What Your Annuity Does (and Doesn't) Guarantee

Annuities may seem like a safe, sound option to fund your retirement. But when you dig even a little bit beyond the surface, you may not like what you find.

Annuities can be extremely complex, and for an owner or potential buyer of an annuity, it can be hard to understand what you’re looking at. Even knowing where to start your analysis can prove challenging. In our experience, differentiating by type is a key first step for anyone interested in annuities. If you don’t know which type of annuities you own or are considering, that is a red flag. Stop and be sure to ask enough questions—do enough research—to know exactly which of the broad types of annuities you’re looking at.

Immediate Annuities

These are the most basic form of annuity. An immediate annuity is annuitized—converted into a set stream of income payments—immediately at purchase. (Hence, the name.) When you buy the annuity, you no longer own the funds. Immediate annuities guarantees two things: One, the amount you’ll receive in each payment. Two, how long you’ll receive payments. That period may be 20 years. It may be shorter. It may be your lifetime or your spouse’s.

Few people buy these, however. There is ample academic research exploring why, but to us it seems fairly apparent: The decision is irrevocable. You can’t decide a year later another option sounds better and you’re getting out. There is no “out.” The money, simply put, isn’t yours any more. For this reason, if part of your investment objective is to leave a legacy when you pass, an immediate annuity is a poor choice.

Moreover, that stream of payments isn’t certain to keep pace with your changing cost of living over time. Your cash flow isn’t adjusted for inflation (without a provision that likely reduces your monthly payments now). Exhibit 1 is a hypothetical illustration showing the effect of even very low 2% inflation on a $50,000 income over 30 years. Note that without an inflation adjustment on payments, you could be looking at a severe decrease in purchasing power over 15, 20 or 25 years. And what if inflation is higher than the very low rates indicated here? Suddenly the income “certainty” you thought you were getting seems inadequate.

Exhibit 1: Hypothetical Illustration of Inflation’s Impact on $50,000

hypothetical illustration of inflation’s impact on $50,000

Source: Author’s calculations.

As noted, though, immediate annuities aren’t common. Much more common are deferred annuities. (There are three primary flavors of these, as we’ll discuss momentarily.)

Deferred Annuities

Deferred annuities do not immediately become a stream of payments at purchase. They have two defined periods:

  1. The accumulation phase — when your funds are invested within the insurance contract — adds more complexity to deferred annuities, though.
  2. The annuitization phase is effectively when you turn on guaranteed payments, and here all the points raised under immediate annuities apply.

However, beyond that, there are broader considerations that hinge on the investment method chosen to get growth. There are three types of deferred annuities: Variable, fixed and indexed. We’ll briefly cover each and discuss what is and isn’t guaranteed.

1. Variable Annuities

During the accumulation phase, variable annuity owners choose from a menu of mutual-fund-like options called subaccounts to invest in. The options are limited to what the insurer offers. And those options, very frequently, carry high fees that dilute returns. And those fees aren’t alone! Variable annuity owners will pay a vast array of fees for the contract itself, any special riders and features they add and, as noted, the investment options. Moreover, the returns are not guaranteed with variable annuities. They fluctuate like funds. If your subaccounts’ investments decline in value significantly, the aggregate value of your annuity will likely decline significantly. The fees reduce returns while you are still exposed to volatility. You’ll get the immediate-annuity-like guaranteed payments if you annuitize, but up until that point, you’re on your own. You’ll get the immediate-annuity-like guaranteed payments if you annuitize, but up until that point, you’re on your own.

2. Fixed Annuities

Fixed annuities differ dramatically from variables. Fixed annuities do guarantee returns, setting a fixed rate, like a savings account, at the beginning of a period of time. Your contract value will not fluctuate with the stock or bond market, and there often aren’t any fees. Fixed annuities returns are tied to interest rates, so in a low interest rate environment, insurers can't guarantee you big returns for long. We said, "for long," because insurers frequently offer teaser rates for the first year in order to lure investors.

3. Indexed Annuities

Indexed annuities (occasionally called equity-indexed annuities or fixed-indexed annuities) link your return to a market index. With indexed annuities, the insurer guarantees your investment won’t decline, but doesn’t guarantee what you will earn. You see, the portfolio isn’t invested in the market index the annuity is linked to (therefore, the value doesn’t fluctuate). The index is merely the basis for calculating the rate the insurer pays you.

Note: This does not mean that you can get equity-like upside with no downside risk. That is simply not true. You will only get a slice of what the linked index returns—e.g., you may get half of what the index returns in a month. This is called a participation rate. Moreover, there are often limits to the amount you can earn in a given period, called performance caps. All in all, performance caps and participation rates mean even indexed annuities linked to stocks usually yield returns on par with CDs and bonds—which is what they were designed to compete with anyway. Your return, as with any investment devoid of volatility, is likely to be very, very low.

In Conclusion

Ultimately, annuities may seem like a safe, sound option to fund your retirement. But when you dig even a little bit beyond the surface, you may not like what you find.

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