WOW, everyone. There's been so much to talk about in the financial world these past few weeks. CERTIFIED FINANCIAL PLANNERS™ and financial advisor representatives, like myself, have no shortage of content to talk about or explain to clients. You may remember, in my last blog, we spoke about bear versus bull markets, their differences, and similarities and did a bit of a deep dive into what they are. I can see now that the blog was incredibly timely, as it seems "preparing for the bear market" articles are almost all you see in the financial news. Well… that and the fact that the Fed has once again raised interest rates. But this time, by .75%, which hasn't been done since 1994 (that's a blog for the future, for sure).
When there's a bear market, you can almost be assured that advertisements for things called annuities start popping up all over the place. Part of this is that when the stock market becomes volatile, people look elsewhere for places to invest their money. While stock markets can be volatile during a bear market, annuities are relatively low risk. And when there's so much uncertainty, people love the comfort of being able to turn on their television and know that their money isn't in the red with the rest of the market (even though down markets don't last forever).
At first glance, this makes total sense, right? The market's down, and you don't want to keep losing money, so you put it into something less volatile. Unfortunately, however, it's never quite that simple. As we discuss this topic, you'll see that annuities can be incredibly complex products, and there's always a trade-off. In fact, I highly suggest/recommend/beg that you speak with a financial advisor or financial planner (so long as they aren't attached to an annuity in some way) and read the annuity's prospectus before buying into one.
What IS an Annuity?
Without getting too deep into the weeds, annuities are essentially contractual agreements between an annuitant (the person who receives the annuity) and a financial institution. The annuitant agrees to pay monthly to receive a future stream of regular payments. They're often seen as a low-risk way to assure one won't outlive their retirement. Often, companies that offer annuities are insurance companies, and their products are intended to be a long-haul way to save for retirement.
Why Are they popular?
So, if annuities are so complex, why are they popular? That's a great question, for a person who isn't me! There are several tangible and several perceived reasons why annuities are popular! However, I'd like to preface with some age-old advice from my mom, "If all your friends were jumping off of a cliff, would you do it too?" Okay, annuities aren't that serious, but it's an important point. If something is popular, you should still consult a financial planner or advisor about it. Don't believe me? Here are some financial examples that have been popular: NFTs, Multi-Level-Marketing, and Time-Share. I'm not saying that annuities are like those things, just that you should always do a deep-dive into something before investing.
Annuities are popular, especially when markets are in a slump because they come with GUARANTEES. Think about it – when the market's rapidly fluctuating and you see your money move up and down quickly (or even down over and over), you'd cherish a guarantee so that you know your money will be there when you wake up in the morning. Some common guarantees that are commonly coupled with annuities are guaranteed income and a guaranteed rate of return.
Guaranteed income annuities are designed to give you a guaranteed amount of fixed income during your retirement, thus the name. The guaranteed rate of return annuities promise huge rates of returns and are guaranteed. However, there's more to dissect than either of these guarantees state. Retiremitten states, "typically, there is a part of the annuity that is growing by 7 or 8%. However, it's not what you would expect, and you will never be able to withdraw this money all at once… The cash value is typically what is important to you; however, it is the income value that actually has a high rate of return. But, once you do the math, the rate of return is actually pretty ugly."
Outside of guarantees, annuities also offer things like downside protection, death benefit, and tax-deferred growth. In addition, they can offer long-term healthcare with riders, optional perks that may be opted into.
How are Annuities Guaranteed?
The word "guarantee" in the financial industry sends a rapid series of shudders through the body of every compliance officer, and for good reason! There are very few things in life that are guaranteed. Most of the time that's limited to death and taxes. There are even fewer things in the investment world that are truly guaranteed.
Annuities are sold on the premise that they are guaranteed, and to a certain extent they are. To be specific the accumulation value of your annuity is covered by the financial backing of the insurance company or carrier you are doing business with. To be clear the extra riders and income benefits that are often purchased to "enhance" your contract are not included in the guarantee. While annuity company insolvencies are not regular occurrences, they do happen. Carriers such as Bankers Life insurance Company, American Chambers Life Insurance Company, and Time insurance Company have all failed within the last 3-5 years. Perhaps you have never heard of companies like Bankers Life but you might know AIG, who is one of the larger carriers in North America. AIG was "bailed out" during the financial crisis by the government in order to stay solvent. If they had failed it could have potentially put all of their policy holders at risk.
