What’s an Annuity? Stripping Away the Buzzwords

When considering retirement savings and income options, investors should ask themselves this question before believing any advertising hype: Seriously, what is an annuity?

Above all else, investors should know that annuities are, in essence, a type of insurance contract. When you buy an annuity, you’re really purchasing an agreement with the insurer to deposit a large sum of money with them that they’ll invest on your behalf and then return to you through regular repayments. This occurs in two distinct phases, the first of which is accumulation. This is the time when the investor deposits his or her money into the annuity account. Depending on how the annuity is structured, it may provide a return that is either fixed or variable, based on how it’s invested in the market. At some point, as specified in the annuity’s contract, this account can be annuitized—the next phase—where the money becomes the insurer’s and the investor begins receiving payments, either in fixed amounts or as a percentage of the account.

If that sounds pretty straightforward, don’t be fooled. While generally simple in concept, annuities are available in a wide range of forms, which can function in equally varied ways. Some have legitimate benefits for retirees, but in our opinion many more are structured in a way that benefits the insurer and the salesperson far more than the retiree. We’ll get into them more later, but some key issues we often see in annuities include:

• High annual administrative and maintenance fees
• Significant commissions and/or sales fees
• Expensive surrender fees
• Capped returns
• Complicated guarantees
• Restrictive terms
• Complex and confusing contracts
• Dictionary-sized amounts of fine print
• Risk of losing money should the insurer’s business fail
• Little-to-no liquidity

Types of Annuities

As we’ve mentioned, these issues don’t apply across the board, so it’s important to know what an annuity is offering when it’s called “fixed,” “variable,” “indexed,” or some other variation. Below are a few of the most popular forms:

• Fixed annuities are the simplest type, providing a fixed rate of return for their deposits until the account is annuitized. Although fixed annuities offer more stable growth than other annuities and rarely risk a loss of principal, their rates of return are usually far below what direct equity investments can earn. Though annuities can protect against outliving savings when they provide lifetime benefits, investors who rely on them may also suffer as a result of inflation eating up the purchasing power of the annuity’s income over time.
• Variable annuities operate differently in that rather than simply generating fixed interest, they divide deposits into sub-accounts that are invested in the stock markets. These investments are usually in the form of various mutual funds selected by the insurer. In theory, then, variable annuities can offer market-like returns—but they can also experience market-like losses. Additionally, variable annuities’ punitive annual fees along with their rigid terms and conditions mean that investors are unlikely to actually achieve similarly high gains. A 3% annual cost per year, for example, can add up over time and create significant headwind against your investments. Question: What’s a variable annuity when it claims to offer market-like returns? Answer: It’s still a longevity insurance product.
• Indexed annuities, also called Equity-Indexed Annuities (EIAs) or Fixed-Index Annuities (FIAs), offer interest rates calculated using stock market index returns. However, participation rates, management fees and performance caps can restrict the upside growth to only a fraction of the actual index. On the other side, losses are generally limited as well through a “floor” rate that guarantees return. Indexed annuities often have some of the highest surrender fees, particularly if they imply the offer of a “bonus” return for signing up. Question: What is an indexed annuity? Answer: Confusing, often even to the firms selling them.
• Qualified Longevity Annuity Contracts (QLACs) are one of the more novel forms annuities have taken. They enable investors to use money from a qualified retirement plan (such as a 401(k) or IRA) to purchase an annuity, and shield those funds from Required Minimum Distributions (RMDs). Although QLACs come with tax advantages, they can also lock you in for the long term, as the accounts generally won’t annuitize until you are in your 80s. Another drawback: Unless you pay an extra cost for a contract rider, QLAC payments are not likely to grow with inflation, which can reduce their ability to keep up with the rapidly rising cost of living that comes with longevity.

Immediate vs. Deferred Annuities

In addition to looking at how annuities grow their deposits, they can also be evaluated in terms of how they are annuitized. What is an annuity, which takes a large sum of your capital in return for a regular income stream in the here and now? Why, it’s an immediate annuity, of course—or a way to trade the flexibility and opportunity of your capital in exchange for restrictive regular payments. This arrangement can last for a set time period (e.g., 10 years) or can be for the remainder of your life (though usually this feature comes as an additional contract “rider” paired with an extra fee).

