This is a follow-up to my last article about the role that immediate income annuities could have in providing additional income for someone running low on income in retirement. The focus was on Single Premium Immediate Annuities (SPIAs), a type of fixed income annuity.
But there are two other types of annuities: indexed and variable. The main difference between fixed annuities and the indexed and variable varieties is that fixed annuities pay a fixed amount each period. In contrast, your income from indexed and variable annuities is tied to the stock market’s performance in one way or the other.
Indexed and variable annuities are not ordinarily purchased to provide immediate retirement income. Instead, they’re usually sold to those still saving for retirement who want to safeguard their principal in exchange for potentially lower stock market—based gains. (As such, they’re used mainly as a de-risking strategy.) Others may use them as longevity annuities and let them grow for 5, 10, or 15 years into retirement before tapping them for income, thereby helping to ensure they don’t run out of money later on. On that basis, they’re used as a mitigation strategy for market and longevity risk.
Still, you may be interested in one or be offered a proposal for one at any time before or while in retirement, and the sales pitch can sound quite appealing. Therefore, you would do well to have a general understanding of what they are, how they work, and what to look for in the “fine print” should you decide to purchase one.
Not Your Father’s Annuity
These products are more sophisticated than plain vanilla immediate income annuities. In fact, they have only been around since the 1990s, whereas income annuities came on the scene in ancient Egyptian and Roman times.
An indexed annuity is a kind of hybrid product that combines features of fixed and variable annuities. It typically has a “base” return similar to a fixed annuity, but its value is based on the performance of a specified stock index such as the S&P 500. If the index goes higher, then your returns may rise, though not as much as the index when the market is up big in any given year.
Variable annuities are tied to an underlying asset account, typically containing mutual funds, instead of a market index. You have some freedom in selecting the investments that you hold in that account relative to how much risk you want to take, but your options in each risk category may be limited. The overall performance of your annuity is tied to the performance of those assets, typically stock mutual funds.
All of these products are government-regulated. Federal laws put equity-indexed annuities under state insurance regulation, but variable annuities are subject to state insurance regulation and federal securities regulation.
Annuities can also be either deferred or immediate. This has to do with when you start receiving annuity payments as income.
Deferred annuities are typically indexed or variable annuities but can also be income annuities. Because you leave your principal and any earnings alone, they accumulate more assets and grow in value over time. Exactly how they grow depends on how you invest your principal—stocks, bonds, or guaranteed interest. Withdrawals are taken as a lump sum or as regular income payments later on, usually in retirement.
Immediate annuities allow purchasers to convert a lump sum payment into a stream of income that begins immediately (like the SPIAs I mentioned earlier, but they can be initially purchased as a deferred annuity and converted to an immediate annuity later on). The income is “guaranteed” by the insurance company for a specified period, or for a single person’s life, or the life of that person and a survivor. Income tends to be highest for period-certain policies, then for a single person’s lifetime, and lowest for the lifetime of a single person and a survivor.
As you might imagine, given the number of types and variants, navigating the world of annuities can be a daunting task. That’s one reason I lean toward SPIAs for those who would benefit from an annuity as a source of some of their retirement income. Their relative simplicity makes them easy to understand and integrate into an overall retirement plan.
The most attractive feature of indexed and variable annuities is that, unlike SPIAs, they generally offer some upside potential while also limiting the downside, often while also paying a guaranteed income stream (which may come at an additional cost—a “rider” fee).
SPIAs pay a fixed income unless you purchase one with scheduled payment increases of a certain percentage each year, which results in lower initial payouts, but they will grow over time. Unfortunately, inflation-adjusted SPIAs are no longer available in the marketplace.
Because of their possible upside and limited downside, indexed and variable annuities can be very attractive. And I’m not going to say that no one should ever purchase one. There are undoubtedly some decent products in the marketplace, but I want to emphasize that they’re not suitable for everyone and come with a fair amount of complexity and cost.
Their complexity makes variable annuities hard to understand and compare. And their cost makes them, well, costly, at least compared to other options.
But you may be surprised to learn that annuities outsell all other life/health insurance products. In fact, according to the Insurance Information Institute, ”Measured by premiums written, annuities are the largest life/health product line, followed by life insurance and health insurance (also referred to in the industry as accident and health).”
In other words, insurance companies sell a lot of them make a ton of money from them!
What can make indexed and variable annuities even more attractive is equity and credit market turmoil. It’s no secret that this creates concern— and sometimes angst and panic (during a market crash)—among investors, which can lead to making emotionally driven investment decisions instead of prudently considering all factors and alternatives and rushing to purchase a product they don’t completely understand. Such actions can have undesirable long-term consequences.
Have you noticed that the marketing of these products by insurance companies on TV and online and print media has increased over the last couple of years? The insurance industry thrives during times of market volatility and uncertainty. The more market turmoil there is, the more appealing annuity products become. This is especially true in the wake of major market declines.
