Many financial advisers recommend annuities in retirement plans. Annuities are often easy to buy, shield investments from taxes as they grow and may generate guaranteed income. These advantages can lead investors to believe these vehicles will be a valuable part of their retirement plans. In reality, annuities are typically complex investments. They tend to have high costs, complex restrictions and other risks that could offset any actual benefits.
Annuities are a form of insurance that can be tied to (or directly own) investments. They can provide long-term income through a stream of future payments. The process of converting a lump sum payment into a regular income stream is called annuitization. An investor can choose between either a deferred annuity or an immediate annuity. In a deferred annuity, the payouts are deferred to begin at a later time. In an immediate annuity, the lump sum is converted into a stream of future annuity payouts that could begin in less than a year. There are three primary types of annuities—fixed, indexed and variable:
Annuities are simply insurance contracts for which buyers pay the insurance company to invest their money on their behalf. In exchange for providing this service, the provider of the annuity gives some form of assurance the buyer will receive some income at retirement. The provider of the annuity typically charges for this service in two ways—directly via fees and indirectly using caps (in the case of indexed annuities). Variable annuities generally have high fees that can limit growth and often don’t offer the same protection against loss as other annuities. While investors can purchase insurance “riders” to seek protection against loss for a variable annuity, these riders further increase fees.
Annuities have several barriers to growth, including:
Participation rates mean that you only keep a portion of any market returns. Caps limit the upper end of your return. For example, indexed annuities are often sold as protecting the investor from downside loss in bear markets. But in exchange for this downside protection, they will often cap any growth. If, for instance, the benchmark is the S&P 500 and it grows 10%, an indexed annuity may have a 5% annual cap, which means the investor will only get 5% of any upside growth. When viewed over the longer term, it may not be appropriate for many investors to give up so much upside potential growth in exchange for downside protection.
The effect of direct and indirect fees charged by the annuity provider is that, over time, investing in annuities can significantly lag returns made by more direct investments in the underlying securities (in the case of variable annuities) or indexes (in the case of indexed annuities).
Annuity providers often reserve the right to change the contract terms, which can have a significant impact on your investing goals. Suppose, for example, you plan on contributing regularly to your annuity to receive higher income benefits. Some annuity providers reserve the right to limit future contributions to avoid having to pay more in benefits. Annuities may also change their fees, participation rates, performance caps and floors on an annual basis, potentially making it more difficult for you to meet investment goals.
Floors and caps may suggest steadier returns over time, which could be attractive for your retirement account. However, there can be significant trade-offs for that growth. For example, an indexed annuity purchased in 1994 and held through November 2017 with a 1% floor, 5% return cap and 100% participation rate—generous assumptions, in our view—would be worth less than a similarly sized investment in bonds or stocks. In fact, this hypothetical annuity would have lagged far behind the index, by just over $680,000.
Exhibit 1: Indexed Annuities' low growth potential
Source: FactSet, as of 11/30/2017; Hypothetical annuity indexed to the S&P 500 with a 1% floor, 5% cap and 100% participation rate.
Inflation is a silent threat that can be overlooked by investors, especially when purchasing an annuity as part of a retirement plan. Many annuity contracts don’t factor inflation into payment or terms, and unfortunately it may not even be brought up in the sales process. Although it is possible to buy a rider that allows for annuity payments to adjust for inflation (known as inflation-protected contracts), these generally come with increased fees, and the annuity provider may set the initial payouts lower than they would otherwise be to account for this feature. The payout on these types of inflation-protected annuity contracts could be 25-30% lower relative to an otherwise comparable unprotected annuity. This means slower payments, which increases the likelihood that the investor will pass away before getting his or her money back.
Because annuity income typically isn’t adjusted for inflation, the payments received during retirement tend to lose purchasing power with the passage of time. Many investors need increasing purchasing power to sustain them at retirement as health care and other costs can increase as they age. An annuity could be a hurdle rather than a help in achieving and maintaining these increasing financial needs.
Also, because of increasing life expectancy, it may be necessary to rely on income from an annuity for longer periods than a generation ago. This increasing life expectancy means the impact of inflation on the purchasing power of a fixed annuity income will be even more severe. If used as the primary means of retirement savings, an annuity can leave investors struggling to make up for the shortfall in their income later on in their retirement.
When it comes to retirement planning, Fisher Investments believes that annuities generally should play a limited role in hedging against longevity risk if needed. But in most cases, other approaches could achieve the same goals at lower costs. Fisher Investments offers evaluation services that can provide investors with a clear explanation of exactly what the annuity you own or are considering offers.