Embarking on the journey of retirement requires a thoughtful approach, and understanding the role of annuities in retirement is paramount. As the financial landscape evolves, so do the complexities surrounding income choices.
The blog delves into the nuanced world of annuities for retirement, exploring their types, mechanics, and potential pitfalls. Continue reading to gain the expert knowledge needed to make informed decisions for a secure financial future.
Key Takeaways
- Annuities have a dazzling array of options and combinations of start dates, earnings rates, and payment options. These complexities present challenges and risks that retirees must manage.
- Retirees must understand that although annuities have some unique benefits, they come with hidden costs and risks. Investors must understand the tradeoffs and make the right decision given their circumstances and goals.
- Unfortunately, most annuities tend to underperform compared to equivalent investment accounts. This issue becomes more acute for individuals aged 50 and above, who have less time to recover from such financial setbacks. Seniors are often the preferred demographic for annuity salespeople, leading to a prevalence of sales abuses and false promises within the insurance industry.
Types Of Annuities For Retirement
An annuity is essentially an insurance contract. The insurance company collects premium payments for a certain period of time, invests the money at a certain earnings rate, and then, at some point, makes monthly payments to you for a certain period of time. The primary difference between an annuity and a life insurance policy is that annuity benefits are paid to you during your lifetime rather than to your beneficiary after you’ve passed away.
There are different types of annuities for retirement. The differences revolve around when benefits start and whether the earnings rate is fixed or variable. Essentially, this allows you to choose from four different combinations.
Immediate Annuities
Your benefit payments begin almost immediately. Typically, you would make a large one-time contribution or premium payment, and then, within a year, the insurance company would start paying you benefits.
Deferred Annuities
Your benefit payments don’t begin for a while. Typically, you make monthly, quarterly, or annual premium payments over several years.
In both immediate and deferred annuities, the insurance company deducts certain costs and expenses from the money you contribute and then invests the remaining amount with the goal of growing it to a level that sustains the benefits you want.
Fixed Annuities
The earnings rate on the contributions you make is set by the insurance company; it’s “fixed” and can only change on a specified anniversary date. The insurance company makes this decision and annually informs the annuity owner of the fixed earnings rate for that year.
Variable Annuities
The earnings rate on the contributions you make is determined by how you decide to invest the money. In a variable annuity, the insurance company would provide you with several investment fund choices. They usually include several stock funds, several bond funds, and a guaranteed fund, which acts much like a low-interest-rate savings account. How you mix those funds together and how that combination performs each year will determine your earnings rate.
The investment funds – like mutual funds – are managed by a money manager who decides which stocks and bonds to buy, hold, or sell over time. Sometimes, the investment choices will include an index. An index fund is a specific investment fund that provides an earnings rate determined by a stock market index. For example, if the index was the S&P 500, your earnings rate would be set at some percentage of the S&P 500. They might credit you 85% of what the S&P 500 earns, or they might credit you 95%; this crediting percentage is specified in the annuity contract.
Variable annuities expose you to market risk, which is the possibility that the funds you pick will lose value rather than gain value. Insurance companies sometimes provide a floor to help reduce this market risk.
There are four types of annuities based on the possible combinations of the features above:
- Immediate fixed annuity
- Deferred fixed annuity
- Immediate variable annuity
- Deferred variable annuity
These names describe the various combinations of when benefits start (immediate vs later) and how earnings are determined (fixed or variable).
The annuity contract specifically describes what combination you pick. When the benefit payment term begins, the contract also specifies how much your annuity payments (the income payments you receive) will be and how long they will last. Here again, there is a confusing array of options.
How Long Do Annuity Payments Last?
Most annuity contracts give you the following options for receiving annuity income:
- Single Life – payments will continue as long as you live.
- Joint Life – payments will continue as long as either you or someone else you select (usually a spouse) lives.
- Term Certain – payments will continue for a specified period of time (eg. 10 years, 15, 20, etc.) regardless of how long anyone lives.
- Life And Term – payments will continue for the longer of someone's life or the term picked. For example, if you select a "joint with 10 years certain" payment option, your annuity payments will last until you and your spouse have passed away, as long as one of you lives longer than 10 years. If you both passed away in less than 10 years, the insurance company would continue to make annuity payments to your beneficiaries to the end of that 10-year period.
You would think that all this flexibility is an unqualified benefit. However, the dazzling array of options and combinations of start dates, earnings rates, and payment options presents challenges and risks that must be managed. Before getting into those, let’s spend a little time understanding how annuity income is taxed. These income tax consequences can be very confusing.
How Are Annuity Payments Taxed?