In contrast, deferred annuities only become annuitized at some agreed-upon point in the future (e.g., on retirement, or when the contract is 10 years old, or at the discretion of the owner). These annuities provide more time for your deposits to grow and accumulate but, as we will explain later about withdrawal fees, they can significantly reduce how accessible your money is once contributed to the account.

Riders

What is an annuity when it looks most attractive? Why, it’s an annuity plus a collection of additional contract riders, each of which is likely to come at a significant additional expense.

Below are some of the most common riders found in annuity contracts:

• Guaranteed minimum income riders sound appealing, but often they refer only to growth prior to annuitization, rather than the payouts actually received by the investor. These riders can also be costly, so it’s wise to consider how their potential benefits weigh against their guaranteed fee.
• Minimum withdrawal benefits riders guarantee that some amount, a typical example may be 5-7%, of the initial principal can be withdrawn each year until the investment has been recovered or in order to receive income without annuitizing the contract. This can be helpful in maintaining access to at least some of the money in your annuity—but consider: You’re paying to access your own funds.
• Guaranteed lifetime income riders reduce longevity risk and help ensure regular lifetime income payments, transferring the risk of living past your savings to the insurer. However, this increased risk to the insurer also means the cost can be significant, especially for annuitants in good health.
• Death-benefit riders enable beneficiaries to access some or all of the remaining principal upon the death of the annuitant; otherwise, it will remain with the insurer.

It’s important to remember: Annuity companies may use different names for these riders, so be sure to read your particular contract. These contracts may define terms in a much more specific way than they are used in casual conversation (say, with an annuity salesperson), so it’s easy to misinterpret what you’re actually buying. Careful reading of any annuity contract before you sign is the only way you can really know.

More Annuity Fees and Commissions

As with riders, annuity fees can be complex, opaque, multi-layered and, ultimately, expensive. Below is an example of how typical fees could impact a $100,000 variable annuity:

Fees must take account of annuity commission structures, which can be so high that they effectively eat into your gains. For example, with variable annuities, commissions typically range between 5-10% of total assets, or even more. This means that if you were to buy a $500,000 annuity, the broker could earn more than $50,000!

Annuities are also notorious for being illiquid, so it can be very difficult or costly to access the money they hold. For example, once a contract is annuitized and payments begin, there is generally no way to recover the principal (other than through a rider). And although many annuity providers allow annual withdrawals of up to 15% without surrender charges, these short and restricted windows are unlikely to be sufficient to meet unforeseen income needs. Making unscheduled withdrawals or surrendering the annuity altogether can be very expensive, potentially triggering both tax penalties and surrender fees.

Annuities–Yes or No?

After reading to this point, it's understandable if you're pulling out your hair and now asking: "What's an annuity actually for and what can it do for me?" Summed up, annuities are likely the most complicated form of longevity insurance you’re likely to find.

So, annuities–are they good or bad? While they can be useful in very specific forms and situations, our opinion is they rarely contain features that truly benefit investors. Probably the best answer we can give is that they can be a useful way for annuity salespeople to put their children through college.

If you’re considering an annuity or already own one, Fisher Investments offers a complimentary evaluation service for prospective clients. † Our Annuity Counselors will analyze your annuity contract and clearly explain what features it actually offers, as well as how those features align with your investment situation and retirement goals. In cases where it does not serve your goals, we may even be able to assist in getting you out of your annuity.† For more information, contact us today to request a consultation with our Annuity Counselors.

¹ Source: Securities and Exchange Commission, Variable Annuities: What You Should Know, https://www.sec.gov/reportspubs/investor-publications/investorpubsvaranntyhtm.html

² Source: Insured Retirement Institute, 2011 IRI Fact Book (Washington, DC: IRI, 2011), 36-38, 56.

^† Terms and conditions apply.

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