Brad Tinnon

Brad Tinnon

Are Fixed Annuities A Good Idea?

Shortly after I wrote a recent blog post titled Why I Hate Annuities, a reader of our blog said the following: “I have determined after several years of evaluation that you will never be my financial advisor because of your one-sided view of annuities.” The reader went on to say that “immediate fixed annuities should be a part of every retiree’s income stream”. So, in today’s blog post I will answer the question of “Are Fixed Annuities A Good Idea?” and provide you with some of their pros and cons. 

WHAT IS A FIXED ANNUITY?

A fixed annuity is an investment product, sold by an insurance company. It is very similar to a CD that you get from a bank. Both the annuity and the CD guarantee that you will never lose your principal and they both guarantee a specific interest rate for a certain period of time.

DEFERRED VS IMMEDIATE ANNUITIES

There are essentially two types of fixed annuities – deferred and immediate. A deferred fixed annuity is where you defer receiving income until a later date and an immediate annuity is where you begin receiving income immediately.

GUARANTEED INCOME PAYMENTS

One of the features of a fixed annuity is that you can convert it to a guaranteed stream of income. While this sounds great on the surface it comes with two very big caveats.

First, you have to give your entire principal to the insurance company; it’s gone forever. So if you ever need more than the guaranteed income the insurance company is giving to you, then too bad; you’re out of luck.

Second, once you begin receiving your guaranteed income it will never grow with cost of living (note, there are some annuities that offer a cost of living rider, but it comes at a cost). And as you likely know, if you’re receiving the same amount of income in 20 years as you are receiving today, it will not go as far due to rising prices. 

3 DANGERS OF FIXED ANNUITIES

Lack of Liquidity

When you purchase an annuity, it usually comes with a major restriction – you can’t move it or liquidate it for quite some time (called the surrender period; see below). Additionally, whenever you invest into an annuity you are immediately locked into it until at least age 59 1/2 because it’s considered a tax-qualified investment vehicle by the IRS. What this means is that if you tap into the money before that age, then you will likely be penalized 10% plus owe ordinary income tax. You wouldn’t of had this problem if you invested in a non-annuity taxable account.

Surrender Periods and Penalties

One of my biggest beefs with annuities in general is that they often times carry huge penalties if you decide to get out of them before a pre-determined amount of time has passed. This goes back to the liquidity concern mentioned above. If you need to cash out of your annuity for whatever reason at all (i.e. unplanned house expenditure, new car, emergency, etc.) you could be penalized thousands of dollars. As mentioned in the Why I Hate Annuities blog post I discussed a client who has an annuity with a never-ending surrender period and a $55,000 penalty. That’s a tough pill for the client to swallow!

This brings up an interesting question – Have you ever wondering why annuities have such large surrender periods and penalties? One of the primary reasons is because salespeople get paid a very hefty commission when the annuity is sold and if you get out of the annuity early without paying a surrender penalty, the insurance company would lose money.

Insurance Company Risk

Whereas a CD is protected by FDIC should the bank fail and a brokerage / investment account is protected by SIPC should the investment firm fail, annuities do not have such protection. Instead your investment is only as safe as the insurance company. In other words, if the insurance company fails, then so could your investment. This is a tremendous risk (possibly even more risky than directly investing into the stock and bond market) because you are literally invested in one company – the insurance company. It’s for this reason that if you decide an annuity is right for you, then you should spread your investment over multiple insurance companies – preferably highly rated ones!

One other point to make is that most states guaranty some level of protection should the insurance company fail. However, there could be a lengthy period of time where you won’t have access to your own funds and you may not even receive the full amount. This is yet another reason why you would want to spread out your investment dollars among several insurance companies.

TAX TREATMENT OF FIXED ANNUITIES

One of the so-called attractive features of an annuity is that your non-IRA money will grow tax deferred. If you were to instead invest that money in a portfolio of bonds (skipping the annuity altogether), then you would have to pay tax every year along the way at ordinary income tax rates which ultimately reduces your yearly return. But if you invest into a fixed annuity, this tax is deferred until you begin withdrawing money. This tax deferral can be a powerful benefit, but with fixed annuities, it is somewhat of a mirage. 