Annuity benefits are taxed based on how your original contributions were taxed and/or how much of the annuity value was generated from earnings. If you purchase an annuity through a qualified retirement plan (such as a 401K, 403B, IRA, etc.), then your contributions were made with pre-tax money. You received an income tax deduction when you made your contribution(s). Therefore, when you receive annuity payments, 100% of the annuity payment will be taxable income in the year you receive it.
If you purchase an annuity outside of a qualified retirement plan, your contributions come from money that was already taxed. This is called “after-tax” money. Therefore, when you receive annuity payments, some portion of the payment will be considered a return of your principal, and some portion will be considered earnings.
Remember, the earnings inside an annuity were not taxed. Each year’s annuity earnings were tax deferred. You did not have to pay any income taxes on that growth. When you start getting annuity payments, those earnings will be taxed on those years.
When you start taking withdrawals and receive annuity income, a formula is used to determine how much is non-taxable return of principal and how much is considered taxable earnings.
How Do Annuities Work In Retirement?
In retirement, annuities can provide vital cash flow to supplement social security and pensions. Most insurance companies advertise this as “guaranteed income,” and many refer to their annuity products as “income annuities” to drive home this point. For many, the consistency of a regular monthly annuity payment is a comfort. During retirement, they don’t want to worry about income or running out of money. They like that the insurance company guarantees some minimum level of payments no matter what happens in the economy or the stock market.
While these are all benefits of annuities, they do come with hidden costs and risks. Remember that Milton Friedman taught us there is no such thing as a free lunch; there is always a tradeoff. Typically, to get something, you have to give up something else. That’s not necessarily bad news. Many of those tradeoffs are good. You just have to understand the tradeoffs and make sure you make the right decision for your circumstances and goals.
Working with an objective, fiduciary financial advisor can really help in assessing whether an annuity will help or hurt you in pursuing your retirement dreams. Objectivity is the key here. Too many “financial advisors” are actually annuity sales reps using “advice” as the cover for a sales pitch. Ensure you get solid, experienced advice from someone who doesn’t receive commissions from annuity sales.
The Dangers Of Annuities In Retirement
Insurance companies have a long history of developing exceptional advertisements, brochures, and sales pitches to trumpet the benefits of annuities. They rarely point out the risks of annuities, and as we mentioned above, all the choices and possible combinations in an annuity mask real dangers all annuities pose.
Deteriorating Lifestyle
The primary danger posed by annuities is people’s tendency to over-rely on them to meet their retirement needs. Your retirement cash flow needs to meet your living expenses, which will increase with inflation for as long as you live. Your retirement cash flow must also grow with inflation, or your retirement lifestyle will deteriorate; if you don’t keep up with inflation, you will be able to buy less and less each year as inflation inexorably increases the prices for everyday items.
Your retirement nest egg also needs to keep up with inflation, or you may outlive your money and not be able to leave a legacy for your loved ones. Both your retirement income and your retirement assets need to grow during retirement.
Annuities cannot provide those benefits. As attractive as a “guaranteed” lifetime income seems or as good as a “crash-proof” retirement sounds, annuity payments struggle to keep up with inflation and certainly don’t protect the real value of your retirement assets for your heirs.
You may indeed receive a consistent annuity check every month for as long as you live, but what is the value of that annuity check over time? If the average American retires at 65 and lives to 87, that means the average American spends 22 years in retirement. If your annuity payment was set at $2,000/mo, then by the time you turn 87, it would only buy $1,000 worth of everyday items. That math is based on a low 3% inflation rate. That represents a full 50% decrease in purchasing power; that’s 50% less food, 50% less gas, 50% clothing, etc.
Poor Performance
The benefits offered by annuities depend on the annuity performing as promised. The money you contribute to an annuity through premium payments needs to grow. More importantly, it needs to grow by the rate of return that meets your retirement goals. You are different from every other person, and your retirement goals will reflect that. You need to assess and then meet your retirement goals.
Fixed annuities (where the insurance companies fix the earnings rate) don’t offer you that option. In fact, the fixed rates on these insurance products are usually so low that there is little chance they will keep up with inflation, let alone grow by enough to seriously help your retirement. In our opinion, this lack of flexibility is enough to rule out fixed annuities for most retirees or pre-retirees.
Unfortunately, variable annuities (annuities in which you can influence the earnings rate by combining investment funds) don’t help as much as they might seem to. While the flexibility to combine different investment funds to boost returns is good, this benefit is significantly decreased by hidden, embedded costs, participation rates, and caps.
We’ve written an entire annuity guide that provides a deep dive into these hidden items, so we’ll only provide a quick summary here. As you’ll see, each of these diminishes the return you can earn on your money and hinders your efforts to retire successfully.
In a variable annuity, you can choose a selection of stock funds that, over time, should generate strong earnings and propel your retirement portfolio toward its goals. But you can do this outside an annuity as well. In fact, you could take the money you are considering investing in a variable annuity and invest it in a brokerage account. You can make the same investment allocation (the portion devoted to stocks and the portion devoted to bonds) inside and outside an annuity. So what’s the difference?
