By Steve Doster
Annuities are extremely complex and dangerous! Most annuities should not be part of your financial planning. It’s important to understand them at a high level to avoid trouble. There are three types of annuities: variable, indexed, and immediate. Let’s look at all three types and how they work. But first, a financial planning spoiler alert — don’t ever buy a variable or indexed annuity!
Starting with the worst: variable annuities are not appropriate for smart wealth management. Financial advisors earn commissions by selling expensive variable annuities. Unfortunately, they are excellent at it, selling their U.S. clients more than $100 billion of variable annuities in 2018! This is $100 billion of clients’ retirement money going into expensive financial products. And this is happening every year!
After boiling away all the marketing mumbo jumbo, a variable annuity is an expensive way to invest in mutual funds. There are several fees (insurance charge, rider fees, subaccount fees) that add up to about 3-5% per year. And once you sign the paperwork, you are locked into the annuity for several years unless you pay a huge fee of 7-10% of the cash value (sort of like ransom).
While your real cash value is being eaten away by high fees, those tricky financial companies send you quarterly statements showing a growing account value. Look closely though. These values on your account statement will name it something like “accumulation value,” “benefit base,” or “annuitization value.” These values are funny money accounts that are meaningless to you. The funny money values are used in a formula to calculate a monthly payment you could receive. You can never get your hands on these funny money account values. The only value that matters on your variable annuity statement is the section labeled “cash value.” This is the actual value of your investment account.
You may also be told that it’s a good idea to purchase an annuity with IRA money because annuities have tax-deferred growth. This is not true — actually, it’s a horrible idea! Your IRA already allows for tax-deferred growth until you take distributions in retirement. Don’t pay all the extra fees of a variable annuity for something you already have.
The second type of annuity is called an indexed annuity. These little critters are tricky! The financial advisor (aka salesperson) will promise you the upside of the stock market when it goes up, and your account value will never go down when the stock market corrects. While this is not exactly a lie, it’s not the whole truth either.
Here’s how indexed annuities work. Think of a certificate of deposit (CD) you get from a bank. It pays you an interest rate and never loses value. Indexed annuities work similarly. The difference is the interest rate comes from how the indexes perform. When you buy an indexed annuity, you choose how to “invest” your money. You might choose 50% in the S&P 500 index, 25% in the S&P Small Cap index, and 25% in the MSCI international stock index. Your interest rate will be tied to how those indexes perform each month. If they are negative, no big deal because you will just earn a 0% interest rate that month.
Here’s how you lose in this deal. The annuity company puts a cap on how much they pay out each month. For example, the annuity company will say you can’t earn more than 2% per month on the S&P 500 index. If the S&P 500 goes up 5% in one month, you get 2% (your cap) and the annuity company gets 3%. If the S&P 500 goes down 5%, you get 0% and the annuity company takes the hit for the 5% loss. You probably think “hey, that’s not a bad bet.” However, it is.
Annuity companies have the statistics to know that they will always win with this deal. Historical data shows that most market performance occurs in just a handful of days each year. For instance, missing out on the S&P 500’s five best days each year results in investment returns about one-third less than money that is invested the entire year. Investment returns drop even more when you miss out on the 10 best days of the year. This means those caps embedded in your indexed annuity hold you back from ever participating in those top five and 10 days every year. The annuity company collects all the winnings on those big earning days, not you!
Finally, we get to an annuity that can help with your financial planning and provide peace of mind if utilized correctly. Immediate annuities are an exchange of your money for a guaranteed payment for the rest of your life. An example would be buying a $100,000 immediate annuity. This money is paid to the annuity company. In return, the person buying the immediate annuity will get a monthly payment for life. (The monthly amount is based on age and sex, but 5-10% of the original purchase amount is a typical range.) This can be a great trade-off for a person in their 70s in good health. The immediate annuity provides an income stream that will never be depleted and can help them achieve their goals of covering a certain amount of living expenses no matter how long they live.
The downside is that someone could pass away shortly after buying an immediate annuity. In that case, that $100,000 is gone and will not go to any heirs or charities. However, there are payment options to avoid this problem by guaranteeing a certain number of years’ worth of payments even if the person passes away.
Most types of annuities should not be part of your financial planning to achieve your goals. Be particularly wary of variable and indexed annuities. Immediate annuities can be a good option depending on your situation and financial goals. If you currently own a variable or indexed annuity (especially if you used IRA money), find a fiduciary financial advisor to help you understand your annuity and determine if it makes sense to surrender it.
— Steve Doster, CFP is the financial planning manager at Rowling & Associates – a fee-only wealth management and CPA firm helping individuals create a worry-free financial life. Rowling & Associates works to a fiduciary standard of care helping people with their taxes, investments, and financial planning. Read more articles at rowling.com/blog.