Next to reverse mortgages, there is perhaps no other financial product more confusing than annuities. Unfortunately, confusion often breeds fear among investors, and with fear comes ill-formed negative opinions. When I bring up annuities with clients, some will dismiss the idea out-of-hand, having read or heard about someone whose cousin’s best friend’s mother-in-law purportedly lost money with annuities.
The annuity industry is partly to blame for this. A few financially strapped annuity providers have gone belly-up over the years. This made headlines. But now, annuities are heavily regulated, and the companies selling them must have ample reserves on hand. Even during the 2008 great recession, there were no annuity provider bankruptcies.
Another black eye for the industry is that many, if not most, annuities are overly complicated and expensive. In fact, the more complicated they are, the more costly they are. But some are neither. In this and a follow-on article, I will explain what annuities are, give some examples, and describe why some annuities might be right for some people under certain circumstances.
What exactly is an annuity?
At its core, an annuity is an insurance product that allows you to save or invest money tax-deferred, often in a way that reduces investment risk, and then use the money later in life as an inexhaustible source of retirement income.
All annuities have an accumulation phase and a decumulation (or income) phase. In the accumulation phase, the annuity owner (the “annuitant”) can contribute as much money as desired to the annuity, either at once or over a specified period. The money can be invested in stocks and bonds, or it can receive a prespecified safe rate of return. Any growth the annuitant receives during the accumulation phase remains tax deferred as long as the money remains in the annuity.
In the income phase, the annuitant can withdraw money from the annuity, all at once or over time, paying tax on each withdrawal. Alternatively, the money can be converted to a guaranteed stream of income (usually monthly) for some agreed-upon period (usually the annuitant’s lifetime). The latter option is called “annuitization”, in which the asset is relinquished to the insurance company and replaced with a steady and predictable income stream. The annuitization process is irreversible. Once the process starts, the annuitant cannot change her mind and take back the “asset”. However, the income is guaranteed to continue for the agreed-upon period. There is often a death benefit option available, whereby a portion of the income, or a lump sum, would go to heirs if the annuitant dies prematurely.
How can an insurance company guarantee lifetime income?
To understand how an insurance company can guarantee lifetime income, it is important to understand the concepts of risk pooling and mortality credits. Both are key features of income annuities.
Annuitants’ payments or premiums all go into the risk pool. Individuals who live longer than average benefit from the premiums paid by those who pass away earlier. Since annuity payments continue for the life of the annuitant, the insurance company makes no payments to those who die early, and their funds are essentially redistributed to those who live longer.
Mortality credits represent the additional income that long-lived annuitants receive because other annuitants in the risk pool do not live as long as expected. This pooling of risk allows for higher lifetime payouts compared to what individuals could achieve on their own, especially if they outlive their life expectancy. The longer an individual lives, the more they benefit from mortality credits, making income annuities an attractive option for those seeking longevity protection.
In this sense, annuities are the exact opposite of life insurance: with life insurance, you “win” the insurance game if you die, and your estate collects the benefits. With annuities, you win if you stay alive as long as possible. For this reason, people who have reason to believe they will not live to life expectancy should think twice before purchasing an annuity.
How does one purchase an annuity?
Many life insurance companies offer annuities, often through captive agents (agents who work for the company) or independent insurance brokers. You can also purchase them over the Internet. As with any insurance product, annuities are contractual: the benefits and obligations of both parties – the annuitant and the annuity provider – are clearly spelled out, often in excruciating detail. Some annuity prospectuses are the length of a James Michener novel, but I wouldn’t recommend them as beach reading. The more features the annuity offers, the longer the prospectus.
You can hold an annuity either in a retirement account, such as an IRA, or in a non-retirement brokerage account. Think of the IRA or brokerage account as a bucket where you hold your money, and the annuity as a set of agreed-upon instructions for how the money (potentially) grows and is taxed. If it is a “variable” annuity, the annuity will require that you use its own set of investments (called “sub-accounts”). Sub-accounts are very similar to mutual funds.
Why (and when) might you consider purchasing an annuity?
Most people who purchase annuities do so with retirement in mind, even if retirement is still years away. As an aspiring retiree, annuities can help you
- Save for retirement in a tax-efficient manner
- Approach retirement with less risk of loss
- Live in retirement with reduced risk of outliving your money
The first two points relate to the annuity’s accumulation phase, and the last one relates to the decumulation or income phase. When annuitized, annuities can offer predictable income for as long as you live, even after your entire principal is returned to you through monthly distributions. This feature of annuities is referred to as “longevity insurance”, a major advantage of annuities. Ironically, few people who buy annuities ever take advantage of the annuitization feature. There are many reasons for this, including the reluctance to give up control of their asset, underestimating their chances of living past the average life expectancy, and a general lack of understanding of the benefits of risk pooling. This is unfortunate because much of the value that annuities provide — longevity insurance — comes from the second (income) phase.
Here are two examples that illustrate how an annuity can help reduce investment and longevity risks:
Example 1: Fixed Annuities
Mark (58) and Alexa (56) received an inheritance of $500k from Alexa’s mother, who died recently. They plan to set it aside until they retire in seven years and purchase a vacation home by the lake. CDs provide decent rates now, but they would have to pay taxes on the interest. Instead, they can put their inheritance into an annuity paying a guaranteed fixed rate of 5% per year, with tax-deferred interest. If they don’t withdraw the money for seven years, they won’t be hit with “surrender charges”. Surrender charges are fees the annuity provider charges if you terminate the annuity before the period specified in the contract. This timeline works well for them in terms of their lake house. When they withdraw the money after retirement, they will be in a lower tax bracket. So, their overall tax burden on this investment will be lower than with a CD.
Example 2: Variable Annuities
Now that Sam (55) and Jill (55) have put both their children through college, they have extra savings capacity after maxing out their (tax-deferred) 401(k)s. They would like to save additional money to a non-retirement account. They identified a variable annuity that will allow them to invest in some fixed income (bond) investments, without paying taxes on the semi-annual bond interest until they are retired and in a lower tax bracket. Once they both retire, they plan to annuitize the asset and receive a steady stream of income for life, thereby reducing the risk that they will outlive their money.
In a follow-on article, I will cover some of the more common types of annuities in more depth, including how and for what purpose they might be used, and the advantages and disadvantages of each.
Photo by Indra Utama on Unsplash