Inside the variable annuity, the insurance company will charge some hefty fees to cover their costs and marketing expenses, such as the commission they pay to the agent who sells you the annuity. These internal fees can easily range from a low of 2% to 4.75% per year.
Let’s use a low 3% for an example. Dollar for dollar, if you invested your money outside an annuity with the same allocation as you could inside the annuity, you will earn 3% less per year on your money inside the annuity. That 3% annual difference will cut your potential portfolio value in half over 20 years. If your portfolio outside the annuity could grow $100,000 in 20 years, then that same portfolio inside the annuity would only grow by $50,000.
Those overt hidden costs are only part of the hurdles you face. These variable annuities often have participation rates that restrict how much of the market return you can earn. An 85% participation rate means you’ll only earn 85% of what your investment funds earn. So you start with a 15% haircut and fall further behind by the 3% difference in our example above.
“But wait… there’s more!” as the TV ads say. Some variable annuities also have caps. Even if the market goes up by 30% (not an unreasonable occurrence in the broad US stock market), and your participation rate suggests you’d get to keep roughly 25% (that’s 85% of the 30%), your cap rate might restrict you to 15% per year.
Now, 15% is a good return, but if you restrict your upside, you inevitably restrict your long-term average return. If you’re going to invest in a stock fund, you should enjoy all the benefits and earnings. This is exactly what happens outside an annuity when you invest through a regular brokerage account. But inside the annuity, the hidden fees, participation rates, and caps restrict your success.
The bottom line is that most annuities will perform worse than a correspondingly equivalent investment account. These two major problems with annuities – deteriorating lifestyle and poor performance – are exacerbated at ages 50 and above because you have less time to recover from the mistakes. Sadly, seniors are a favored target market for annuity salespeople. The sales abuses and false promises have been so bad in the insurance industry that many states have taken steps to provide specific warnings for seniors.
We offer one such reference for your consideration, but you might check with your state’s Attorney General’s office or Office of Consumer Affairs. Beyond getting educated about annuities before you consider buying one, we recommend that you engage the services of an experienced financial advisor. These are complex enough financial products that even with all the information you need, it will be helpful to have an experienced, objective voice to help you decide what is best for you.
Why do Financial Advisors Push Annuities?
So with all the dangers and risks of annuities, why do some financial advisors do everything to sell them?
The reason is that many of these “advisors” are more focused on product sales than on providing truly unbiased advice. They often recommend annuities because the annuity company will pay the advisor a substantial commission to sell the product. Annuities are essentially insurance contracts, and the upfront commissions are among the highest paid in the insurance industry. They also pay ongoing annual commissions, which ultimately come from the client’s account balances. This financial incentive to promote annuities creates a huge conflict of interest.
Making Informed Decisions
The key to successfully navigating the decision of whether or not to buy an annuity is to make an informed decision. That may seem obvious, and it is. That may also seem simple, but it’s not. There are many factors that get in the way of making informed decisions. One is “self-serving bias, ” which is “the tendency to interpret information in a way that confirms our existing beliefs and serves our own self-interest. In situations that lack clarity, we often make assumptions that bolster our egos and self-esteem. We selectively interpret information to support our position and overlook or dismiss information contradicting our views.”
As we’ve written in other blog posts and articles, retirement planning is complicated and needs to be done correctly. As retirement draws near, the risks of making critical mistakes grow because there is less time to recover. Too many people are tempted to do their planning on the back of a napkin.
That won’t work. It takes serious analysis to identify your key assets, sources of income, expenses, and risks. You need to thoroughly understand your living expenses and what they will be in retirement with inflation. Annuities offer some powerful benefits for some people in some situations. But those are limited. You need to work with someone who can help you develop the right plan – the plan that is right for you – and objectively determine whether annuities fit your needs and goals. Don’t let your biases get in the way.
First Financial Consulting has 45+ years of experience helping clients prepare for retirement. In that process, we review all the available tools, techniques, and products that might help our clients accomplish their goals.
Our advice is always 100% objective, and we meet the highest fiduciary standard, always acting in our client’s best interest. Without additional information, we can’t tell you whether annuities are good, bad, or neutral for your situation. But we have absolute confidence we can provide that insight and advice if we have the time to get to know you and develop your unique retirement plan. If you’d like to begin that conversation, please use the button below to schedule a complimentary introductory appointment.
Greg Welborn is a Principal at First Financial Consulting. He has more than 35 years’ experience in providing 100% objective advice, always focusing on the client’s best interests.
Greg Welborn is a Principal at First Financial Consulting. He has more than 35 years’ experience in providing 100% objective advice, always focusing on the client’s best interests.
