“The truth is, annuities are like any other financial tool or investment vehicle; they are great for some financial situations and not-so-great for others.”
A quick Google search for the word “annuities” will bring up several opinions about annuity investments. Sometimes, this mix of perspective can be confusing to investors who really just want to know “are annuities are a good investment?” or whether they are an investment that should generally be avoided. The reason that opinions are so varied is that the answer is somewhat complex and can’t be summed up with a simple “yes” or “no”. The truth is, annuities are like any other financial tool or investment vehicle; they are great for some financial situations and not-so-great for others. Whether an annuity is good or bad (for you!) is highly dependent upon your personal financial situation, the goals you have set forth, and the timespan in which you plan for those goals to be met. Depending on various factors regarding your personal situation, annuities can actually be “good” or “bad”. We can’t tell you whether an annuity is right for you, but in the following article we will give you some tips to help you answer the question, “Are annuities good or bad for my portfolio?” for yourself.
What is an annuity?
Knowing exactly what an annuity is is the first step to deciding whether it is a proper investment for your portfolio. An annuity is an insurance product that pays out income and is popular for investors who want to receive a steady and consistent income stream during their retirement years. Specifically, an annuity is a contract between an individual and a third party, which is usually an insurance company. In exchange for a lump sum payment, the insurance company promises to provide an income for a specified period of time; asset growth and accumulation; a death benefit; and long-term care benefits.
Different types of annuities
Generally, there are two types of annuities, fixed and variable; and two options for each, immediate and deferred.
With fixed annuities, in exchange for a lump sum payment, the life insurance company will pay a guaranteed fixed rate of interest while also guaranteeing the principal investment. Variable annuities do not have a fixed interest but require that the investor decides how to invest their money by choosing between various subaccounts offered within the annuity. The performance of these funds will impact the value of the investor’s account, whether positively or negatively.
Within fixed and variable annuities, investors can choose between two options:
- Immediate: Income begins shortly after the investor’s initial lump sum payment. This option starts paying within a year and may be a good choice for individuals reaching retirement.
- Deferred: This annuity accumulates money over time and does not pay out immediately. Typically, payments are deferred anywhere between 1-50 years. The annuity owner can decide to convert their deferred annuity into an immediate annuity when they are ready to begin collecting payments.
The Benefits of Annuities
Are annuities good? When used for the right purpose, annuities can be a powerful financial planning tool. The main value is that they can help stabilize an investor’s portfolio and they provide excellent tax benefits. Unlike 401ks and IRAs, annuities do not have an annual contribution limit; which allows investors to put away more money for their retirement. Additionally:
• Money invested in an annuity grows tax-deferred. Money compounds consistently without being taxed.
• Retirees can set up their annuity to ensure guaranteed consistent payments for a specific length of time, or for the rest of their lives.
Are annuities good for retirement? In many cases, annuities work best when they are used to support other retirement income sources within an investor’s portfolio.
Are variable annuities a good investment? Variable annuities are often best suited for individuals who can tolerate a specific level of risk within their portfolio and are seeking higher appreciation on their investments.
The Drawbacks of Annuities
Why are annuities bad? When people speak negatively about annuities, it is often due to high associated fees, and mixed with perspective from buyers who purchased annuities without considering how well it fit (or didn’t fit) into their specific long-term financial goals. Annuities can be powerful for the right situation, but on the other hand, they can be damaging to those who end up pulling money out too early or those who purchased their annuity from high-commission brokers and salespeople. Charges and fees vary among different types of annuities, whether fixed, variable, immediate or deferred. Fees that you may come across as you search annuity options include:Commissions: Salespeople will collect a commission, which sometimes can be as high as 10%.Insurance Charges: Also referred to as mortality and expense (M&E) fees and administrative fees. These fees pay for insurance guarantees that are automatically included in the annuity, along with selling and administrative expenses.Surrender Charges: If you pull money out of your account too early, you will likely face a surrender charge. Typically the surrender charge is 7% of your account value if you leave after the first year, and decreases by a single percentage point each year until it reaches zero.Annual Fees: Most variable accounts come with high annual expenses; insurance charges that can run more than 1.25% of the account’s value.Investment Management Fees: Often, variable annuities are subject to investment management fees, which are similar to management fees on mutual funds.
Other drawbacks that are often mentioned, include:Illiquidity: Annuities aren’t often recommended for younger individuals or those with immediate liquidity needs. The lump sum put into the annuity is generally illiquid and subject to stiff withdrawal penalties. In emergency situations where funds are needed immediately, owners who withdraw partially or in full may lose significant value. Difficult to Understand: Sometimes it can be difficult for even seasoned investors to understand the ins and outs of some annuities. The language and terms can sometimes be complex and some salespeople may not explain associated fees and charges in a way that is completely transparent to the buyer.Paying for Guarantees: Many annuities come with guarantees that are extremely comforting to buyers, but investors pay heavily for these guarantees. While some salespeople use these guarantees to “sweeten the deal”, buyers are sometimes unaware that they are actually paying for and funding these insurances.Guaranteed Guarantees?: Annuities are guaranteed, technically. As demonstrated by American International Group Inc. during the financial crisis though; even a $100 billion insurance company could potentially collapse. In this type of case, annuity policies held by a company that declares bankruptcy could come down to a matter of the language in a particular agreement.
Are Annuities a Good Idea for My Situation?
Before purchasing an annuity, there are several questions to ask yourself, and many elements to consider. Start off by doing heavy research on annuities before speaking to a salesperson about what annuity products they offer. Once you have decided that an annuity is the proper investment vehicle to add to your portfolio, consider the following:
• Make certain that you dealing with a reputable insurance company that will deliver on its promises. Don’t just take a salesperson’s word for it. Check how the company is rated through:
– AM Best: Highly trusted insurance companies are rated as A++ and A+.
– Fitch: Insurance companies that are top rated are given ratings between AAA and A.
– Moody’s and S&P: These entities also rate top quality insurance companies between AAA and A.
• Review the numbers carefully. Don’t buy into an annuity until you know how much the contract will cost annually, including all expenses. Understand what types of charges you will face if you withdraw from your account early, and ensure that you have emergency funds available so you do not have to withdraw from your account until your surrender charge percentage has reached 0%.
• Remember that guarantees are not free. Don’t allow a salesperson to over-promise and over-sell you. While many of these guarantees and protections are great, keep in mind that they do translate into additional fees and costs.
The Secret to Knowing if Annuities are Good or Bad for You!
Finally, if you have gone through these steps and are still unsure about whether annuities are a good or bad choice, find a financial service professional who can help. A properly licensed and credentialed financial advisor such as a Chartered Life Underwriter, Chartered Financial Consultant or Certified Financial Planner can help you evaluate your current financial situation; and assist you with reviewing and evaluating annuity contracts.
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