Given that we work with many clients who are either retired or approaching retirement, the subject of annuities is a topic that occasionally surfaces during the course of our conversations. More often than not, discussions are precipitated by clients asking us to review a contract purchased prior to their relationship with us. While we are not insurance agents, we are equipped to provide an informed outside perspective. In light of this, as well as the fact that annuities continue to be a familiar part of the overall retirement planning landscape, we thought we’d share some of our general thoughts on these products.
Some features of annuities may seem appealing, particularly for those who fear they will not be able to cover their basic fixed, nondiscretionary living expenses with Social Security and their liquid financial resources. As with most things in life, however, annuities have pros and cons that need to be carefully weighed by consumers.
We’ll review two general types of annuities sold by insurance companies (known as commercial annuities): deferred annuities and income annuities. Other types of annuities, such as those offered through workplace retirement plans, as well as charitable gift annuities, are beyond the scope of this discussion.
The Role Annuities Can Play
In a nutshell, annuities are insurance products that serve two primary purposes. The first is to obtain a stream of guaranteed income during the annuitant’s life (and, often, the joint life of her or his spouse). This guaranteed lifetime income stream is meant to mitigate so-called longevity risk, or the risk of depleting your financial resources during retirement. Importantly, however, the “guarantee” is not iron-clad, as it is ultimately subject to the claims-paying ability of the issuing insurance company. The other main purpose of annuities—which specifically pertains to the first type of commercial annuity we’ll discuss—is to attain an additional tax-advantaged means of saving for retirement.
The Annuity Most of Us Already Own
First, though, it’s worth noting that most of us already have an annuity as part of our retirement income: Social Security. (If you don’t, it is typically because you qualify for a plan offered by another government agency, such as a state retirement system, which may provide a similar stream of income for life.)
Data show that many retirees claim their benefits as early as possible, so it is fair to assume that Social Security is often used as a means of boosting immediate cash flow. While of course no one knows how long she or he will live, if you expect to live up to and possibly beyond your actuarial life expectancy, it may make sense to delay filing if you can, thus not only increasing the eventual monthly benefit amount, but also maximizing the aggregate benefits over your expected lifetime as well as the lifetime of your spouse, if applicable (due to widower/widow benefits). In other words, Social Security should be used for the purpose for which it was originally designed—as longevity insurance. Thus, it is best to keep your lifetime (single, if not joint) horizon in mind when claiming.
As a matter of fact, Social Security has several appealing advantages over commercial annuities. First, unlike many of them, Social Security benefits are indexed for inflation. Second, they are based on unisex mortality ratings, whereas commercial annuities typically have lower payouts for women, given their longer life expectancies. Finally, Social Security benefits are guaranteed by the U.S. government.
All of this said, some may like the additional reassurance of a supplemental lifetime income stream from a commercial annuity, particularly to help cover fixed costs. But, is this the right choice for you?
Perhaps the most familiar type of annuity—and the one that has been subject to a fair amount of scrutiny and debate—is a deferred annuity. A deferred annuity delays payments until the investor elects to receive them, or annuitizes—with payments occurring over a specific period of time or for the life of the annuitant. They have two main phases: the savings phase, or accumulation phase, during which you invest money into the account, and the income phase or annuitization phase, when you exchange your assets for a stream of income. As such, deferred annuities are designed for those still saving for retirement.
A common characteristic of deferred annuities is tax-deferred treatment of earnings. Indeed, our sense is that these annuities are often pitched on this feature, as they provide the opportunity to set aside funds on a tax-deferred basis, with no IRS limit, even if one has already contributed the maximum amount to a tax-favored retirement account, such as a 401(k) or IRA. However, the key here is tax-deferred, not tax-free. If you use after-tax (or so-called “non-qualified”) funds to purchase an annuity, you’ll still ultimately owe ordinary income tax on the earnings portion of your withdrawals—and notably, withdrawals are taken first from earnings and then principal (principal is not taxed). If one purchases an annuity with pretax (or “qualified”) assets, then withdrawals from both principal and earnings are taxed as ordinary income.
There are two subcategories of deferred annuities: variable and fixed. Variable annuities offer owners a choice of funds to be purchased inside the annuity—usually both stock and bond asset classes, thus providing the opportunity for long-term growth. However, as always, risk is the handmaiden of growth potential in investments. Thus, variable annuities are most appropriate for those who have a long-term time horizon and can handle interim account fluctuations. Some variable annuities have riders to protect your assets against loss while still affording potential growth. But, of course, you pay for these riders.
The other subcategory is fixed deferred annuities, which are designed for more conservative investors. These offer a guaranteed rate of return for a number of years (typically three to seven years). Again, the guarantee is subject to the insurer’s claims-paying ability and financial strength. Furthermore, most fixed deferred annuities allow only limited access to your investment during the guarantee period
Costs During the Accumulation Phase
One of the main reasons we, as well as many others, are reluctant to advocate the purchase of deferred annuities is their high expense. Indeed, according to a recent article in Kiplinger’s Retirement Report, “many variable annuities charge more than 2% in annual fees, which can include annuity charges of 1.2% or more (called mortality and expense or M & E fees) plus investment fees often topping 1% per year for a limited menu of expensive mutual funds.” 1 Then there are sales and so-called surrender charges. The latter is a fee levied on the policyholder if the contract is canceled within a certain period, typically within the first seven years. Finally, any optional riders, such as guaranteed lifetime benefits and inflation adjustments, come with additional costs. As the SEC itself has cautioned, “Be sure you understand all the charges before you invest [in a variable annuity]. These charges will reduce the value of your account and the return on your investment.” 2 Indeed, the fees and charges on some annuities are so high that they may negate the benefits of the aforementioned tax deferral!
