Annuity Guides from Fisher Investments

Annuities are often advertised as tools to help investors with their retirement goals without exposing them to the risks of market forces. Unfortunately, while it’s simple to claim annuities offer "safe” or “guaranteed” returns, these terms can have different meanings from what investors expect. Having seen numerous clients invested in annuities that don’t work as expected, we believe it is important you have someone other than an annuity salesperson acting as your guide to annuities’ inner workings.

While advertised as investments, annuities are actually insurance contracts. Annuities are an agreement between an individual and an insurance company. That individual pays one or multiple installments, known as premiums, in exchange for an income stream either in the present (an immediate annuity) or at a specified point in the future (a deferred annuity). For many annuity types, during the time before the annuity begins providing payouts, the premiums will be invested to generate returns that increase the eventual income it provides. How these increase the value of the income stream is determined by various factors laid out in the contract.

You may not hear this type of information in some of your salesperson's annuity guides or informational materials, just as your salesperson may not highlight the steep surrender fees sometimes associated with annuities. Annuity investors can be required to pay these surrender fees to the annuity company if they decide to exit the contract prior to a predetermined time. The time frames and fees vary widely—with fees often gradually decreasing as time goes on—but in our experience these surrender periods can last as long as 10 years. These are designed to help the insurance company compensate for the high commissions paid to salespeople, and in effect make it very costly to escape from the contract.

To that point, you’re well advised to scrutinize what you hear from an annuity’s salesperson. We’ve frequently seen clients with annuities come to us assuming they are receiving one thing when they hear “guaranteed protection against loss” or “guaranteed minimum withdrawals,” but find it defined much differently in their contract. This is why we have created some in-depth annuity guides to help investors who find themselves confused by or curious about these complex contracts.

Whether you already have an annuity, or you are just considering the possibility that an annuity may be right for you, we believe you’ll find our free guides informative and straightforward. They’re designed to help you understand the important factors that you’ll want to consider when working out whether annuities really are right for you. To download any of our annuity guides, follow the links at the bottom of the page. You can also read on for some basic information on annuities to get started.

Confused About Annuities?

First, let’s address one of the reasons annuities are so confusing—how they’re named. Annuities can be divided into a number of different categories by some key features. While there are dozens of potential combinations, and our annuity guides explain the differences in more detail, the following provides a brief explanation of some of the common naming conventions you may see:

  • By when payouts begin:
    • Immediate annuities—these annuities typically begin payments soon after purchase, and are often used by those who are on the cusp of retirement age as a way to begin an immediate income stream.
    • Deferred annuities—with this type of annuity, money is typically invested over a long time horizon and allowed to grow until the investor is ready to retire or otherwise begin taking payment.
  • By how premiums are paid:
    • Lump-sum annuities—common for immediate annuities, but also possible for a deferred annuity, all premiums are paid in a single payment.
    • Periodic payment annuities—in these cases, premiums are paid in smaller chunks over time, similar to how one might contribute to an IRA or 401(k).
  • By how returns are calculated
    • Fixed annuities—the premiums deposited generally earn a fixed interest rate and payouts do not vary until the end of a predetermined time period, at which point the annuity may reset the fixed rate of return.
    • Variable annuities—customers choose to invest their premiums in mutual-fund-like sub-accounts that can potentially offer growth to increase the eventual payout, but also expose funds to market risks (though riders, discussed later, can be purchased to provide some protection).
    • Equity-indexed annuities—these annuities base their return on the movement of a chosen index (e.g., the S&P 500, Dow Jones Industrial Average, etc.). Generally they have a “floor” rate that guarantees a small amount of growth, to ensure the customer never receives a negative return, even in years when the market is down. However, equity-indexed annuities combine this protection with performance caps, participation rates and potentially punitive surrender terms, all of which can significantly reduce their upside growth potential.

Now when a salesperson offers you an annuity of some type, you’ll hopefully have a rough idea of how it would function. But this is only a very general way to group annuities. You can find many thousands of individual products in any combination of these categories, making it important to look at the specifics of any annuity you are considering closely.

Beware Terms and Conditions

But getting familiar with even one annuity is no easy feat. An annuity contract can come with a dictionary-thick list of terms and conditions, which can be hard to follow if you are not familiar with the industry’s jargon. As we’ve mentioned, when you are talking with an annuity salesperson or reading one of their guide books or other informational materials, you may see lots of language offering “guarantees” for things like your rate of return, protection from loss, benefits to heirs, and much more. But how the contract actually defines these benefits may be much narrower than you initially assume when you hear about them.

This is why, above all else, we believe you must read all terms and conditions closely, no matter how microscopic the small print—and never sign the contract unless you understand all the implications in relation to conditions, restrictions and costs. A financial planner, independent investment adviser and tax professional are potentially good sources to turn to for an extra review. Qualified investors can also take advantage of ourAnnuity Evaluation program. We have a number of annuity experts who are well-versed in understanding how annuities are structured and the value in the benefits they provide.  

Optional Riders—Added Complexity?

Another important fact that you can easily miss while you’re being guided through an annuity sales presentation is that many (often most) of the most attractive, protective features in these products are actually optional—called riders. These terms are often what first attracts investors, but they may overlook that there can be significant additional costs associated with them.

