Why the controversy?
An annuity in its most basic form is a guaranteed income stream from the insurance company. Did you know that the social security check that we all hope is around by the time we retire is an annuity? Remember the glory days of when everyone retired with a secure pension? Those are annuities too.
Then why do advisors and investors have such a serious love or hate relationship with annuities? The reason is a lot of these products have been misrepresented by commission hungry investment reps. The agent sells the "guarantee" without explaining how those guarantees have a tradeoff. Most annuity products often carry consequences like loss of liquidity, higher fees, and penalties. However, when used properly annuities can be a useful income solution to take pressure off of withdrawing a higher percentage of money from growth-oriented assets that often carry higher volatility and drawdown risks. TV personality and self-proclaimed industry guru, Ken Fisher, is flat out wrong when he says annuities are bad for everyone. Keep in mind, Mr. Fisher wants your money just like every other advisor eager to grow their business. He's a great marketer and is selling to a specific niche -- people who distrust annuities or people who distrust the agent who sold them their annuity.
Actually, annuity products were created to help investors who want to take a more conservative approach and value certainty in their lives. In other words, annuities offer peace of mind and protections not offered with most other investment strategies found in the securities markets. However, before making a long-term commitment to an annuity, it is highly advisable to do your proper due diligence. Annuities are bad when a broker pushes an annuity that the client never asked for. Unfortunately, many clients will often find out their annuity was a bad fit after it is too late.
How to Shop an Annuity
If you are not sure where to start with your due diligence, an independent fee-only financial planner is usually a good place to begin. On the other hand, if you prefer to do it yourself, the following tips about the various types of annuities should help you determine how and when an annuity might suit your needs. Also as a general rule, most investors shopping for an annuity should consider doing so once they are in their late 40s at the earliest. The sweet spot age for annuities applies when an investor is at or nearing retirement (ages 50 - 70). Keep in mind, there are always exceptions to the rule. The ages given are meant merely as basic guidelines.
At a high level, there are 5 common types of annuities available to investors. However, many of these can have other bells and whistles (i.e. riders) that affect how the income or deferral strategy will benefit you, the investor. To help you understand which one might be right for you, the following is is a summary of the features and benefits associated with the 5 most common types of annuities.
1) Single Premium Immediate Annuity (SPIA)
Lump sum payment goes towards providing the annuitant (person benefiting from income) an immediate guarantee of income specified over a set time period or for that person's lifespan (or joint lives). The income stream is based on the age of the annuitant(s), dollar amount invested, the time period being guaranteed, and current interest rate. The advantage is that an annuitant can create an income stream that will last their entire life. The primary disadvantage is you have very little to no liquidity. Meaning you lose access to the sum of money you just invested.
2) Single Premium Deferred Annuity (SPDA)
Similar features to the SPIA, but the main difference is that the income distributions begin at a later date. The date at which income is to begin is typically specified at the time of purchase. Make sure to read your terms and conditions carefully before signing the dotted line. A commonly used strategy here is referred to as a QLAC (Qualified Longevity Annuity Contract), which allows the investor to exclude up to $125,000 in qualified IRA money from counting towards RMDs (Required Minimum Distributions).
3) Fixed Annuity (FA)
An effective tax-deferred strategy for more conservative investors. Similar to a CD in terms of overall protection features. The primary difference being that a fixed annuity is NOT backed by FDIC insurance. However, these annuities are backed by the full faith and credit of the insurance company, so make sure you pick a company with good ratings. Basically, a fixed annuity is a deferred annuity investment that pays a fixed interest rate for a specific number of years and protects the principal against loss. Typical contracts range from 5 to 10 years. Longer term contractual commitments usually mean a higher interest rate to the investor. Be aware that during the contract period when the interest rate is guaranteed is when penalties could be imposed (surrender charges) to access your money. Keep in mind, most insurance companies provide a 10% liquidity feature. So an investor with $100k in an annuity could pull $10k without incurring a penalty. The liquidity option can be a one-time deal, or on an annually renewable basis. Withdrawals that are the result of RMDs typically avoid being penalized as well. Note, the deferred sum of money can be annuitized into a guaranteed income and converted to SPIA. Lastly, some insurance companies force annuitization once the annuitant reaches age 95.
4) Fixed Indexed Annuity (FIA)
A hybrid between a fixed and a variable annuity. Also, offers tax-deferral for after-tax dollars invested or transferred cash value from life insurance. Provides the principal protection desired by the fixed annuity investor, but offers the upside potential of a variable annuity, up to capped level. So there are limits placed on the growth of the account because of the downside protection feature. In other words, the investor is giving up the unlimited upside available in the stock market. It's common to have the index linked method like the S&P 500 be used to generate the upside performance. For example, say a fixed indexed annuity has a point-to-point participation cap rate of 6% that is tied to the S&P 500. In scenario A the market goes up 10% -- here the investor is credited 6%. In scenario B the market goes up 3% -- this time the investor gets 3%. In scenario C the market is down 20% -- thankfully the investor doesn't lose any money and sees a flat account value year over year. More recently, a lot of new fixed indexed annuities offer other customized features that you can add to the contract called riders. For instance, a Fixed Indexed Annuity with a guaranteed income rider is a way to provide the investor a better liquidity alternative than the SPIA or SPDA, while still offering the contract owner income certainty. The disadvantage is that the guaranteed income stream will be less than what is provided with a SPIA or SPDA.
5) Variable Annuity (VA)
VAs originally came about as a way to provide tax-deferred growth for extra savings lying around. The sub-accounts available through these types of annuities are essentially the insurance companies version of a mutual fund. High-net-worth investors and investors who have maxed out all other retirement vehicles (IRAs & 401ks) stand to benefit the most from the tax-deferral feature. Also, an income rider can be used (like the FIA) for guaranteeing an income stream while offering the contract owner partial liquidity. Other riders you might see are a death benefit guarantee, "10-year put" that protects the principal from any losses in 10-years, or guaranteed return of principal in the form of lifetime income distributions. These products more than the others get a bad rap because of all the confusing options that the investor has to select from. Actually, sometimes the advisor doesn't understand what they are recommending. Whoa! However, that is where a good financial advisor that holds themselves out as a fiduciary can help bring some clarity. The biggest challenge for a lot VAs is that they can be very expensive. On the low-end, a VA with no riders might cost the client 1.25% per year, whereas a VA with every bell and whistle can cost the client as much as 4% per year. Needless to say, 4% is a mega hurdle to overcome. At the same time, the guarantees offered by that VA contract just may be worth paying such a high price to some investors.
Choosing the right annuity ultimately boils down to what safety features an investor values or needs. A well thought out financial plan is the foundation for making such decisions come into focus.