Should I use annuities as a temporary investment?
I invested in a four-year fixed annuity several years ago to allocate a percentage of my portfolio into a vehicle that was conservative. At the time, it was the safest, risk-free investment recommended by my investment adviser. The annuity is set at 4 percent annually. I am a long-term aggressive investor who makes about 12-15 trades a year. My retirement horizon is between 2-5 years away from now. Is this a safe strategy going forward?
Yes, fixed annuities can be a great option for the conservative portion of your portfolio for three reason:
- The rate of return can be higher than a bank account or short-term bond ladder etc.
- The interest is tax-deferred until you take it out of the annuity. In other words, if you are still working and most likely in a higher-income bracket than when you will be retired, so the interest that you would have paid in taxes for a bank account or other short-term investment, will stay in the annuity earning more interest.
- The account cannot go down in value like some bond funds.
But there are a few cations about annuities too.
- Almost all annuities pay the salesperson a commission. Some annuities pay more commission than others and how do you know you are getting the best annuity option for you or the annuity that pays the agent the most income?
- Associated with most annuities is a “guaranteed minimum interest rate” and a stated “current interest rate”. Some annuities have an artificial high first year rate and then drop low after that. To counter this trick, ask for a fixed rate for a set period of time.
- Look at surrender charges. These are fees that are deducted from the account if you close it prior to the end of the surrender period. The longer the surrender period, the higher the interest rate and sometimes the higher the commission.
- Look at the quality of the company. Lower quality insurance companies have to pay higher interest rates to counteract the higher likelihood that the insurance company cannot make good on its obligations.
- Sometimes the annuity does not work exactly as it is verbally presented. Index annuities have some of the highest commissions, have the most-harsh surrender charges and are hard to understand exactly how they work. The client hears the “4% return” and assumes it is 4% interest fixed every year and that is not the case.
At the current time, it would be hard to find a 4-year locked in interest rate from a quality company that would pay even 2%. If in fact you have an annuity that is truly fixed rate interest at 4% from an A rated insurance company, it would appear that your advisor did well for you. If on the other hand the company is B rated and it is not a fixed rate annuity but in fact an indexed annuity than it is debatable as to if the recommendation was correct.
Allocating a portion of your portfolio to something safe and that produces a decent level of income is always a smart idea. What you need to know about the annuity is what the expenses and charges are becasue they will reduce your actual rate of return. Was there a sales charge for this annuity? What is the mortality and expense ratio? What is the annual policy fee? What is the underlying investment management fee?
If you are a long term Aggressive investor you need a longer time horizon than 2-5 years. Since you are nearing retirement it would be advisable to reduce your risk to at least a Moderate level to preserve your gains and protect your capital.. When we have another recession be sure to rebalance back to your desired Moderate Allocation.
A 4% return was a decent return 4 years ago, and is OK today, but not a world beater, as other fixed income investments can produce as much income w/o surrender penalities etc. You have offered a partial picture of your situation which makes it tough to opine on, but, something like that may retain a place in your overall allocation. The challenge with insurance products is that your liquidity is tied to the contract, not when you want it, limiting how proactive you can be using it to fund other investments or, spend....
In your situation, that was not a bad solution at all. It gave you a guaranteed return on what would otherwise have been a cash/ money market fund returning little to nothing. More importantly however, it was only one part of a much larger plan.
But let's take a more specific look at your main question "should annuities be used as temporary investments?"
What is a person's timeline? "several years ago" you had more than 2-5 years until retirement, which makes the 4 year commitment less daunting. For some people reading this, that could/ should be a deal breaker. Annuities will generally tie up money for a specified time with only 10% being liquid usually- any money withdrawn in excess of 10% is penalized with 5-12% penalties. So for people with a need to access money within 5 years, any annuity longer than 5 years is inappropriate.
What is your risk tolerance and does your overall portfolio reflect that risk level? In your situation, you are not risk averse which would usually make anything but a variable annuity likely inappropriate. However, you wisely recognize a need for some sort of "cash equivalent" holding to hedge against a broad market decline. Hopefully, you've limited your annuity holdings to a portion of your total investments otherwise your gains will be very disappointing. For other more risk averse investors however, fixed, indexed, and even immediate annuities can be a great option for risk management assuming they are used appropriately and are not overly allocated in terms of overall portfolio percentage.
Lastly, type of annuity and details of the specific contract matter. In your case, you actually did well because you worked with an Investment Advisor, not just a straight insurance guy. While there is nothing wrong with straight insurance guys, they tend to see the solution to every problem as (SURPRISE!) more insurance. This seems like a small and unrelated note but it really is everything- most investors are not steeped in the investment world and I've even seen lawyers confused by the various contract terms in annuity contracts. Because Investment advisors act in a fiduciary capacity and are therefore legally liable for advice they give, they are at large far more interested in the details that really matter to the investor within annuity contracts. For example: in your situation, the 4% you secured in contract is very competitive even today with the rising interest rates. And because they have access to nearly limitless investment options, Investment Advisors generally will be more hesitant to lock in sub-3% rates. Add to this the requirement that they have transparent fees, and you can be assured that not only are you getting competitive rates but that costs and fees will not be popping up to rob you of the smaller returns you do receive on the cash portion of your portfolio.
Going forward, I cannot say that annuities are the best option. Or even treasury notes for that matter. Instead, I'd recommend you continue to consult your investment Advisor each time you begin looking at cash-equivalent options because "if it ain't broke, don't fix it".
Annuities can be useful as a bond alternative especially as interest rates are rising. If you have bonds as part of your portfolio, the bonds or bond funds could be losing value since bond prices decline as rates rise. You state the annuity is earning 4%/year. As you approach retirement, the 4%/year with downside protection during market corrections could be a valuable part of your retirement strategy. You may consider your retirement goals as you near that target in 2-5 years. One of the things to consider are your income needs during retirement and the risk tolerance during withdrawal years. With your "long term aggressive strategy", you may experience a market downturn during the withdrawal period that could ultimately impact your lifestyle. You would not have that risk with the annuity. Consult your investment advisor to review your retirement goals, income needs, and the amount of risk your income needs can tolerate.