You are essentially purchasing a bond when you buy a fixed annuity. And bonds will likely pay you a higher rate of return than the fixed annuity (see How The Insurance Company Makes Money Off Of You below) which would likely make up for not getting the tax deferral in the first place. 

Additionally, there are other ways to defer taxes on your bond portfolio without purchasing an annuity. For example, most people have IRA or 401k accounts, so you could easily invest your bonds into these accounts and achieve the same level of tax deferral as the annuity. I discussed this concept in an Asset Location article I wrote for ThinkAdvisor.com.  

HOW THE INSURANCE COMPANY MAKES MONEY OFF OF YOU?

Insurance companies, as mentioned above, guarantee your principal and interest. This is very appealing, but how is it that the insurance company can afford to do this?

It’s not that they are charging you a fee, but instead an opportunity cost. The insurance companies ultimately end up investing in corporate and government bonds with your money. These bonds then provide the insurance company with a certain interest rate, out of which they pay you a smaller “guaranteed” rate.

The difference between the actual interest rate the insurance company receives and the guaranteed rate you receive is the insurance company’s profit. But ultimately it is an opportunity cost that you pay as you could have simply avoided the insurance company altogether and instead invested in bonds just like they did and earned a higher rate of return.

Another way of saying all of this is that you loaned your money to the insurance company so that they could invest it and earn a higher rate of return than they paid out to you. Again this is no different than a bank CD. You deposit your money into a CD at the bank. The bank then takes your money and invests it, earning a much higher return than you receive on your CD.

At the end of the day, insurance companies and banks sell you on the idea of safety and guarantees, but ultimately they are the ones who are profiting!!

WHAT OTHER INTERESTING THINGS DID THIS READER SAY?

I thought it would be interesting to share several other quotes from the reader and address each one individually.

“We have much more income from those annuities than we would have had if we had just taken 4% of that retirement amount as income.” Just so you know, the standard rule of thumb in our industry is that you should not withdraw more than 4% of your portfolio annually so that you don’t increase your chance of running out of money. While it may be true that she is currently receiving more income from the annuity than if she withdrew 4% from her portfolio, the 4% number is just a rule of thumb. Depending on the circumstances it may very well have been acceptable to withdraw more than 4%, which may be necessary to cover rising expenses. Additionally, it is possible that she would have been far better off income-wise with a strategy not locked into an annuity. We have seen too many situations where a person would have ended up with much more money had they not been in an annuity. And possibly taking 4% of a larger portfolio would have resulted in more income that she is receiving now. It’s one thing to say the guarantee of the annuity provides a significant amount of comfort, but a completely different thing when you say “we have much more income than we would have had otherwise”. Often times, people don’t know what they missed out on. 

“There is no buyer’s remorse when you start receiving income the first month.” The reader is referring to the fact that she gave up control of her annuity in exchange for a “guaranteed” income. I’m glad the reader has a comfort level in her annuity and overall strategy. That is certainly very important. But ultimately, she could have also created her own income stream from her portfolio without buying an annuity. We have many clients who do this; also without remorse. Plus, these non-annuity clients have an opportunity for their portfolio to grow even though they are taking withdrawals. If they are able to earn a higher percentage than they are taking out, then this would occur. Even if the client earned the same amount they were taking out at least they would have their principal intact which could eventually be passed on to heirs. An annuity owner would not have these luxuries as they have to give up complete control of principal in order to receive the guaranteed income. 

And the tax benefits are great too!” As mentioned above, the tax benefits on fixed annuities are somewhat of a mirage.

“You can probably take me off your email list now.” Sorry it didn’t work out.” Well, I guess that kind of sums it all up. 

CONCLUSION

So, while the reader of our blog was angry at my comments regarding annuities, you can see that annuities aren’t always a benefit to the investor. Additionally, it is readily apparent that the reader “doesn’t know what she doesn’t know.”

At the end of the day, fixed annuities can be an ideal solution if you are looking for safety, guarantees, and tax deferral. However, due to their complexity, lack of liquidity, surrender penalties, insurance company risk, lack of cost of living adjustments, and possible reduced returns, I believe that there are generally more beneficial ways to invest your money.

I hope that you have found this week’s blog post informative and helpful. Please feel free to share any comments, questions, or experiences you have below. 

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Brad E.S. Tinnon
CERTIFIED FINANCIAL PLANNER™
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