The "A" Word: What Are Annuities?
The “A” Word: What Are Annuities?
One of the most misunderstood investment vehicles are Annuities. A common statement I hear is: “I don’t like annuities” or “Annuities aren’t good investments.” I’m a firm believer that there is a time, place, and person for almost every investment, and most of these objections are based on people’s overgeneralization of the investment. Annuities can be fixed or variable, immediate or deferred, have fees or have no fees, be liquid or have no liquidity.
So let’s do a brief crash course on annuities.
Annuity vs. Annuitizing
One of the biggest misconceptions about annuities is that you give your money to an insurance company and they have total control over it and pay it back to you for a set period of time. That is not an annuity, that is annuitizing.
While most annuities have the option to annuitize – if you have a deferred annuity, then this option is purely at your discretion and you never have to annuitize if you do not want to. (Note: Many companies have annuitization dates that range between age 90 – age 115, but if you don’t want to annuitize you can just take the money out before that date.)
What most people don’t realize is that annuities are unbelievably diverse and have a wide range of uses and benefits besides just income. Let’s get into some of the types of annuities.
Types of Annuities: Single Premium Immediate Annuity (Your Grandfather’s Annuity)
Single premium immediate annuities are what most people think about when they think of annuities. These are basically a pension plan through an insurance company. You give an insurance company a lump sum of money, and they promise to pay back a set amount of income for a set period of time, usually 5-20 years and/or the owner’s life.
These annuities are becoming increasingly less popular because of the lack of liquidity and the low payouts due to low interest rates and increased life expectancy.
SPIA’s typically have no fees.
Types of Annuities: Multi-Year Guaranteed Annuity (CD Alternative)
A Multi-Year Guaranteed Annuity (aka MYGA) works very similar to a bank CD. When the account is purchased, there is a declared interest rate for a set amount of years. These are typically between 3-10 years. Like CD’s, most MYGA’s don’t have fees.
So let’s look at the pros / cons of using a MYGA over a bank CD:
- Usually much higher interest rates than bank CD’s. As of January 2017, there are 5 year MYGA’s paying over 3% interest, while the average 5-year CD is under 1% interest.
- MYGA’s are tax deferred until you take a distribution. CD’s interest are taxed annually. MYGA’s can also be 1035-exchanged at the end of their term which transfers the tax liability on the growth to a new contract.
- Free-out distributions. Most MYGA’s allow you to take out a certain amount of money and keep all of your interest. These distributions are usually between the amount of interest earned and 10% per year.
- Bank CD’s have government FDIC insurance while MYGA’s are backed by the claims paying ability of the insurance company.
- If most CD’s are broken (taken out early) you usually just give back the interest. Most MYGA’s have surrender charges between 5%-10% if you go over the free amount available.
Types of Annuities: Fixed Indexed Annuities (FIA)
Fixed indexed annuity’s interest rates are based on a market index with a guaranteed minimum interest rate typically between 0% and 1% per year. These investments have quickly become one of the most popular choices for retirees because of their high level of stability, potential for growth, and low to no fees. FIA’s are one of the only ways that give you the chance to exceed 4% or 5% without risking your principal.
FIA’s are usually long term investments between 5-12 years, and some are as long as 20 year investments. During the surrender period, you will typically have free-outs ranging from 5%-10% per year.
There are hundreds of FIA crediting methods, so make sure that you understand exactly the way your interest will be calculated. I will be getting into some of these crediting methods in a later post, but for the time being make sure that you have an in-depth conversation with your financial professional, because some FIA’s have caps (the most you can make) under 2% per year. Which makes no sense considering that you can get a MYGA for over 3% per year.
Types of Annuities: Variable Annuities (VA’s)
When someone is talking about annuities having high fees, they’re usually referring to Variable Annuities. That’s because some variable annuities have over 4% in total fees, but there are also plenty of variable annuities that have no fees.
Many of the employer plans in the state of Florida are Variable Annuities, but they almost all have fixed investments inside of them that have no fees and no risk. Some of these interest rates are 2%-4.5%.
There are also variable annuities that have no fees, but instead just have a surrender period.
Even the 4%+ variable annuities have their place. The reason you’re paying those high fees is because there are a lot of guarantees tied to high risk investments. Usually you’ll have an income rider and death benefit rider, and the opportunity to participate directly in the market without a cap.
The point of me writing this article is not to encourage you to buy an annuity. For many people, annuities are not an appropriate investment, but there are many people that should be using them and are not because they heard someone overgeneralize them on TV or their friend said that they’re bad investments or they don’t want to annuitize their money.
Please seek out advice that is tailored to your individual needs, and stop listening to people who are giving blanket advice to everyone.
Also – I know a 1,000-word article explaining annuities isn’t the easiest thing to read, so in later articles I will separate the types of annuities and talk about them specifically to make it easier to digest.