Annuity products are all-in-one solutions with bells and whistles that befuddle all but the most financially sophisticated. They make claims like “receive guaranteed income while also capturing stock market returns without stock market risk.” Claims like that appear to be good to be true—and they often are. (And telling only part of the “truth” doesn’t qualify as truth, in my opinion.)
But, “Caveat Emptor”
I took two years of Latin in high school, but the only phrases I remember are “e pluribus unum,” “novus ordo seclorum,” “carpe diem,” and “caveat emptor” (buyer beware). (Okay, I know a few more, such as “North Carolina est non insula” and “Florida est non insula, Florida est peninsula.” But I digress.)
Why “buyer beware”? Well, on the one hand, indexed and variable annuities are especially popular with investors because they offer guarantees in addition to the potential for growth—a very tempting proposition. But they can be difficult to understand and compare, expensive to buy, and they’re not totally risk-free.
Do they offer some attractive features? Absolutely, but you want to make sure you need them, understand them, and know what they will cost you before signing on the dotted line.
As discussed in the last article, some retirees will need additional guaranteed income in retirement, and without a pension, an income annuity can meet that need. But purchasing an indexed or variable annuity is more of a want and has to do with their risk tolerance in relation to their financial goals and how best to achieve them. Annuities can be a good option to “fill in the gaps” of a retirement income plan running short on income from other sources.
Fixed annuities appeal to those with a very low risk tolerance who use them to substitute for fixed income investments (such as CDs, bonds, etc.) in their portfolio. Those who are willing to tolerate more risk may lean toward indexed or variable annuities as it enables them to stay invested in the stock market, directly or indirectly. They can also add contract riders (for a fee, of course) for things like higher earnings caps, guaranteed income, or a death benefit.
These products may also be useful to wealthier individuals with more investable assets who have maxed-out their retirement accounts. Indexed and variable annuities are some of the few vehicles that enable tax-deferred growth in non-retirement accounts.
Costs really matter because they reduce earnings. If you pay 1.5% in fees, your earnings will be reduced by that amount. It’s also problematic that all annuity costs are not readily apparent. Some may be explicitly stated, but others are more obscure and hard to identify. It’s important to know which costs to ask about so you can figure out exactly what an annuity product will cost you in total per year.
Annuity costs come in two ways: direct and indirect. Direct costs are typically in the form of fees, whereas indirect ones include things like sales commissions. We’ll look at both.
Fixed Index Annuity Fees
The most common costs for fixed index annuities are for optional features such as an income rider, enhanced death benefits, or higher caps and participation rates. Fees can cost up to 1.75% of the account value annually, depending on your benefit.
Some of these products have “built-in” benefits or riders with an annual fee, so they may not be listed as a separate option with a clearly identified fee.
Variable Annuity Fees
Variable annuities are among the most popular. In 2020 alone, according to the Insurance Information Institute, investors purchased $98.6 Bil. of them versus $120.5 Bil. in immediate and fixed income annuities combined.
They are also the most costly, primarily because they’re investment products, not insurance products. Here is a list of the standard fees you’ll pay for a variable annuity:
- Administrative Fees: This is a relatively minimal service fee for your retirement account. You can expect to pay up to .30% of the account value annually, but most are much less and are sometimes zero.
- Mortality Expense: This is to provide death benefits to your heirs (some annuities pay a death benefit, similar to a life insurance policy.) These fees can run from .50% to 1.75% per year.
- Investment Fees: This is an investment advisory fee for choosing and managing your selected assets (typically stock and bond funds) in the underlying sub-account. These can be from zero to 1.5% of asset value per year.
- Underlying Investment Fees: This is the fee charged by the mutual fund managers for the various investments chosen for the sub-account. These can range anywhere from .05% to 2.0% per year or more, depending on the funds.
- Guaranteed Lifetime Withdrawal Benefit (GLWB): An income rider fee similar to an index annuity’s income rider. The income rider provides a guaranteed income payout regardless of the performance of the sub-account. These can be up to 1% of the account value per year, depending on the policy.
- Other Riders or Annuity Expenses: These include optional increased cap and participation rates, enhanced death benefit riders, long-term care riders, joint life or spousal income riders, death benefit riders, or even a minimum accumulation benefit. (The exact names will vary, but I think these are the main things that are likely to come up.) Depending on which ones you select could add anywhere from .50% to 3.0% or more of additional fees.
- Annuity Surrender Fees: Variable annuities that pay a large up-front commission almost always have a surrender charge. This charge only applies if you withdraw money from the policy during a specified time frame, usually between 5 and 10 years. It won’t be an issue for most retirees who want to keep the annuity throughout retirement.
These are not fees per se since, in most cases, you won’t pay them directly from your principal. The insurance company pays them, and occasionally the firms managing the underlying investments in the sub-accounts of a variable annuity. You won’t see it as a debit from your account; the company does it in the background as part of its cost of doing business.
