Some annuities’ “guaranteed income for life” features often intrigue investors as a potential long-term investment option, but many people overlook the risks associated with annuities’ guarantees. The many terms and conditions of an annuity contract can greatly affect the annuity’s returns. This goes for immediate annuity contracts as well. Before committing yourself to an immediate annuity, you should consider your long-term investing goals and how long you may need your money to last.
If long-term portfolio growth is one of your investment objectives, immediate annuities may not provide the returns necessary to reach all of your long-term financial goals. Before understanding whether an immediate annuity is right for you, you should have a good understanding of how they work. In this article, we’ll discuss immediate annuities, their features and potential risks.
Immediate annuities are insurance contracts purchased in a lump sum and the annuitant begins receiving an income stream when the contract is established. You can elect to receive the payments from the contract for a set number of years or for the rest of your life. Some contracts allow you to have the payments continue for the rest of your spouse’s life, should they outlive you. Remember though, the longer the expected time period, the smaller the payments may be.
Because the annuity begins paying income immediately, the income amount may vary depending on the following:
The interest rate is often fixed. So, in a rising interest rate environment, you may not have the flexibility to move your assets to a better yielding investment.
Immediate annuities are sometimes referred to as single premium immediate annuities (SPIAs). With pensions shrinking in popularity, some investors are looking for reliable income stream to supplement Social Security. Given the relatively straightforward nature of these products, they may seem like a “safe” and appropriate supplement to Social Security. This may sound great on the surface, but it may not make financial sense depending on your goals and financial situation. The internal rates of return on these products are often low compared to competing investment options. The same is often true of their variable and fixed annuity counterparts.
Generally speaking, immediate annuities are straightforward and easy to understand compared to other annuities. In our opinion, they may be the only type of annuity an investor should even consider, assuming an investor is comfortable with the risks associated with the contract.
If you haven’t heard of SPIAs, one reason could be that these contracts usually aren’t as profitable for sales people or insurance companies as other annuity types may be. Instead, insurance agents and advisers may be more inclined to sell annuities with added features with steeper costs and can generate higher commissions.
Since annuities are a form of income, payouts may be subject to ordinary income tax rates instead of capital gains tax rates—an important consideration with annuity income. Immediate annuities also have other important risks for investors to consider.
Before you purchase an immediate annuity, consider these potential drawbacks.
The cost of inflation: In many cases, an immediate annuity’s payout is fixed and not adjusted for inflation. The cost of inflation could materially reduce the purchasing power of those income payments over long periods of time, and the longer the payouts continue, the less value they might offer. Since 1925, inflation has averaged about 3% per year.i So, as an illustration, if you require $50,000 annually to cover your expenses today, you would need $67,000 in 10 years, over $90,000 in 20 years and over $120,000 in 30 years.
This could work against investors and they may require more long-term investment growth than they had anticipated.
Illiquidity: When you invest in annuity, you may be taking on liquidity risk—the risk of being unable to convert your investment into cash at all or without significant costs. This could be a problem in times of emergency or if something unexpected comes up and you need quick access to cash.
Opportunity Cost: For immediate annuity investors, the “safety” from the volatility in the stock market may provide them with peace of mind. What they may be overlooking is the opportunity cost they are forgoing by investing in the market. If growth is one of your objectives or you end up needing more long-term growth than you expected, there are likely better options available. While insurance salespeople may tout annuities as low-risk relative to stocks, in our view, an often-overlooked risk is the opportunity cost of forgoing the growth available in other investment options.
Even though immediate annuities may be more straightforward than other types of annuities, there are many factors to consider before purchasing one. While some of these contracts offer features to adapt to your investments goals, such as inflation protection and death benefits, these features can be costly. When determining if an immediate annuity is appropriate for you, you should consider how long you need your money to last. If you elect to receive lifetime payouts, your payments would generally stop when you pass—leaving the remainder of your money with the insurance company. Your benefits are often tied to your longevity or that of your spouse.
Ultimately, the most important outcome is for you to reach your long-term investing goals. Before committing yourself to an immediate annuity, it is important to understand how they work and how they fit into your overall financial plan.
Fisher Investments offers an Annuity Evaluation program for qualified investors with at least $500,000 in investible assets. Our professional Annuity Counselors will help you understand the terms of your annuity contracts and how they fit in with your financial goals.
i Source: Global Financial Data, Inc. as of 01/09/2018. Based on BLS Consumer Price Index from 1925–2017.