Are Annuities a Bad Deal?
Annuities get a bad rap and for some, there are very good reasons this is so. However, annuities do serve a purpose. Here is a simple explanation of what purpose annuities serve and some guidelines to know when you should consider an annuity.
Do you need to insure your income?
Annuities are financial products that are offered by insurance companies. As such, it is important to understand that the main purpose of an annuity is to provide insurance. Simply, an annuity is a stream of income payments over a certain period of time. Most often, that period of time is an individual’s life. Since annuities are guaranteed to provide income for life, they are sometimes thought of as longevity insurance (or insurance against outliving your income).
Annuity payments can start immediately or be deferred to start at a later time. These deferred annuities offer specific terms for how your money grows before the income starts.
The first point to remember is that an annuity should provide some guaranteed income. It’s like creating your own personal pension. The terms and the guaranty come from the insurance company, so it is important to be selective and understand what is being offered.
Do you need to insure your investment returns?
When your money funds a deferred annuity, there are several ways that you may receive earnings. Some annuities provide a fixed interest rate, others allow you to invest in mutual funds (called separate accounts in an annuity), and others provide interest that is credited based on the performance of a stock index.
Often, these deferred annuities will offer additional benefits (riders) that provide enhanced income or death benefits. These riders come at a cost. You essentially pay a premium by paying an additional expense rate on your portfolio. This payment will provide some type of future benefit that you can count on regardless of your actual investment performance. In a way, these riders are insuring you a minimum rate of return on your money. The caveat is that these benefits are typically only applied to a future income benefit, not your actual portfolio value. This can be a way of ensuring a future income or death benefit regardless of how your portfolio performs over time.
Do you need peace of mind against down markets?
Some deferred annuity products offer protection from market drawdowns. These annuities typically provide some type of “buffer” if market returns are negative for a specified term. This means that when the market index is negative, the annuity product may provide a reduced negative return or just not credit any return.
When you should consider an annuity:
The answer to this is unique to each financial plan. As mentioned above, annuities can provide benefits that are useful to some individuals. Income guarantees, predictable future income, and peace of mind against down markets are all benefits that could enhance retirement.
Annuities typically come back in to favor when interest rates rise. Most product benefits are sensitive to interest rates and benefits are greater when interest rates are higher. Just like with other fixed-interest products, a higher interest rate environment is typically a more optimal time to consider an annuity.
It is important to view an annuity purchase as part of entire plan. Income needs and sources should be carefully considered. When more consistent predictable income is needed, an annuity may be an option to consider.
Another benefit that annuities offer is tax-deferred growth. Similar to other retirement accounts, the gains within an annuity are not taxed annually. Instead, when gains are withdrawn from an annuity they are taxed as ordinary income. This could provide a useful benefit for tax strategies.
Risks to be aware of:
Annuities are illiquid in general. This means that typically your money is not accessible. It is extremely important to understand how to access money within an annuity, the penalties involved, and to have ample liquid assets outside an annuity product.
Annuities include additional expenses. As mentioned above annuities are insurance products. Their benefits cost money and the insurance companies carefully calculate how to price their products for profitability.
Caps and spreads. Make sure you understand the terms. Most annuities that provide peace of mind against the downside also cap returns on the upside. This is essentially the fee. Remember, in these products, insurance companies employ professional investment teams that are using complex strategies like options and derivatives to hedge market risk. They understand risk and the cost of the benefits that they offer.
Tax-deferred products are subject to penalties for withdrawing money before age 59 ½.
There are various types of annuities, and each company offers unique products and benefits. There is also a wide range of annuity salespeople. Sometimes annuities are placed as a strategic part of a financial plan and other times annuities are marketed to the masses over a free dinner. Because of this it is often difficult to know if an annuity is the right choice.
If you are considering an annuity purchase, make sure to do your research. You should understand where it fits in your plan, and what benefits it will provide. You should be aware of the expenses that you are paying, and they should be acceptable to you. You should also know the exact terms for how to withdraw your money when you need it. Lastly, you should have trust and confidence in the insurance company and the agent that you are working with.
Make sure to do your homework and invest with purpose!
Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.