Want peace of mind when funding retirement? Beware of the 3 hidden dangers in fixed annuities.
There are three hidden dangers with fixed annuities. First, you may not outpace inflation: With any fixed income stream, the danger is loss of purchasing power. Second, reinvestment risk: “Guaranteed” teaser rates don’t last. When they reset, they’ll likely be lower. Third, opportunity risk: Even if you want a volatility-free asset, interest rates usually aren’t stable for long.
Despite these dangers, fixed annuities remain a popular investment product. Why? In the heyday of defined-benefit pension plans, before the rise of 401(k)s, folks didn’t worry as much. Now the plethora of retirement savings plans to supplement Social Security (or, more like, which are supplemented by Social Security) make matters more complex. That makes simplicity seem attractive, and with skepticism and fear of the economy and markets high, many seek products that seem safe and assured—like fixed annuities. While fixed annuities may seem like an ideal option for those fearful of loss and aiming for some certainty, they can unwittingly introduce quiet dangers into your financial plan. Buyer beware.
Fixed annuities are simple. They are often compared to bank Certificates of Deposit: low-returning assets with no volatility. Someone opening a fixed-annuity account deposits a sum with an insurance company. In return, the insurer guarantees their principal—no volatility or risk of market losses—and promises to pay a fixed or minimum interest rate for a set period of time, with rates resetting at the end.
There typically aren’t fees except charges for exiting the contract soon after purchase. When you need to start taking income, you convert the accumulated value into a stream of income payments determined by the insurer that are also guaranteed—for a set period or life. This is called annuitization.
Straightforward so far, and simple enough as a contract, which is its appeal. But before you sign on the dotted line, understand: Fixed annuities are long-term investments carrying implicit risks to meeting retirement goals.
It is true fixed annuities won’t see volatility. But, like any low-volatility investment, fixed annuities usually offer low yields and, as such, may not be able to meet retirement goals or keep up with inflation. This latter problem is severe, considering Americans are living longer lives in retirement. Over time, even low rates of inflation can eat away at low fixed returns.
This is an even bigger problem right now. Insurance companies offer these products because they can earn a (very lucrative) profit or “spread” over what they (minimally) guarantee. They do so by investing your capital, usually in an investment-grade bond portfolio. In the unusually low interest-rate environment we are in now, insurers can’t guarantee high yields for long. If they do, check the fine print—it may be a teaser rate that seems lofty to entice you to buy, only to expire soon thereafter.
Even the comparison with CDs is off. CDs expire after a relatively short period, allowing the owner to shop around again. That introduces reinvestment risk—the risk you can’t replace the yield you had. But fixed annuities carry reinvestment risk on steroids, as they have exit fees that can last many years, meaning that you are subject to whatever rate the insurer is promising for long periods unless you exit. If you decide those rates aren’t good enough and want out, you’ll get dinged. And, if you leave annuities altogether, you are potentially subject to ordinary income tax on your investment gains—plus an additional 10% IRS penalty, if you are under 59.5 years old.
Moreover, while it is true fixed annuities are guaranteed, unlike CDs, they aren’t FDIC insured. The guarantee is from the insurer, which is backed by state guaranty funds that may—or may not—equal FDIC levels. The insurer’s guarantee is basically as good as the insurance company’s credit. Be prepared to check the insurer’s credit rating and understand what your state’s guaranty fund will cover if one fails.
Do fixed annuities actually earn enough return to meet your long-term needs? This is damning problem and you might not know until it’s too late. Fixed annuities give you certainty about principal and (for a period of time) about returns, but they don’t assure your income need is certain. And that will heavily affect whether the return you earn is sufficient. Don’t wait for buyers remorse, or the surrender fees, to kick in.
Before you buy into a restrictive contract providing low long-term returns that may not be sufficient, we’d suggest considering alternatives. While they may be less certain, investments in stocks and bonds could increase the likelihood your retirement is fully funded.