When thinking of an annuity as insurance rather than an investment, it’s becomes obvious why this occurs. In order to make a profit, insurers must pay less in benefits than they collect in premiums from annuity owners. So the more protection that is needed and the more likely that protection will need to be used, the more expensive an annuity contract can become. As such, investors may overestimate the benefits of these riders and can overlook significant costs, which generally appear to be a small percentage of assets each but can add up quickly to eat into the annuity’s return.

There are many types of riders, and different companies give them different names. But three common ones you may see in some form include:

  • Guaranteed Minimum Withdrawal Benefit riders—generally these riders allow a certain percentage of assets to be withdrawn each year without paying surrender fees. It’s important to note any tax or early withdrawal penalties are not waived by these agreements, so you’re essentially paying to pay for access to your money if you’re under age 59½.
  • Guaranteed Lifetime Withdrawal Benefit riders—these riders guarantee that your income stream will continue for life, even after your payouts have surpassed the value in your contract.
  • Guaranteed Minimum Income Benefit riders—usually apply to variable annuities, providing a floor rate for them similar to an indexed annuity.

We identify some common fees associated with several popular riders in our annuity guides, along with some examples of how they can impact growth over time.

Murky Marketing and Misleading Language?

In our experience, it is easy for investors to be taken in by annuity marketing given the fear many still feel after the recessions and bubbles of the 1990s and 2000s. As we’ve said, the language you’ll commonly hear during annuity sales pitches is designed to provide a great deal of reassurance, but the actual definitions in the contracts are often much more opaque than what’s usually heard during the annuity sales process.

For example, you may assume that all deposits and gains are your money, right? Actually, while this is true during the accumulation phase (the period during which you make payments without drawing income), once you annuitize the contract (that is, convert it into an income stream) the money becomes the insurer’s. You have irrevocably exchanged your premium payments for the income stream, which also usually means growth in the account stops as well. This may be fine if you are at or nearing retirement and want a relatively uncomplicated and risk-averse way to receive income. But if you want continued potential for growth to protect you from inflation, or you anticipate that you may have to cover a large medical bill at some point or hope to pass money on to heirs, then the restrictive nature of annuities can prove problematic.

Tax Implications[1]

Relative to other types of investments, the tax implications of annuities can also be particularly complex and confusing. To begin with, how you buy an annuity can affect how it is eventually taxed. Many annuities are purchased through other tax-advantaged retirement plans like IRAs or 401(k)s, in which cases their full payouts are taxed at regular income rates just like any other withdrawals. Annuities purchased directly with after-tax dollars, however, are treated differently. They allow the money to grow tax deferred, with restrictions on withdrawals before age 59½, similar to other types of retirement accounts. But only the portions of payouts that represent growth are taxed. To further add to the confusion, annuity taxation has been subject to legislative changes multiple times, so certain older annuities have taxes calculated in an entirely different manner all together. 

This may have negative tax implications for any investor who pays income tax at a higher rate than the long-term capital gains tax rate. This goes some way to explaining why the Financial Industry Regulatory Authority (FINRA) recommends that investors try to utilize all other available tax-advantaged accounts before considering the value of annuity products. [2]&[3]

Additionally, if you’re younger than 59½ years old, you are likely to be subject to a 10% tax penalty on any withdrawals from your annuity in addition to surrender fees, making it even more painful if you decide to surrender. So be cautious about letting a salesperson guide you to an annuity early in your investing, as it can leave you locked in with serious penalties for premature withdrawals even if you avoid surrender charges.

A Vehicle for Growth?

Annuities are often sold as a low-risk investment, able to help avoid the downturns of the market while earning market-like gains. Although this might be true on some levels, it’s a basic principal of investing that risk and reward go hand in hand. Any time you lower risk, it’s likely to come wrapped in a significant trade-off: limited growth.

Annuities are no different. As you may have seen going over annuity types, you essentially have a choice between annuities offering a lower fixed rate with full protection for your deposits or a variable rate that is potentially higher but offers no protection for them. This can even be seen in indexed annuities, where participation rates and other factors reduce the investor’s reward in order to cover the costs of risks that the insurer assumes through the annuity.

Over time, these growth limitations can add up significantly. Through the effect of compounding (where returns are reinvested to increase future returns), we believe the difference between what annuities offer and what can be achieved through other investment strategies with lower fees becomes significant.

Check Out Fisher Investments’ Annuity Guides

We know that annuities are more complex than you could read about in a single article, which is why we’ve developed a series of informative annuity guides to provide detailed insights into these products. In each, we break down important aspects of annuities providing examples of their common fees and growth models, helping inform investors of what to be on the lookout for when they are being offered these products. You can get any of Fishers’ annuity guides free today, by completing a simple form. Fisher Investments does not sell annuities, so we approach these products without the usual pitch you hear from insurance salespeople.

If you already have an annuity, but no longer feel confident that the insurance contract will work successfully towards your retirement goals, you may be also able to take advantage of our Annuity Evaluation program. Find out if you qualify for this assistance today by requesting an appointment. You’ll also find more information on this program when you download any annuity guide we offer.

[1] The contents of this article should not be construed as tax advice. Please contact your tax professional.

[2] Source: Financial Industry Regulatory Authority, Investor Alerts - Variable Annuities: Beyond the Hard Sell

[3] Source: Financial Industry Regulatory Authority, Investor Alerts – Equity Indexed Annuities: A Complex Choice

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