Easy Money: Is an Annuity a Bad Investment?
Annuities have really become a hot topic nowadays and I almost feel like it’s because everybody else is bashing it and they want to get on that train of bashing annuities. And while annuities can be bad, they can also be very good and very valuable. So what I want to do today is explain what annuities are, make sure you understand it, and make sure you’re not just taking somebody else’s opinion on it. As a financial advisor, I meet with clients all the time and they’ll walk in and say, “Okay, I just don’t want an annuity.” And I ask, “Okay, fine. Why? Tell me why you don’t want an annuity so I make sure we get you into the right product or account or fund.” And oftentimes when I say, “Why?” they say, “Because annuities are bad.” That’s not an excuse. That’s not a reason why.
If you understand what annuities are and the pros and cons and then you still don’t like them, fine, that’s great. But you need to understand and be educated on what an annuity is whether you like them or not, and that’s what I intend to do here.
So what is “The A Word”, or annuities? An annuity is just a financial contract that you have with an insurance company, and that can be anything from a variable contract that’s market-based to something fixed, or income-based, growth-based, death benefit-based, etc. The specifics can vary, but what you need to start with is that it’s a financial contract with an insurance company. That’s your base on what an annuity is.
One of the biggest misconceptions about annuities is that they are all annuitized and a lot of times people think that annuitization is the same as an annuity. Annuitization is where you give a company or a pension fund or even a person your money, and they give you back a set amount of money for a set period of time. This is where most annuities got a bad rap, we like to call these your “grandfather’s annuity”. These annuities make you annuitize the contract, and when you do this, you lose control of the money. Now the insurance company has your money and they have control, and in some cases, they pay you out this money, an emergency happens or you pass away, and now there’s no more access to the money. The insurance company actually keeps everything and your beneficiaries wouldn’t inherit anything. The truth is that most annuities are not annuitized anymore. This is a fallacy that annuities have to be annuitized. Most annuities are just financial contracts that offer some type of security, whether it’s income, or death benefit, or security from the market. That’s how most annuities work nowadays, they don’t actually annuitize.
Let’s get into the four basic types of annuities. Now, there’s more than that. We’re going to get into the four most common types so you understand what types of annuities there are.
The first one is exactly what we talked about. It’s an immediate annuity, and this is an annuity that makes you annuitize, the aforementioned “grandfather’s annuity”. While my explanation sounded negative of these, there are certain instances where an immediate annuity does make sense. For instance, if you’re under the age of 59 1/2 and you want to take some qualified money and turn it into income without a tax penalty, you can actually use one of these and they won’t give you a tax penalty because you’ve annuitized. So there are strategies behind using these, but for most people, they are not a good fit.
The second type of annuity is a fixed annuity, and a fixed annuity works a lot like a CD where you give your money to an insurance company and they’ll give you a set interest rate for a certain period of time. For example, right now there are five-year fixed annuities paying over 4% and there aren’t really any five-year CDs paying that much. So if you’re just looking for a set guaranteed interest rate, this is probably the way you want to go if you’re thinking about an annuity. The nice thing about fixed annuities is there typically aren’t any fees. You just give your money to the company, they say, “For the next five years you’re going to get a certain amount of interest,” and then after those five years you can take your money and do whatever else you want with it. You can keep it there, you can roll it over to something else, you have the choice and it gives you a set interest rate.
The third type of common annuity is becoming very popular, that’s a fixed indexed annuity. A fixed indexed annuity is a combination of a fixed annuity and a variable annuity, which we’ll get into next. I like to call it a hybrid account. It’s fixed because it can’t really lose money. The only time they can lose money is if you added fees or riders on it, but a lot of these annuities will not have any fees unless you elect for a rider. So what they’ll do is they’ll base you on a market index and they’ll give you a floor and a cap. The floor, let’s call it 0% and let’s say there’s a cap of 5% and you’re based on the S&P 500. Well, if the S&P 500 does 10% you’re capped out at five. But if it does negative 10% you won’t lose any money. The big complaint about this is people will say, “Yeah, but if you just invest directly in the market, you’ll earn a lot more,” which is true. Historically, if you invest directly in the S&P 500 instead of a fixed indexed annuity, you’re going to earn a lot more. BUT you’re also taking a lot more risk. So this account is good for somebody who says, “I like the idea of some type of market participation, but I don’t want any risk to my principal.” A lot of times when people retire, they’ll come to me and they’ll say, “I have $200,000 in my retirement plan. I want to see it grow and I would prefer it to grow, but I don’t want to open up my statement and have to worry about it being less than $200,000.” This would be a pretty good option for somebody like that.
The last type of annuity that’s commonly used is a variable annuity. Now if you’ve ever heard of annuities having high fees, you’re probably hearing about variable annuities. A variable annuity lets you participate in the market(they call them subaccounts, but they’re pretty much mutual funds) and they let you get as aggressive as you want to get, but they will guarantee a part of the contract. So they’ll guarantee that no matter what the account does, you’ll have a guaranteed income or you have guaranteed death benefit or maybe after 10 years, you’ll at least be able to get your principal back if the market tanks. Now, for all these guarantees the trade-off is typically pretty high fees. You’ll see variable annuities anywhere from 2% all the way up to over 4% in fees to provide all these guarantees to you.
Some clients come in and they say, “You know what? I’m okay with 3% in fees because I want to be able to invest aggressively, but I want to make sure that no matter what happens, my income and my family is covered.” In that case, a variable annuity would be good for you, but you just have to realize how much you’re paying in fees. If you have $200,000 in your account and you’re paying 3% in fees, that’s $6,000 a year. That means over two decades you paid over $120,000 a year, and that’s assuming your account doesn’t grow. If it grows, you’re going to pay even more. So just make sure you’re okay with the fees if you want to go into one of those products.
So those are the four basic types of annuities. And one of the reasons that I recommend to be careful of anybody who says annuities are bad is because they’re all different. Let me give you an example: I had a gentleman who was about to retire come in, and he actually used to sell annuities back in the 1970s. I told him, “Some of these older annuities aren’t great. They might make you annuitize and they might not be the best option. Let me take a look and see what you have.” Well, this annuity that he had paid a guaranteed 4.5% interest, no matter what happened. He could add money, he could take it out. He never had to annuitize, and it was basically a liquid savings account that earned 4.5%. Now let me ask you, is that a bad investment? Of course not.
Whenever you hear somebody say annuities are bad, maybe they’re not giving you the full picture or maybe they don’t understand the full picture. It’s definitely a sensationalized take because nobody would say a 4.5% fixed interest rate is bad.
When you’re making your investment choices, make sure you’re not going by over-generalized statements like annuities are bad or mutual funds are bad. There are different options available that you can use to your advantage. And sometimes people will come in and they’ll say, “You know what, I don’t want an annuity,” but it actually ends up being that they need to get an annuity to accomplish their goals. So don’t go right out and get one, look into your options, and keep an open mind about it.
Securities and advisory services offered through Madison Avenue Securities, LLC, member FINRA SIPC, and a registered investment advisor. Madison Avenue Securities, and Don Anders are not affiliated companies.