Annuities can be advertised as a risk-free way to invest for retirement. Annuity salespeople may make it seem like your annuity will actually reduce your risks—possibly by guaranteeing your investment is safe or maybe by promising you’ll continue to receive income for the rest of your life. On the surface this makes sense—annuities are, after all, a form of insurance. In reality though, there is no such thing as a risk-free retirement plan, only different kinds of risk.
Ultimately, successful retirement investing is about trying to balance these risks so that you don't run out of money while giving yourself the opportunity to achieve your goals. As such, we believe it’s prudent to closely consider how an annuity actually affects risks in your long-term retirement goals before deciding if it’s right for you.
Many annuities operate by converting the owner’s premium payments (either a lump-sum or regular contributions during the “accumulation” phase) into an income stream (the “annuitization” phase). This change can happen immediately, but it generally occurs at some future time, as specified in the contract. Deposits during the accumulation phase are generally invested to generate growth, which may have a fixed or variable rate depending on the type of annuity. Once you annuitize the contract, you typically turn the entire principal over to the annuity provider and begin receiving an income stream to help fund your retirement.
However, there can be major problems with this model. For example, the income stream an annuity generates is often fixed. As with any fixed amount of money, inflation can erode the purchasing power of these funds over time. Inflation can be particularly problematic for retirees, who may be more exposed to categories like medical care that, in recent years, have experienced greater inflation than other categories.1
It’s worth noting that some annuities may offer ways to mitigate inflation, but these measures can come with considerable costs. For example, the annuitant can purchase a contract “rider” that allows the payments to grow along with inflation. In addition to an additional fee for such a rider, it may not work as the annuity holder expects. In some cases, the rider may not mean you receive more of an income stream over time, but simply receive smaller payments than you would have normally early on, and larger payments later on. The total amount you receive may not change, simply when you receive it. By back loading payments, the insurer also increases the chances you’ll pass away before recouping your annuity’s full value.
In terms of annuity risks, believing what you hear is perhaps the most dangerous. It’s not hard to find coverage that encourages caution concerning annuities. The Securities & Exchange Commission (SEC) has an extensive resource to help clarify what variable annuities offer to consumers.2 It is important to look into each of annuities’ features to determine if it really works the way you think it does.
For example, “guaranteed loss protection” (a popular annuity feature) sounds fantastic in conversation, doesn’t it? After all, who wouldn’t invest if they knew they couldn’t lose? But as you might expect from a claim you can invest with no risk, the reality of what this language means can be starkly different from how it’s perceived or presented in a sales conversation.
Remember, all the words you exchange with an annuity’s salesperson are just those: words. The only thing that defines what your annuity will really provide is the language in the contract. Words in a contract can be defined in manners far different from how they appear in your standard dictionary. In the case of “guaranteed loss protection,” this generally means recouping what you put in—not the maximum value the account reaches. On the surface, you might still think getting something back is better than nothing, but this ignores the continued effects of inflation, which can erode the value of that initial purchase amount.
When you pay your premiums to the insurance company providing the annuity, you are effectively locking your money away until age 59.5. As we’ve mentioned, this is even more pronounced with annuities relative to 401(k)s, IRAs and other tax-deferred retirement accounts, as annuities have high early withdrawal and surrender fees that can present a major and dispiriting challenge to anyone needing to cover unexpected expenses. This highlights one of the major annuity risks: illiquidity.
Relying on annuities for a significant part of your retirement assets could mean you’re at risk of finding yourself short of funds to cover an unexpected expense. Consider having a terrible accident after paying years of premiums or stashing away a lump sum just months before retirement. This could leave you forced to pay a significant surrender penalty, leaving you with fewer funds for your future.
This also assumes you have yet to begin taking payments. Quite simply, you don’t really own the premiums you’ve paid once you’ve annuitized your contract. As such, if you face financial challenges caused by a change in your personal or health circumstances, you may not be able to meet them with funds from your annuity, unless your contract specifically allows withdrawals after payments begin.
Lastly, if you tie your money up into an annuity, you may be missing out on the opportunity to make greater returns elsewhere. Annuities that do allow investment in the market, such as variable annuities, usually limit the funds you’re able to invest in. Before accepting the notion you really could experience market like growth within the annuity, look into the mutual funds you’ll be able to choose from for your investments in the annuity sub-accounts:
Without looking at the annuity’s options thoroughly, you risk locking yourself into a very limited range of investment opportunities that may not be appropriate for you.
We know annuities can be overwhelming for many investors, which is why we offer our Annuity Evaluation program. Our team of Annuity Counselors are available to help those who are considering or already own annuities to better understand them. We can help explain how your annuity operates, and clarify any misunderstandings you may have about what it offers. Our annuity specialists can help you weigh all your annuity risks, and the risk presented by potential illiquidity and we can compare them to the risks presented by other strategies.
By looking at your annuity through this lens, we hope to provide a chance for you to review your retirement strategy so that you can properly establish whether your annuity really does serve your retirement goals. If not, we may be able to help you choose another path. By providing the research, communication and support you need, we aim to help you plan for retirement with confidence.
1 Source: FactSet, as of 2/12/2018. Consumer Price Index data, 12/31/1990 to 12/31//2017.
2 Securities and Exchange Commission, Variable Annuities: What You Should Know, https://www.sec.gov/reportspubs/investor-publications/investorpubsvaranntyhtm.html