The “A” word. Annuity. This financial instrument gets a lot of attention in the media nowadays.
Much of the noise is from these products getting improperly sold to consumers. Unfortunately, the financial services industry is polluted with unscrupulous advisors or insurance-only agents that only sell annuities.
My goal of this article is to give you an objective view on annuities as a Fiduciary and Certified Financial Planner.
Not all annuities are created equal. Similar to how not all mutual funds or stocks are the same. My team’s role is to evaluate all potential strategies for clients to retire as safely as possible. Sometimes this includes reviewing annuities.
- Basics & Types of Annuities
- Personal Pension
- Pros and Cons
1. Basics & Types of Annuities
An annuity is a financial instrument that is a contractual agreement between a consumer and an insurance company. The investor purchases an annuity with their principal for a period of time in exchange for an interest rate to be credited in the future based upon an agreed calculation.
Many annuities are used to either provide a guaranteed income stream for a retiree or to accumulate wealth given its tax deferred status for cash.
An annuity is not FDIC insured, it is instead backed by the claims-paying ability and strength of the insurance company that sponsors the annuity. The A.M. Best ratings agency is the most recognized agency that rates insurance companies.
There are many nuts and bolts to consider before considering if an annuity is right for you and your situation.
In general, there are three different types of annuities in the marketplace:
- Fixed Annuity
- Fixed Index Annuity
- Variable Annuity
A Fixed Annuity is very simple. Similar to a bank CD (Certificate of Deposit), a fixed annuity pays a fixed interest rate for a certain period of time. Very popularly sold at bank institutions, an example of a fixed annuity is the insurance company’s guarantee to pay 2% for the next five years.
Each insurance carrier has different interest rate terms and surrender schedules. Make sure to use an “insurance broker” to confirm you are receiving the best rates in the marketplace.
A Fixed Index Annuity is slightly more complex. Interest may be fixed and/or credited based on the performance of an index. The S&P 500 or Dow Jones are common indices used.
A very appealing feature of this type of annuity is the downside protection. There is what you call a “0% floor” with fixed index annuities meaning if the index goes below 0% during the contract year, the investor’s principal remains the same and is essentially fully protected. Back in the 2008 downturn when the S&P 500 was down -37%, indexed annuity owners kept their entire account principal.
A disadvantage however, is the limited upside. This type of annuity is not built for consistent double digit returns. Again, if you are expecting stock-like returns you should look into investing in stocks, not a fixed index annuity.
Since the investor is fully protected on the downside their upside potential is limited. Each insurance carrier has various methods to follow the performance of the index. Some common crediting strategies which is how investors profit include an annual cap or participation rate method.
For example, with a 5% annual cap on the S&P 500. Three different scenarios may occur.
If S&P 500 gained +8% the past contract year, the annuity company will credit up to the 5% cap to the investor.
If the S&P 500 returned anywhere in between 0-5%, that exact amount is credited.
Lastly, if the S&P 500 is at all negative like in 2000 and 2008, no interest is credited but the principal is protected.
Another crediting strategy is the participation rate of the index. Example, 50% participation on the S&P 500. If the index returns +10%, the investor participates in half of the upside and is credited 5% in this scenario. Again, any loss in the index and the investor maintains their principal.
A Variable Annuity is the third and last type of annuity.
This vehicle in a sense is similar to your 401k or IRA in that it is invested in mutual funds (baskets of stocks and bonds). Investors profit based on the performance of the selected mutual funds. The term ‘variable’ refers to the ups and downs the portfolio may encounter from the stock market risk taken.
The key difference with variable annuities lies in the fees that are charged to investors.
2. Personal Pension
A key feature of an annuity that is often misunderstood by consumers is the ability to generate an annual guaranteed income amount in retirement.
For an additional annual cost to the investor they can add what you call an “income rider.” Essentially this adds a pension-like feature to the annuity contract by guaranteeing the investor a minimum amount they can withdraw from their annuity for life.
Annuity payments pay similar to pensions. The paycheck to you and your spouse is backed by either the strength and claims paying ability of the insurance company (annuity) or employer (pension).
This “income rider” add-on differs from a traditional corporate pension since if structured properly the investor is able to pass the annuity to not just their spouse but children and additional heirs also.
In contrary to a standard pension company which will stop sending paychecks upon the death of the surviving spouse. The kids typically do not receive anything.
Investors may add this type of pension-like rider to both fixed indexed and variable annuities for an additional cost.
Keep in mind this add-on to an annuity is not right for everyone. I meet teachers and government workers where they are fully covered by state and local pensions and the need for this add-on may not be appropriate.
For the rest of society, pensions are dying. From the employer perspective, pensions are simply too expensive to maintain and administer for employees. The trend we are seeing today is the shift from pension plans to 401(k) plans. The employer now puts the burden on the employee to properly save and invest for their retirement
3. Pros and Cons
No investment is perfect.
Annuities are not right for everyone.
Some pros of using annuities in your retirement plan may include adding a guaranteed income stream via the pension rider we discussed and/or protecting your principal with an indexed annuity.
Another advantage an annuity has is the tax deferred gains. Inside cash accounts, the opposite of IRAs, investors would not pay taxes on the annual gains of the account. Compare this to a mutual fund that triggers taxable dividends and interest to the investor. Many people that maximize their 401k contributions and/or Roth IRAs may find a lower cost variable annuity appealing given the tax deferral of stock market type gains.
Key cons include surrender charge schedules and fees to the client. A surrender charge is a fee charged to the investor if they withdraw more than the free withdrawal amount from their annuity (typically 10% of the balance). Most surrender charges are on a decreasing scale meaning each year the fee is reduced until the surrender period is over.
Some surrender periods may last up to 16 years or as short as 5 years.
The fees to the investor differ based on the type of annuity and if a pension rider is added to the contract.
Typically, fixed and fixed indexed annuities have lower fees than their variable annuity counterparts. The reason for this is variable annuities have mutual fund costs embedded inside from the annual expense ratios charged to each mutual fund.
If considering purchasing an annuity, make sure to consult with an independent Certified Financial Planner that has broad perspective and your best interests in mind and not someone limited to just the insurance industry.
In conclusion, annuities are not right for everyone. For those that it may make sense for it can be a reliable source of income for all your retirement years to come.
Consult with a Certified Financial Planner. As an independent CFP that is legally obligated to act as a fiduciary for your best interests, I can give you that much needed second opinion via a no-cost review. You may contact me below.
Annuities are insurance products with guarantees based on the financial strength and claims-paying ability of the issuing insurance company.
Variable annuities are sold by prospectus only. Before purchasing a variable annuity, you should carefully read the prospectus and consider the annuity's investment objectives and all risks, charges, and expenses associated with the annuity and its investment options.
The above article is informational in nature only. Individuals should always consult with their tax advisor regarding their personal tax situation.
Dustin Javier, CFP® AWMA®
CERTIFIED FINANCIAL PLANNER™
President | Dean Johnson Advisory, LLC
Securities and investment advisory services offered through Ausdal Financial Partners, Inc. Member FINRA/SIPC. 5187 Utica Ridge Rd., Davenport, IA 52807. (563) 326 2064. www.ausdal.com Dean Johnson Advisory and Ausdal Financial Partners are independently owned and operated.