In recent years, American retirees have been offered annuity products as a way to investment with less risk. If you’re at or near retirement, you may have had people try to sell you one often enough to guess how the conversation may go. “Annuities let you get market like returns while avoiding downturns!” “They will provide you with income for life!” “You’re guaranteed not to lose your investment!”
These assurances are certainly comforting to hear when you’re worried about preserving the money you need to last the rest of your life (or maybe beyond), but the devil is always in the details. How an annuity will provide these benefits is a question that too many retirees wait to ask until after they’ve made the purchase. But these same mechanisms that offer protection can significantly limit the growth of, and income generated by, your retirement investments, so it is important you fully understand the inner workings of any annuity you’re considering before buying it.
To understand how an annuity is different from what you might typically consider an investment, you first need a clear picture of what typical investments are. Many retirement investments are in securities such as stocks or bonds. More broadly, a security is essentially any negotiable instrument that carries a monetary value, usually because it represents either a debt someone owes or a degree of ownership in something. The key term here is “negotiable,” meaning the security can be transferred from one party to another in an appropriate market (also called an exchange).
Annuities, on the other hand, are generally complex insurance contracts between insurance companies and individuals. There are several types. For some, such as variable annuities, the insurer offers to invest the premiums paid by the individual and eventually return this money, typically along with appreciation, as a long-term stream of income. An annuity’s contract is only valid between the company that sold it and the individual who bought it (or their designated beneficiaries (as applicable).
This is the key difference to keep in mind above all others: annuities aren’t themselves an investment, but insurance. They are often used in an attempt to protect against the possibility of outliving one’s assets.
While this type of arrangement may seem to make sense, it can be counterproductive when investing for retirement. The peace of mind the insurance annuities provide can come at the price of high fees and caps on potential returns, which can seriously limit the potential for your investments to grow. This means you may simply be trading the risk of loss for the risk of not being able to grow your money enough to reach your investing goals.
One of the reasons annuities are successfully sold to investors despite their limitations is their many options. Annuities come in many forms and with many varied features. This makes it easy for investors who, understandably, want reassurance that their future will not be jeopardized by market volatility, to find a product that addresses the risks that worry them most. But the truth is that an annuity investment is likely to end up reducing the power of your money to grow in support of your retirement when compared to investing in securities directly.
Another common refrain from annuity salespeople is that it provides tax advantages. While money within an annuity has the benefit of tax deferral, there’s also much more to the story. For one, investors may purchase their annuity within a retirement account such as an Individual Retirement Arrangement (IRA). In this case, there are no tax advantages provided by the annuity itself that aren’t already provided by the account holding it.
When purchased outside of these tax-deferred accounts, deposits into the annuity can’t be deducted from an income tax, which reduces annuities’ potential benefit relative to other forms of investing in retirement. They do still retain one tax advantage—money in an annuity is allowed to grow tax-deferred until it is withdrawn. However, the way you choose to extract the money from your annuity can affect its taxation. If you annuitize your contract and take regular payments, a portion comes as tax-free return of your investment while any amount coming from gains is counted as regular, taxable income.
Additionally, annuity withdrawals made before you are 59½ are penalized 10%. Even death benefits may attract taxes depending on whether the beneficiary is a spouse or not. If this seems confusing, that’s because it is. So consider another expense you’ll likely need with your annuity investment: a tax adviser.
Quite simply, we believe an annuity is not the retirement planning silver bullet that salespeople sometimes claim it to be. In fact, most of the features that draw people to annuities (protection against loss, lifetime payments, death benefits) come in the form of contract riders—additional optional terms that provide benefits beyond what the annuity would offer by default. As we know, insurers aren’t going to offer protection if they expect to lose money on it, so it should come as no surprise that the these features can add considerably to an annuity’s already high fee burden. Individually, these each may look small (often just tenths of a percent), but in sum they can be significant. Consider that an average variable annuity could have fees as high as 3.44%2 :
This type of burden can create a strong headwind for your investments to fight, significantly limiting their long-term performance. But you may be asking yourself, “What about the protection against loss available from an indexed annuity? Wouldn’t that help make up the difference?” Consider the graph below, showing how a hypothetical S&P 500 Indexed annuity with a 1% floor, 5% cap and 100% participation rate would perform over time.
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.
This period includes two of the largest bear markets in US history, and even the protection in these times do not compensate for the annuity’s limited potential for growth.
Realizing these drawbacks can be especially problematic if you’ve already invested in an annuity, as they are designed to make cashing in early costly. Indexed and variable annuities can have “surrender charges” that serve to deter an early exit. These typically start at about 10%,3 though we have seen surrender charges as high as 20% for some annuities. This doesn’t even factor in any early withdrawal penalty that could come on top of this. While many annuities allow a percentage of assets to be withdrawn each year before surrender fees are charged, if you are facing a significant emergency expense, you may face fees significant enough to threaten your retirement’s funding.
Surrender fees can compound the costs of an already-expensive product with an array of other fees. This problem makes annuity investment plans stand out as problematic.
If you want to define your retirement goals so that you can define and enact your retirement strategy, contact Fisher Investments to learn how we can help you.
1 The contents of this article should not be construed as tax advice. Please contact your tax professional.
2 Sources: Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 102, 114; Investment Company Institute, 2017 ICI Fact Book, https://www.ici.org/pdf/2017_factbook.pdf, 89.
3 Source: Securities and Exchange Commission, Variable Annuities: What You Should Know, https://www.sec.gov/reportspubs/investor-publications/investorpubsvaranntyhtm.html;