Thus far, we’ve been discussing the accumulation—or savings—phase of deferred annuities. The second phase of deferred annuity ownership is called the annuitization phase—the time during which you elect to take your withdrawals at a predetermined future rate, for a set number of years, for life, or for the life of a beneficiary. We will cover this in more detail later, after we discuss income annuities (since annuitization is common to all annuities).
Income Annuities: Straight to Annuitization
Income annuities are more straightforward and typically less expensive and controversial than deferred annuities. Unlike deferred annuities, these are pure, plain-vanilla insurance products, with no investing component for the purchaser. Furthermore, they are geared toward those in or near retirement.
In essence, a retiree (or near retiree) makes a single, upfront payment to an insurance company, which, in turn, sends a regular payment beginning on a certain date, usually immediately.3 In most cases, these payments continue for the life of the annuitant or the joint life of the annuitant and her or his spouse. Income annuities can come in two forms: (1) immediate variable annuities (offering growth potential, with the payment amount varying based on the performance of the annuity/insurance company’s underlying investments), and (2) immediate fixed income annuities (with no market risk or growth potential).
In addition to lifetime income, income annuities—particularly fixed income annuities—can offer higher initial payout rates compared to traditional, conservative fixed-income investments (i.e., CDs and high-quality bonds), because along with the investment returns generated by the insurance company on their premiums, there is another return component known as mortality credits. For these credits, insurance companies use the unpaid assets of annuitants who die at younger ages to pay those who live longer—thus leading to comparatively higher payout rates. But again, these benefits come with a cost.
Trade-Offs and Costs During Annuitization
So what are the largest trade-offs to consider before purchasing an income annuity or annuitizing? In exchange for this lifetime stream of payments—which can look appealing compared to fixed income rates at the time—you are transferring your assets to an insurance company; that is, those assets no longer belong to you. Rather, they become the property of the insurance company, and you become a claimant—or, essentially, a creditor—of the insurer. Moreover, the decision to annuitize is typically irrevocable.
Furthermore, as stated earlier, these annuitized income streams are often referred to as guaranteed, but it bears repeating that any guarantee is subject to the solvency of the insurance company. Per a cautionary alert issued by the Financial Industry Regulatory Authority, “while it is an uncommon occurrence that the insurance companies that back these guarantees are unable to meet their obligations, it happens.”4 Solvency risk is ultimately hard to quantify. Moreover, while there are state guaranty associations that provide some level of protection in case of insolvency, these are not obligations of federal or state governments; rather, they are funded with assessments placed on insurance companies that sell policies in a given state. Either way, you should be careful not to exceed the guaranty coverage thresholds in your particular state.
Another trade-off is the potential opportunity cost of an annuity. While income annuities often provide a comparatively higher initial payout, it’s impossible to know what the ultimate return will be, as no one can predict when they will die, or what the equivalent return would be on the assets if they were invested in a balanced portfolio over that same time period. Further, there’s the risk that that you and/or your beneficiary will die soon after you pay a large premium to the insurer. And if you annuitize, you may be leaving little, if any, of those assets to your heirs.
Also consider the possibility of an unexpected health crisis after a large premium is paid. This not only can shorten your life expectancy and thus your expected income payout over time, but can also mean a loss of needed liquidity due to foregone premiums paid to the insurer.
Finally, for those who gravitate toward immediate fixed income annuities, given the sense of security they may provide, you must consider that inflation will reduce the purchasing power of your fixed payouts over time. This can be addressed by purchasing inflation-adjusted fixed income annuities, but these come with a cost: a lower initial payout amount. Relatedly, all payouts are a function of general interest rates at the time of purchase. Just as you should consider diversifying among insurers (up to state guaranty limits), you may also want to spread out the timing of your income annuity purchases, particularly in a low-interest-rate environment.
As you can see, the decision to purchase an annuity, like many decisions for retirement, is far from straightforward. While some features may be appealing—particularly for those who fear they will not be able cover their basic, nondiscretionary fixed costs—there are several noteworthy trade-offs that should give you pause.
Regardless, we have regularly been able to help clients review—or at least better understand—their existing annuities. This has typically involved helping them decipher their deferred annuity contracts (and often very thick prospectuses!) to see if lower-cost options may exist, particularly for those no longer subject to surrender charges. Making a change may entail a procedure called a 1035 exchange, which allows you to move from one annuity to another while still maintaining the tax deferral. Or, based on the ultimate tax bite, it may be worth considering either cashing out the annuity entirely or, for a qualified annuity, rolling the asset value into an IRA for greater flexibility and control. We also can be a resource for those considering income annuities, not only to help steer you to lower-cost options, but also to discuss the trade-offs with you, with your financial goals in mind.
1. “Trade an Annuity for a Better One,” Kiplinger’s Retirement Report, August 2016.
2. “Variable Annuities: What You Should Know,” Securities and Exchange Commission Investor Publications, April 18, 2011.
3. There are newer income annuities known as deferred income annuities (also known as longevity annuities), which, as their name suggests, have a deferral period before income payments start, as well as an even newer subset known as qualified longevity annuity contracts (or QLACs).
4. “Variable Annuities: Beyond the Hard Sell,” Financial Industry Regulatory Authority Investor Alert, c. 2012.