Funding your retirement is important. Don’t miss these 4 Annuity considerations.
Which Annuity Is Best for Retirement? Probably None.
Since the 1970s, availability of the once-common company pension has declined precipitously, replaced by plans like 401(k)s. As a result, an increasing number of Americans are in charge of determining the best path to fund their retirement—for better and, too often, worse. The fundamental question—How to fund retirement income?—is not one many Americans have been fully educated on and equipped to answer. While these decisions are personal and must be guided by your unique circumstances, our experience in having worked with tens of thousands of American investors leads us to this conclusion: Beware annuities.
What Is An Annuity Anyway?
An annuity is, simply, longevity insurance. When you buy an annuity contract, you give the insurance company a premium—in either one shot or multiple installments—in return for a stream of payments that usually last your lifetime. (That stream of payments can begin immediately or at some later date you determine.) Annuities are very old retirement-funding options; in their most basic form, they date all the way back to ancient Rome.
The sales pitch is that annuities provide certainty: The insurer is guaranteeing payments you can’t outlive. Salespeople often speak in terms of the guaranteed dollar figure you’ll get each month or year. No other investment product offers a “guarantee,” so it is a differentiating factor for the product.i But that differentiating factor doesn’t mean these products are actually good for you.
A Key Question: When Do You Need Income?
A key question: Would you need retirement cash flow immediately or later?
- If immediately, there are very limited circumstances where an annuity can make sense. Intuitively, these are called immediate annuities. Always get a second opinion when considering an annuity, particularly because buying an immediate annuity is usually an irrevocable decision. You are handing over your savings in exchange for a stream of payments. Before you buy, you must consider whether your goals are limited to retirement funding or are broader. If broader (passing on funds to heirs, large one-time expenses, savings, etc.), this option very likely doesn’t make sense for you.
- If you aren’t taking income immediately, you are purchasing a deferred annuity. These are annuities that are designed to grow in value for a time, until you convert them into an income stream later. In our experience, deferred annuities almost never make sense. They are typically costly (either in terms of fees or watered-down returns), restrictive, potentially tax inefficient and low yielding.
Immediate Annuity Issues
Immediate annuities are the simplest form, but that doesn’t make them foolproof. Many times, annuity payments are not inflation adjusted. Inflation is a general increase in prices that reduces the purchasing power of a dollar. America’s median inflation rate since 1948 is 2.9% annually.ii At this rate, $10,000 today will buy you only about $5,800 worth of goods in 20 years. For a product promising lifetime income, this is a serious drawback. And, none of this takes into account your changing expenses. As you age, it is likely your consumption will change, and many expense categories affecting retirees experience much larger than median inflation rates.
Deferred Annuity Considerations
Deferred annuities come in many varieties. There are fixed, variable and indexed annuities. All three have a period called the accumulation period in which your funds are invested (in various ways—that’s where the different types come in). The idea is, the funds will grow tax deferred and then, when you’re in need of regular withdrawals, you turn them into a stream of payments not unlike the immediate annuity discussed above.
So why do we believe these almost never make sense for investors? No matter whether you pick a fixed, indexed or variable annuity, there are likely more effective investment options to deploy while you’re accumulating funds.
Here are some helpful questions to uncover issues with annuities. Ask the annuity salesperson:
- “What broad type of annuity is this? Fixed, variable or indexed?”
- “How is my performance determined? Are there caps, limits or fees?”
- “How is the insurance company making money on this product?”
- “What if I decide I want out? Are there exit penalties? How long will they apply?”
Don’t let the salesperson wiggle out of answering these. We’ve analyzed thousands of annuities for clients and have never seen a free lunch. The insurance company will get its slice, either through outright fees (on variable annuities, most commonly) or through paying you only a small portion of the return they earn investing your money (indexed and fixed annuities). There is usually an exit penalty, often lasting 7 or 10 years, and the penalty can be substantial.
Salespeople often pitch deferred annuities as a way to invest large sums without capital-gains taxes.iii That’s true, but not the full story. You see, while the growth isn’t taxed when earned, when you pull funds out, the gains are taxed as ordinary income. Those rates are often higher, if not much higher, than the capital-gains rates you might enjoy outside an annuity. Besides, between the fees and caps, your portfolio’s growth is likely to be stunted.
In our experience, annuities are arguably the most oversold retirement product in the industry. The number of times an immediate annuity benefits the buyer are small, and deferred annuities almost never benefit the buyer. For these reasons, we strongly suggest investors dig deep into annuities they may be considering. Doing so before you buy is best. But even if you already own an annuity, research can help shed light on whether it is optimal or not.
iAnnuity salespeople can use the term “guarantee” because these are insurance products, not investments.
iiSource: Federal Reserve Bank of St. Louis, as of 12/16/2016. Consumer Price Index, January 1948 - November 2016. Median is a mathematical term for the “middle” rate—there is an equal number of historical monthly rates above and below this figure.
iiiThis is also why the SEC cautions investors about putting annuities in individual retirement accounts. It is doubling up on tax deferral, eliminating this annuity feature.