The Trouble With Income Annuities

As you approach retirement, your insurance company or broker may suggest investing in income annuities, usually emphasizing the promise of guaranteed income for life. Although these promises may sound safe, income annuities, like all financial products, come with their own set of risks.

One of these risks is that the annuity purchaser misunderstands the annuity contract and gets less value out of it than originally anticipated. In one interview with ThinkAdvisor, Fisher Investments’ founder and chairman, Ken Fisher, described this phenomenon, “It’s very rare that the customer understands the long, convoluted annuity contract, where magical words are used that have nothing to do with what the contract actually does […] And almost always, anything that can be done with an annuity can be done a better way.” i

Income annuities also come with other risks, which may not be readily apparent when you purchase them. For example, the annuity’s income stream is often taxed at regular income tax rates as opposed to (often lower) capital gains tax rates. This means less money in your pocket after taxes, which can have a material effect on many retirees and other investors who are dependent on periodic investment income. Additionally, annuity income is often fixed for long periods of time and may not grow to counter inflation, meaning your income would likely lose some purchasing power over time.

People wishing for a “safe” asset in retirement usually consider annuities because of their income guarantee, but fees, taxation and potentially fixed payments can detract from an income annuity’s growth and may even increase an investor’s chances of running out of money in retirement.

Investors should always look beyond the sales pitch and consider some of the risks and potential pitfalls of income annuities. But first, it is important to understand the different ways they are structured and how an annuity provides income.

Different Annuity Types and Payout Methods

Deferred vs. immediate
Annuities are insurance products that some investors use to provide retirement income. Annuities fall into one of two types of time frames—deferred and immediate:

  • A deferred annuity starts with a growth—also known as accumulation—phase, when the investor deposits funds either as a lump sum or in periodic installments. The insurer will begin making payments at some specified later date once the account is annuitized. After annuitization, the payout phase begins. Annuitization means the annuity’s investments transfer to the insurer who begins to make payments based on the account’s total value at the time.
  • An immediate annuity doesn’t have a growth phase and, as the name suggests, is annuitized immediately. The insurer bases the ongoing payment amount on the initial lump sum deposit.

Income-generation phase
This phase can take many forms depending on the annuity’s structure. Here are some of the more common payout structures:

  • Lifetime. You receive a fixed or variable amount—usually monthly—for the rest of your life calculated based primarily on your life expectancy.
  • Joint and survivor life. You and your survivor—commonly a spouse—will receive ongoing payouts as long as either of you is alive.
  • Fixed amount. You select the amount of the ongoing payouts, which continue only until you stop them or the payouts match the principal amount at annuitization.
  • Period certain. You specify a guaranteed period in which the payouts would continue even if you pass away.
  • Guaranteed lifetime withdrawals. Although not technically a payout option, this feature is available on some annuities. It allows you to withdraw a certain percentage of the account annually without the typical surrender penalties, enabling you to get income before annuitization.

Now that you have seen how many annuities are structured and some common payout options, let’s take a deeper dive into annuities’ potential drawbacks—things you aren’t likely to hear at a sales pitch.

Potential Pitfalls of Income Annuities

One commonly cited benefit of income annuities is they have a tax advantage in that they allow money in a taxable account to have tax-deferred status. The money you invest in an annuity typically isn’t subject to capital gains taxes, which investors have to face when realizing gains on most taxable investments. However, taxable income from an annuity is generally subject to ordinary income tax rates. From a tax standpoint, if your income tax rate in retirement is higher than the long-term capital gains tax rate, an annuity may not necessarily be advantageous.ii

Another factor to consider is inflation. In many cases, annuities provide fixed payouts, meaning you could lose an average of roughly 3% of purchasing power annually, which is the average US inflation rate since 1925.iii So, the longer the payouts continue, the less value each subsequent payment may offer. The cost of inflation can especially work against retirees since some common retiree expenses, such as healthcare or college tuition for grandchildren, have been steadily increasing as well. Although some options may exist to adjust annuity payouts for inflation, they tend to come with an additional fee or have lower initial payments than a fixed-payment annuity of the same value.

Investors needing to outpace inflation and maintain purchasing power may be better off looking into other investment options with higher growth potential.

Other Income Generation Methods to Consider

Although annuities are often touted for their income generation, other income options, such as bond coupons, stock dividends or “homegrown dividends,” may be better depending on your long-term goals and individual financial situation. When we say homegrown dividends, we mean the selective selling of stocks and other securities for cash flow. Homegrown dividends could help you maintain a well-diversified portfolio appropriate for your long-term retirement goals, while taking the necessary cash flows to maintain your current lifestyle.

This approach can be flexible and potentially tax-efficient. It allows you to sell invested securities from your portfolio to generate cash flow without the fear of possibly incurring a surrender charge—a common annuity fee assessed if you withdraw money from an annuity before a specified time period. Selling stocks or other securities for cash flow means you will capital gains taxes on any gains from the securities sold. However, along with this potentially lower tax rate, strategically selling securities that may have incurred losses may offset some of that tax burden as well. These are just a couple of factors we think make homegrown dividends a more flexible income strategy than investing in an income annuity

How Fisher Investments Can Help

If you are wondering if an income annuity will be appropriate for your retirement income needs, our Annuity Counselors offer an Annuity Evaluation Program for qualified investors with at least $500,000 in investable assets. In this program, we can:

  • Help you understand the terms of your annuity contract
  • Walk you through the benefits it offers
  • Call your annuity company with you to clarify any questions you may have

Contact Fisher Investments at (800) 568-5082 to speak with one of our representatives or browse our extensive collection of annuity guides to learn more.

Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations. The foregoing constitutes the general views of Fisher Investments and should not be regarded as personalized investment advice or a reflection of the performance of Fisher Investments or its clients. Nothing herein is intended to be a recommendation or a forecast of market conditions. Rather it is intended to illustrate a point. Current and future markets may differ significantly from those illustrated here. Not all past forecasts were, nor future forecasts may be, as accurate as those predicted herein.

i Source: “Why Ken Fisher Hate Annuities,” ThinkAdvisor, 10/26/2015.

ii The contents of this webpage should not be construed as tax advice. Please contact your tax professional.

iii Source: Global Financial Data, Inc., as of 01/09/2018. Based on BLS Consumer Price Index from 1925-2017.

Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns.
Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations.