Annuities 101

Last month, Steve mentioned his issues of sending his youngest off to college and how the 529 plan played a role in funding the college education costs for both of his sons.  I too am sending a child off to college this year, one next year, and our youngest a few years after that.  It was critical that my wife and I planned a funding source for these costs, as we may find ourselves with three kids in college at the same time.  Ouch!

Most of you have already made it over this education hurdle and have turned to planning for funding sources for retirement instead.  That’s one of the reason we’re constantly working with clients to determine reasonable distribution rates during retirement.  And ways to provide monthly income utilizing investment portfolios or pensions, along with the timing of when to apply for Social Security – all to provide necessary income throughout their retirement years.  Over the years, many clients have asked about annuities as another option to provide an income funding source to cover some or all of their fixed expenses.  Generally, I’ve found that there are very strong feelings of like or dislike regarding these products.  Additionally, I’ve discovered that annuities are very misunderstood as many of the opinions held are based on one or two facts that may have been decided over a casual conversation with someone who does not have all the facts.  The reality is that annuities themselves are not good or bad, they are simply used in the right situation or wrong situation.  They can be a disaster if used in the wrong way or used without knowing all the details of how each individual contract works.  Or, they can be a very strong part of a well thought out plan.

I wanted to quickly touch on the different types of annuities and some of the pros and cons of annuities in general.  Most annuities fall into one of the following types.

Single Premium Immediate Annuity – these allow for a one-time payment and then start paying an income stream based on a fixed annual benefit that does not vary with inflation or market conditions.

Deferred Income Annuity – These are generally structured to provide an income stream at some point in the future.  They generally include some kind of stated interest rate while not taking income and then create a fixed annual income benefit that does not vary with inflation or the market.

Variable Annuity – pays varying amounts of interest or generates different returns based on the investment options or subaccounts chosen by the owner or advisor.  The underlying subaccounts do fluctuate with market conditions, but can provide more income or less income over time due to that performance.  Most have floors that income cannot go below.

Indexed Annuities – A fairly new product as annuities go, however, these annuities pay an interest rate tied to the performance of a common or well-known index such as the S&P 500.  The growth of the annuity is based on the participation rate of the index that it is tied to, but generally has a floor that the annuity growth rate cannot go below.

There are many riders that can be added to annuity contracts as well.  Some of these riders can add substantial benefits to the contract; however, most of them come with added cost.  The guaranteed living benefits can come in the form of minimum withdrawal benefits, minimum income benefits, or minimum accumulation benefits.  They can also have differing levels of death benefit provided if that is something the purchaser wants to have guaranteed.  Most purchasers will simply take the standard death benefit since they are more concerned about current income rather than future death benefit guarantees.

There are many pros that annuities do offer. They can:

  • Provide an income for your life, or the joint life of you and your spouse.
  • Be structured to pay for a certain number of years even if you die before that number is reached. Through living benefit riders, they can provide for a return of principal plus an interest component regardless of what happens in the market, or a minimum amount of future income regardless of actual performance.
  • Provide for a minimum lump sum amount at the end of the owner’s life, should that be a consideration.
  • Provide a way to shift risk away from the owner and on to the insurance company.

Obviously it’s not all roses.  There are cons to these products as well.  Fees can be substantially higher depending on the cost of the base contract and any riders that were added.  Remember, an annuity is an insurance contract and just like homeowners insurance, we hope we don’t need the guarantees, but they sure are handy if we do.  Most contracts also have surrender periods with penalties, so they are not intended to be short term investment solutions.  Since they are allowed to grow tax-deferred, there is generally a penalty for taking a distribution before age 59 ½.  However, most have a provision for allowing up to 10% to be taken out annually without being subject to the surrender penalties.

So as I stated earlier, they can be powerful products that fit a certain need for a particular situation.  However, one of the biggest issues that I’ve witnessed over 25+ years in this business is that people get sold products all the time.  Products that they don’t understand or that don’t fully address what is trying to be accomplished, in the most efficient manner.  Be careful of any salesman who tries to fix everything with an annuity, or who offers only one type of contract. To a guy with only a hammer, every problem is a nail.  Also, understand that there are numerous contracts on the market and they all have different bells and whistles.  Be concerned if someone only offers contracts from one insurance company.  And most of all, please understand what you are buying.  I rarely find a client that fully understands what they own and how it works, especially in the case of equity indexed annuities.  Again, I’m not saying they don’t have their place, but each contract must provide an understandable solution to a client’s need.