What is an annuity?
An annuity is a powerful financial planning tool that when used for the right purpose, and in the right situation, can provide tremendous value to the annuity buyer. Annuities can add stability and security to an investor's portfolio when they are used in an efficient manner. Unfortunately, the vast majority of annuity buyers misallocate their resources when purchasing annuities and end up with an underperforming annuity that costs too much, pays too little, and is simply an inefficient use of their resources.
By definition, an annuity is a contract between you and a 3rd party (usually an insurance company) whereby in exchange for making a lump sum payment, the insurance company promises to do four things:
- Provide an income for a certain period of time,or for life
- Provide for accumulation, or asset growth
- Provide a death benefit
- Provide for long term care benefits
There are only two types of annuities: Fixed and Variable.
- Immediate annuities--start paying income right now (to start in less than one year)
- Deferred annuities--start paying an income later (anywhere from 1-50 years)
- Multi Year Guarantee Annuities (MYGAS)--pay a fixed interest rate each year for a certain period of time
- Indexed Annuities-increase in value depending on the performance of a baseline index like the S&P 500, Dow Jones, Gold, Real Estate, or even a negatively correlated index.
The key feature of fixed annuities is that the principal is FIXED--it is guaranteed by the insurance company. Gains are usually locked in each year, and you can mix and match different types of annuities to create a guaranteed income stream in retirement that is not influenced by interest rates, market fluctuations, or other typical market influences. These are good options for conservative individuals, and are not regulated as an investment, but an an insurance only product.
- With these types of annuities, the principal value "varies" based on the performance of the sub-account values that your money is allocated to. These are viewed as investments and are sold by individuals that are licensed to sell both investments and annuities. These are good for individuals that want upside appreciation, and can tolerate risk in their portfolio. This type of investment typically has higher fees and expenses because of the additional insurance costs that are prevalent because of the insurance component.
SHOULD YOU BUY AN ANNUITY?
- This depends on the problem that you are trying to solve. You money has a job to do, and you can choose to find the most efficient and effective way to get the job done, by allocating your scarce retirement resources in a comprehensive, coordinated plan that maximizes returns, reduces risks, and eliminates unnecessary fees, taxes, penalties, and surcharges, or not. This is where the misuse of annuities come into play.
- Insurance companies want you to believe that whatever your financial problem, whatever your worry, there is an annuity that can fix it, and that just isn't true. They are good solutions for some financial problems, but horrible solutions for other problems. Most investors haven't appropriately defined with their advisors what problem they are trying to solve, and therefore end up misallocating resources into an underperforming annuity and have been sold something without looking at the overall picture.
HOW DO I KNOW IF I NEED AN ANNUITY OR NOT?
- Define what problem you want your money to do for you (Income, growth, legacy, or long term care benefit.)
- Look at all of the available annuity options that can solve for those needs
- Look at annuity alternatives that do the same thing
- Determine how much money is required to solve the problem
- Compare fees, costs, expenses, taxes, performance, what-if scenarios
- Allocate resources accordingly
- Monitor your decision and make changes when necessary.
HOW CAN I GET HELP SELECTING AN THE RIGHT ANNUITY?
- You need to work with a professional. Someone who knows what you need, and can match you up with the right solution. In my firm, we like to look at prices and solutions from all available annuity providers, not just 2-3, and try to create the greatest benefit for you using the least amount of money.
This is a complicated question, too long to go into all of the nuances so I will hit the highlights right between the eyes. Technically, an annuity is a contract between you and normally an insurance company where the insurance company promises to provide certain benefits. And it is a tool just like any other investment product. The problem is, they are WAY OVERSOLD and used to generate high commissions. But did you know that there are commission free annuities without any surrender penalties or high ongoing fees? You can put the money in and take it out the next week without any penalties whatsoever. And the ongoing fee structure is very advantageous, much more than a commission based annuity. But you never hear of these because they don't generate large up front commissions.
These "no-load" annuities have over 200+ funds from equity and bond index funds, sector funds, leveraged and even short funds, and guaranteed funds. They have professionally managed funds by some of the best stock and bond managers in the world. But again, you won't normally hear about those unless you get a fee-based only advisor acting as your Fiduciary. Even then, these are normally NOT the answer and should still be used only in certain circumstances.
You also need to understand the tax ramifications of income first and return of principal second, which is a disadvantage of annuities in taxable accounts once you begin to take distributions. Yes, they grow tax deferred, but then you get clobbered when you take the monies out. And your IRA is tax deferred already and bulletproof from creditors, so putting a tax deferred annuity inside something (IRA) that is already tax deferred really needs to be examined. In fact, this is what the DOL Fiduciary Rule is all about, selling commissioned products inside retirement accounts. They are overused, especially in retirement accounts. But that is where most investors have their money.