The pressure on stockbrokers and insurance salespeople is enormous because they can make as much as 10% or more in commissions per sale, depending on the annuity type and how many “bells and whistles” you add. The simpler and more straightforward the annuity contract is, the lower the commission. That’s why SPIAs pay relatively low commissions compared to their more complicated cousins.
A commission of 7% on a $500,000 variable annuity would pay a tidy $35,000—not a bad payday (although the company may pay it out to the salesperson over a period of years). That’s not “bad” or “wrong”—good salespeople are entitled to compensation when they make a sale—but you need to know this because it may (and I emphasize it may) result in a conflict of interest. In other words, a salesperson may steer you toward a particular product that might be okay for you but would be great for them because it pays a higher commission.
Regardless of the type and whether they are held in qualified retirement accounts (like an IRA) or not, annuities grow tax-deferred. However, the IRA taxes money withdrawn at your income tax rate. IRAs also grow tax-deferred, so there is no tax advantage to owning an annuity inside an IRA.
Annuities do provide tax-deferral benefits for after-tax, non-retirement monies used to purchase them. However, money invest outside an annuity is taxed at 15% (long-term gains tax), whereas money withdrawn from a non-annuity investment account is taxed at your income tax rate, which may be higher than 15%.
One could argue that the most significant risk with annuities is not that you might buy an overly complicated or costly one (though that may not be a good thing), but buying something you don’t understand or realize later you didn’t really need.
Another risk is that you spend too much on one and then a lump sum for an emergency or some other need and no longer have access to your cash without paying a surrender fee.
But the main financial risk is insurance company insolvency—the money invested in an annuity is only as ”safe” as the insurance company you purchase it from. An insurance company could default. Granted, this doesn’t happen often, and annuities are regulated at the state level and insured to a point by state guarantee funds. But no insurance company can guarantee that they will never go out of business.
If You Need (or Want) One
Most people I have talked to who have purchased annuities are reasonably happy that they did. Those that aren’t pleased with their decision tend to say that they didn’t fully understand what they were buying and now have regrets. (I once met with a couple who didn’t realize they had purchased a variable annuity to fund their IRA and were so upset they paid the surrender charge to get out of it. I didn’t recommend one way or another—I’m careful not to offer “advice” on certain things—but I made sure they understood their alternatives and that a surrender charge would apply if they wanted out of their annuity contract. They learned a hard lesson in this instance.)
Sorry, but I can’t answer the question that I posed in the title of this article for you. I can’t tell you if one of these products is right for you. They are somewhat esoteric and highly situational in terms of appropriateness. And even if there is a “fit,” it may not be your best option.
If you’re interested, seek wise counsel, consider all your options, and consider products from different providers. It’s essential to thoroughly understand what kind of annuity might be best for you, what specific product you’re buying and whether you really need it in the first place, and what the total costs (all fees) are.
Here’s a checklist of things to help you shop for a fixed or variable annuity should you decide you need one:
- Check the terms. Annuity contracts are known (infamously) for their “fine print,” so be sure to read the contract carefully. You need to understand their terms and conditions related to surrender charges, optional riders, and other fees, not just the potential benefits that salespeople tend to focus on.
- Choose your salesperson wisely. As noted above, insurance companies often pay generous commissions to brokers who sell their particular annuities, which most brokers don’t disclose. They also generally don’t reveal whether they are paid more or less by one insurance company than another or whether the annuity they are selling is the very best option for their client. Ask your broker questions to determine how they are paid. You may want to seek a second opinion to ensure your salesperson isn’t steering you into a product that isn’t right for you.
- Select a sound insurance company. Annuity payments are often supposed to last a lifetime, so you want an insurance company that will stick around. Ensure that the insurer is rated in the top two categories by one of the services that rate insurance companies, such as A.M. Best, Moody’s, Standard & Poor’s, or Weiss.
Wise as Serpents. . .
Remember, annuities are simply tools to help you reach a specific goal or address a financial challenge. You may not need one, but it’s good to know how to shop for one if you decide you do. And even if you’re not sure if you need one or not but want one anyway, you want to be a wise and educated consumer.
If you’re working with a financial advisor, make sure he/she is someone who has more than one tool in their toolbox. (To a salesperson who sells only annuity hammers, every retirement income challenge looks like a nail.)
Rather than a complicated and expensive indexed or variable annuity, you may be better off with a simple SPIA. Or, maybe your best approach is to create a diversified portfolio of bonds, stocks, ETFs, and mutual funds concentrated on value and compound interest and then let them do their thing. Only you (with wise counsel if necessary) can decide what is best for your situation.
If you decide to purchase an indexed or variable annuity, given the complexity and costs involved, it’s best to be “wise as serpents and innocent as doves” (Matt. 10:16). Be sure you understand the terms of the contract, differentiating between the “must dos” (contractual guarantees) and the “might dos” (based on market performance or other conditions).
Finally, read the fine print, even if you have to sit on the contract for a few days. (You should probably do that even if you don’t read all the fine print.) And by all means, get wise counsel and perhaps a second opinion. Such efforts will eliminate surprises (and regrets) down the road.