you probably tried your best to get the lowest interest rate you could. If you had low credit, you may have had to pay more, but that isn’t something you’d willingly choose to do. Why would an insurance company do that? Surely, they are smarter than that. As is often the case, the insurer gives guarantees with one hand and takes them away with another. Without getting overly technical, the “hand that takes away” is always some form of high expenses or income limitations.
One of my rules of thumb when making investing decisions is “don’t throw your brain away” when looking at options. So much of the information we get about investing comes from people trying to sell things to us. An old adage in sales is that people “buy on emotion and justify with logic.” However, when it comes to our money, our desire to protect what we’ve accumulated, as well as our concern about running out of money before we die, often causes us to throw logic out the window. I guess the age-old advice of “buyer beware” still applies.
By Paul Winkler
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