If an insurance company becomes insolvent, the state would step in and take custody of the insurance company. Each state has a separate guarantee fund setup to potentially cover claims due to an insurance company's insolvency. The fund limits the amounts that may be reimbursed per policy, and still does not provide a guarantee that they themselves will be able to meet demands if multiple carriers fail simultaneously.
To summarize... Annuities are kinda-sorta guaranteed. Do your homework on the company and understand that you are still at risk of losing the entire amount.
Do you need one?
The first question on most people's minds when talking about annuities is, "Do I need one?". Well, the answer is, unfortunately, complicated. As I always say, there's no one-size-fits-all for financial planning – it's something that requires you to sit down with a planner, discuss your dreams, aspirations, income, and expenses and go from there. However, I'd say that the primary factor at play in the case of whether someone needs an annuity is their risk tolerance.
As we've discussed before, risk tolerance is the amount of risk someone is willing to take while investing. The more risk you're ready to accept, the higher potential growth your investment has and vice versa. When the math is all said and done, annuities aren't likely to make you rich. However, they may be for you if you're very averse to risk. Most of the time, you only need an annuity once you've exhausted and maxed out other tax-advantaged accounts, and that isn't most of us. To better understand if an annuity would be right for you, I'd highly recommend speaking to a financial planner or financial adviser.
How an Annuity Works
To understand something, you need to know how it works. Now there are tons of different types of annuities, and not all of them work the same way. However, most annuities – work in two phases or periods.
The first phase or period of an annuity is known as an accumulation phase. During the accumulation period or phase, the annuitant (the person who owns the annuity) makes regular contributions to their annuity. This happens over a long period while the annuitant is building up their savings for later in life.
The second phase of an annuity is the annuitization phase, also known as the payout phase. While the accumulation phase of an annuity is the annuitant putting into the annuity, the annuitization phase is when the annuitant receives payment from the annuity. How long this phase of the annuity lasts depends on how the annuity is set up and how the annuitant receives a payout. What you need to understand about the annuitization phase is that once you annuitize your money is no longer yours. You are locked into a stream of rigid payments at an interest rate set by the annuity company. There is no way out of annuitization once you are in!
The payout from an annuity in the annuitization phase can come in a few options; most can come in regular payouts, one lump sum, or periodic payments for life. Regular payouts can come for either a certain period (meaning you get regular payments for a specified number of years) or systematic withdrawal (meaning you withdraw specified amounts until the annuity is gone). With a lump sum, the annuity is paid out upon maturity of the annuity. Lastly, the life option allows monthly payments calculated based on the annuitant's life expectancy.
How an annuity is taxed depends on how it is set up. However, it can be said that most annuity growth is tax-deferred. Tax-deferred investing is a topic that I've covered in the past, and I recommend reading that article to really understand how taxes on annuities work. The short-and-sweet of the meaning of tax-deferred is that you don't immediately pay taxes on your contributions. Instead, you opt to pay taxes on the distributions of the investment (AKA, you pay when you withdraw from the annuity).
As far as annuities are concerned, being tax-deferred is a great selling point and is something that attracts a lot of people. This is because tax-deferred means that your money gets the maximum benefits of compounding interest. However, as with almost anything with annuities, the story doesn't entirely stop there.
There are two types of annuities, qualified annuities and non-qualified annuities. The difference between these two types of annuities is how they are taxed. When it comes to qualified annuities, the money you use to fund them isn't taxed until it is withdrawn from the account. Qualified annuities tend to be better as far as immediate tax relief and owing less on the front end. Non-qualified annuities are funded with post-tax money. This option means you'll likely pay less on taxes overall and less upon withdrawal, but it'll be more difficult month-to-month on the front end.
