Annuities: The Opiates of the Financial Industry?
By Todd Holden, Financial Advisor
Annuities are the most controversial and confusing investment vehicles available. As an advisor and investor, I receive several emails weekly about annuities. One firm touts them as a great retirement option while another writes that purchasing an annuity is a “top ten mistake” that a retiree can make. What’s the reality?
For several months I’ve sought an effective, unbiased way to explain annuities. During a recent conversation with a pharmacist friend, it came to me: Annuities are the opiates of the financial industry. Both annuities and opiates have a legitimate purpose when used appropriately, and both have a history of overuse, abuse and bad sales practices.
When you combine this history with the vast array of annuities available and their many optional riders, it’s no wonder the public is confused. Books have been written on the subject. Short of reading one of these books, the most effective way to determine whether you should purchase an annuity is to reframe the question. If we change from “Are annuities good or bad?” to “Is an annuity appropriate for me?” and then look at what annuities can do, it will both clarify things and allow you to make an informed choice. A few examples of annuities are listed below with a brief explanation of how that feature works and the type of annuity used. If any of these examples appeal to you, then consider an annuity. If not, it’s probably best to avoid an annuity.
Guaranteed Income — This is the oldest and simplest feature of annuities. Traditionally, an investor sends an insurance company a sum of money, and the insurance company provides a guaranteed income to the investor. This guaranteed income could be for a period of years (5, 10, etc.) or lifetime. In this traditional form, there is no account balance and no money back. As baby boomers began to retire, the insurance industry evolved. Now, there are several income riders that can be attached to annuity contracts which provide for lifetime income but still allow for the investor to maintain an account balance. If the investor dies prematurely, there is still an account balance for their heirs. Every company’s riders work differently, and they can be very confusing. A few times a year, someone will bring in their annuity contract — and generally what they think they have is much different than what they actually have.
Guaranteed Death Benefit — These riders guarantee a death benefit should the annuity owner not make any withdrawals from their annuity between the time they purchase it and their death. For example, there is a company that offers a 7 percent (simple interest) death benefit that increases for 15 years. If an investor purchases a $100,000 annuity with this rider and never touches it, the death benefit will be $205,000 in 15 years. I will use this type of rider when the client has money they don’t ever expect to use but want to retain ownership of in case they change their mind in a few years. This may also appeal to a couple where one person has most of the retirement assets (TSP, 401(k), IRA). The spouse with the assets is uncomfortable about enjoying them because they are worried about providing for their spouse. By taking a portion of the retirement assets and investing in an annuity with a locked-in death benefit, they are more comfortable enjoying the portion of their retirement account that is outside the annuity. Given current interest rates, this 7 percent death benefit guarantee is probably a lot more money than they’ll generate in a savings account or CD.
Relatively Safe Returns — Certain annuities are geared toward protecting an investor’s principle while allowing the investor to participate in some of the upside of financial markets. When the financial markets do well, the investor will potentially earn more interest than they could at a bank or credit union, but when the financial markets tank, the investor will likely maintain their principle. This type of an annuity is appropriate for investors like my mom, who in the late 90s handed me a check for $43,000 and told me, “I don’t care what you do with my interest, but I never want to see a statement that’s less than $43,000.”
These are three examples of how an annuity and available riders can be used appropriately. There are many more bells, whistles and characteristics that make annuities confusing than we can deal with in a brief article. Often, I tell clients that annuities are like Baskin-Robbins® ice cream. With 45 flavors, they’re all a little different!
Because of the confusion created by the variety of annuities available, let’s cover some of their common characteristics. All annuity contracts are between an investor and an insurance company. While you may purchase an annuity at your bank or credit union, annuity contracts are not issued by them. As such, no annuity contract is federally insured. When an advisor says that a benefit is guaranteed, they mean it is guaranteed by the insurance company. You may purchase an annuity that is safe or secure and may purchase it from a financially strong company, but you cannot purchase an annuity that is backed by the federal government. How safe and secure your annuity is depends on how the investments inside the annuity work and the strength of the insurance company with which you’re doing business.
If you have further questions about annuities or an old annuity which has not been reviewed in several years, contact an advisor who has the experience to help you select the best annuity for you and your goals.
This information is not a substitute for specific, individualized advice. For advice personalized to your unique situation, please consult with a qualified financial advisor.
Fixed and variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims-paying ability of the issuing company. Withdrawals made prior to age 59½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.