Before you do anything, do your homework. Investment planning should be about strategy, not products. Then if products fit into the strategy, fine. Usually this would be life insurance, cheap term at that, and not annuities. But if you decide an annuity is right for you, research commission-free annuities or fee-based annuities. They are, in my opinion, usually a much better alternative.
Hope this helps and do your research, Dan Stewart CFA®
An annuity is a contract between you and an insurance company in which you make a lump sum payment or series of payments and in return obtain regular disbursements beginning either immediately or at some point in the future.
The goal of annuities is to provide a steady stream of income during retirement. Funds accrue on a tax-deferred basis, and like 401(k) contributions, can only be withdrawn without penalty after age 59.5.
Many aspects of an annuity can be tailored to the specific needs of the recipient. In addition to choosing between a lump sum payment or a series of payments to the insurer, you can choose when you want to annuitize your contributions - that is, start receiving payments. An annuity that begins paying out immediately is referred to as an immediate annuity, while those that start at a preset date in the future are called deferred annuities.
The duration of the disbursements can also vary. You can choose to receive payments for a specific period of time - for example, 25 years - or obtain them until your death. Of course, securing a lifetime of payments lowers the amount of each check, but it helps ensure that you don't outlive your assets.
Annuities come in three main varieties - fixed, variable and indexed - that each have their own level of risk and payout potential. Fixed annuities pay out a guaranteed amount based on the balance of your account. The downside of this predictability is a modest annual return, generally slightly higher than a CD.
You have the opportunity for a higher return, accompanied by greater risk, with a variable annuity. In this case, you pick from a menu of mutual funds that comprise your personal "subaccount." Here, your payments in retirement are based on the performance of investments in your subaccount.
Indexed annuities are somewhere in between when it comes to risk and potential reward. You receive a guaranteed minimum payout, although a portion of your disbursements is tied to the performance of a market index, such as the S&P 500.
Despite their potential for greater earnings, variable and indexed annuities are sometimes criticized for their fees and their relative complexity. For example, many annuitants find that they have to pay steep surrender charges if they try to get their money out within the first few years of the contract.
An important feature to consider with any annuity is its tax treatment. While your balance grows tax-free, disbursements are subject to income tax. Conversely, mutual funds that you hold for over a year are taxed at the long-term capital gains rate. And unlike 401(k) accounts, contributions to annuities don't reduce your taxable income. For this reason, some finance experts recommend annuities only after maximizing your contributions to pretax retirement accounts.
Simply put, an annuity is something to be avoided. If you want to shelter your income from taxes, you have a simple solution: put the maximum 25% of your salary into a 401(k), 403(b), or 457 plan with your employer (or up to 54 thousand annually into a SEP-IRA if you are self-employed), then another 5500 into a Roth IRA (6500 if over age 50), another 5500 or 6500 for your spouse in a Roth IRA, and then 8750 combined into an HSA which is tax-deductible and free of taxes upon withdrawal once you reach age 65. That is about 80 thousand dollars annually which you can contribute out of your income each year.
What if you have millions you want to shelter from taxes? In that case, do what Warren Buffett does and buy something--anything at all, like a stock, bond, or a fund. Don't sell it for ten years, or 20, or more--Buffett still has some shares he bought a half century ago which he hasn't paid taxes on since he hasn't sold, and will never pay tax on if he doesn't sell it. When you die, the purchase price steps up to the closing value on your date of death, so you never have to pay taxes. If you do decide to sell after five years or so, or at least after one year and one day, then you pay only 15% in capital gains (or 18.8% or 23.8% if you are in a very high tax bracket).
With an annuity, you will still have to pay taxes when you withdraw the money, probably with huge surrender penalties and with a tax rate of 28% or 33% instead of 15% because it is all counted as earned income. Then you still have the 10% penalty if under age 59-1/2 and all kinds of other fees and penalties. So there is zero advantage. The only reason annuities exist is since unscrupulous financial advisors get upfront kickbacks from the annuity companies for which they get clients.
I'll give you an example of how an annuity could used to your great advantage. In particular, I am referring to a single premium immediate annuity.
My father passed away a few years ago. He left my mother some money. She was at an age and stage in life in which she could no longer work and generate additional income; so, the money Dad left her was going to have to last as long as she did. And since she would not be able to bring in additional income, she didn't want to take any chances with her money. She wanted a guaranteed income for life.
Since I sell life insurance exclusively, I needed to get her help from an annuity specialist. He set her up with products from three different companies, due to the contribution limits of each. They were all insurance companies with strong financial credentials. Collectively, they provided the money needed each month to pay her bills, and also have some fun. She had peace of mind because she knew that amount would be guaranteed. As long as she did not increase her expenses, she would be fine.
We had to factor some taxes into her expenses, because a portion of the annuity distribution was taxable. Fine. All the bases were covered: financial needs analysis, good carrier selection, guaranteed income, and accounting for the taxes.
And also estate planning. She recently passed away as well, and has left a legacy to her children. All in all, a smart use of the product.