Types of Annuities
I know that all of this is likely beginning to get confusing. However, there's a bit more to learn. For example, annuities come in different types: immediate, deferred, fixed, equity-indexed, and variable. These have vastly different implications for you and your financial plan, retirement, taxes, and risk profile.
The first of these five types of annuities is the Immediate annuity. This type of annuity provides immediate lifetime payouts. Unfortunately, with this option – you won't have access to all your money if you need it because instead, you've opted to accept a specific amount of money each month for the rest of your life. However, with immediate annuities, you know exactly what you're getting for the rest of your life because any fees are included in the payout. Your spouse may also be included in immediate annuities and receive a specific amount of money for the rest of their post-retirement life.
Deferred annuities can be slightly confusing. With this form of an annuity, you agree to make a significant contribution to your annuity investment account, pay monthly, or both. Between that point in time and your retirement, your annuity account has time to grow and mature before you begin making regular withdrawals.
Fixed annuities are the least risky type of annuity but also offer the least amount of growth. You agree to a fixed interest rate from your annuity provider with fixed annuities. This interest rate is typically relatively low. However, on the flip side, it's unaffected by the market (that includes both bull and bear markets). So, while you'll be getting a relatively low return on investment, you know exactly what your return on investment will be.
- Equity Indexed
An equity-indexed annuity is a sub-type of a fixed annuity. Equity indexed annuities, commonly referred to as indexed annuities, are likely the most difficult to understand. This form of annuity is attractive to people because they have some potential to gain from upward swings in the market while having some protection against market downturns. Interest is semi-fixed and semi-reliant on an equity index. These annuities have high surrender charges, which are fees for canceling the annuity early. They also typically have high commission fees, which are fees paid to the annuity issuer.
Variable annuities are the riskiest form of annuities. With variable annuities, you invest into sub-accounts, which are investment accounts blanketed under the annuity. This allows them to grow tax-deferred. However, the growth of these sub-accounts depend on market growth, making them more risky.
Okay, we've finally made it to the end of the details about annuities! We just have one last thing to cover… FEES! Everyone's favorite subject other than taxes – oh wait, no… neither of those are anyone's favorite subjects. However, they're essential, especially regarding your decision-making. Fees charged by annuities can vary based on the carrier and any riders or underlying expenses. They reduce your overall returns, and can be quite expensive.
As an example if you purchase a variable annuity that guarantees you 5.5% income. The core contract chare is 1.3%, the underlying fund expense is 0.92%, and the Income Rider costs you 1.45%. You are now receiving an net return of 1.83% on your money.
- Surrender Charges
We've already touched on this. However, it's imperative concerning annuities. Surrender charges are something that annuity-offering institutions wish they could skip over when selling to you. Surrender charges are essentially fees for premature cancellation of your annuity. These surrender charges can be very high depending on the type of annuity you set up and how it's structured.
- Mortality and Expense Risk
Often institutions selling you your annuity will also charge you annually for a mortality and expense risk fee. This is a charge for the risk taken on by the institution for unplanned events that may occur while working with you. Of course, this covers the risk of your death. These fees average out around 1.25% per year, according to Investopedia.
- Administration Fees
Management and administration fees are also included in most annuities. These are the charge you pay to the administering institution for handling and managing your annuity. Generally, these can be expected to be about .3% of your account annually.
- Underlying Fund Expenses for Variable Contracts
Underlying fund expenses for variable contracts are indirect fees associated with your annuity. While these aren't charged by the institution issuing your annuity directly, they'll still be owed if you opt for a variable annuity.
Wrapping Up Annuities
As you can see, there's A LOT that goes into annuities. While they can often be sold as a low-risk and predictable return option and seem particularly attractive when we experience bull markets, tons of rules, regulations, and fees are associated with them, which can often be glossed over by a slick salesperson. So, of course, I recommend speaking with your financial planner or financial adviser when considering buying into an annuity to ensure it's your best option.
However, If you'd like to learn more about annuities and how they ACTUALLY work, be sure to check back next week for the second part/installment of this topic.
If you're interested in exploring options that will help you save and invest for retirement, please call or email to schedule an appointment with me. We can create a financial plan that can weather and thrive in any market.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.