What is an Annuity?

When you strip away the buzzwords, an annuity is nothing more than longevity insurance

Pop quiz! What is an annuity?

  1. A surefire way to fund your retirement
  2. Protection against bear markets
  3. A cost-effective, safe pension substitute
  4. None of the above

Much of the annuity industry’s advertising might lead you to pick a, b or c. But when you strip away the buzzwords, an annuity is nothing more than longevity insurance. When you buy an annuity contract, you give the insurance company a premium—often, a huge chunk of your savings—in return for a stream of payments over the rest of your life.

There are two main types of annuities: immediate and deferred. If you buy an immediate annuity, you exchange your principal for a payment stream that starts right away. The payments are usually linked to some combination of your principal value, life expectancy and interest rates. Deferred annuities, however, are much murkier. When you buy the contract, you don’t begin receiving payments right away. Instead, they are invested in one of various ways, giving the premiums a chance to grow over time before you annuitize the contract—turn it over to the insurer in exchange for income. Typically, once you convert your principal to periodic payments, you can’t undo it or rejigger the particulars of the income calculation.

In our experience, few deferred annuity buyers fully grasp that they’re buying an insurance contract—or that the contract is heavily skewed in the insurance company’s favor. This shouldn’t be a surprise. Insurance firms are for-profit businesses, not charities. They wouldn’t sell annuities if they weren’t moneymakers. Nor would the brokers who pitch them.

Investors who take time to read the entire prospectus or scrutinize contracts will find some glaring drawbacks. For instance, if you try to break the contract for years after purchase the provider typically charges a stiff penalty, known as the surrender charge, to compensate for the high up-front commission the broker earned for selling it. And because they aren’t charities, annuity providers may take a healthy cut while you own the contract too—some annuities have sky-high fees, while others can cap your returns and deftly pocket the spread between your account and the market.

Riskless return doesn’t exist. As longevity insurance, deferred annuities claim to hedge you against the risk you would otherwise outlive your money. But they come with a host of other risks and drawbacks. In our experience, what most high-net worth investors seek from annuities, they could probably achieve more efficiently with an investment portfolio of stocks, bonds or other securities—with far fewer fees and restrictions, and much more transparency.

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