I’ve been in the financial industry for a long time. It seems like the majority of the time I have been talking finances with someone and the word “annuity” is mentioned, the other person immediately says something like, “Oh I’ve heard bad things about those” or “My uncle bought one of those and got ripped off.” I’ve always wondered why there is such negative publicity about annuities. My theory is that there is really only one type of annuity that gets bad publicity, and the other 2 types get lumped in with it. What you end up with is 3 types of annuities all getting a bad rap because 1 of them has the potential to go south. It’s kind of like getting a bowl of mixed fruit at lunch and, because you don’t like melons, the whole thing gets thrown out even though there are delicious grapes and strawberries in there too.
My goal here is to clear up the differences between the 3 types of annuities and further explain why 1 of them has a bad reputation and why you shouldn’t immediately discard it if you know someone who got “ripped off.”
Annuities are insurance products. They are not bank products like a checking accounts. Insurance companies sell these products. I wanted to start there because many people don’t realize this point. It’s especially confusing when a bank representative tries to tell you to buy an annuity. What’s really happening is the bank employee is selling another company’s product and acting as the agent or broker. If you were to buy the annuity, it likely wouldn’t have the bank’s name printed anywhere on it. Another reason I make this point is because your total FDIC coverage limit is separate from anything you put into an annuity. If you put $250,000 into an annuity, it has zero impact on the deposits you keep at the bank(as far as FDIC limits go).
What are the different types of annuities?
1. Income Annuity
How it works: You take a lump sum of money and purchase an income annuity. You receive an income stream for a set period of time(usually the rest of your life, but that can be adjusted). The payments can be set to monthly, quarterly, semi-annually, or annually. How long you set the payment stream affects how much you receive per year.
For example: If you set your payment term to be for the rest of your life, then you may get $1000/mo until you die. When you die, payments cease, even if you die within a year. You can also set the payment term to be “Life with 15 year certain” which means the payments occur for the rest of your life or 15 years, whichever is longer. If you died a year after beginning the contract, the payments would continue to a beneficiary for the remainder of the 15 year period. If you opted for this payout, you might receive $750/mo instead of the $1000/mo earlier. Don’t take these payment numbers to the bank—I’m only illustrating a point and not using an actual payout formula. If you look into this type of annuity, you will see a plethora of payment options to choose from with the actual numbers in front of you.
You can have the following types of riders(add-ons) to the income annuity contract: annual inflation adjustment, beneficiaries, guaranteed payment periods, long-term care benefit, some type of death benefit, and maybe a few others depending on the company.
There are some other variations to income annuities. They can be:
Immediate: the payments start within a month of your deposit
Deferred: payments start at some future date
Lump sum: a single, large deposit is used to start the annuity with no future deposits
Periodic: payments into the annuity are periodic and made over time instead of one lump sum payment
If this sounds like a strange idea, consider this: this is exactly what Social Security is. You make periodic payments over time through payroll taxes, you defer the receipt of payments until a later date, and the payments last the rest of your life. That is no different from a Periodic Deferred Income Annuity.
Insiders sometimes refer to these as “Playchecks for life” or “Creating your own pension plan.” It’s the same idea.
Why would somebody purchase an income annuity?
The main reason people purchase these is to guarantee a paycheck for life. Think about it: If you are sitting on $500,000 in a 401k account and you’re afraid you’ll outlive the money, then an income annuity makes a lot of sense. It removes the question of, “What if I outlive this money?” Considering that people are living longer now than we ever have, there is a lot of appeal to these products.
These are also commonly used for special situations like disbursing lottery winnings or setting up a special income trust for someone.
Bottom line
While there are numerous variations to the particulars, the main idea is this: you trade your money for the insurance company’s money to be received as a payment plan for life.
2. Fixed Deferred Annuity
How it works: You take a lump sum of money and purchase a fixed deferred annuity. The account is given a contractual guarantee on how much of a return you receive and for how long. The guaranteed rate is typically just above what your CD rates are. The contract length is typically between 3-7 years. The interest earned is tax-deferred, so you won’t pay taxes on the growth each year. The money you use to purchase these can be from a retirement account(which hasn’t been taxed yet) or from a non-retirement account(which has already been taxed). Much like a Traditional IRA, you are only taxed on the growth once you pull the money out. If you keep the funds inside the annuity, or roll it into another annuity, you won’t get a tax bill.
Some standard contract details to know
While there are some variations depending on the company, most annuities of this type have the following options:
1) Surrender schedule and 10% annual free-withdrawals: this means that you are penalized for withdrawing funds prior to the end of the contract, much like a CD. However, most of the ones I’ve seen will allow you to withdraw 10% of the contract value each year without a penalty. If you go over the 10%, then the overage is hit with an extra fee, called a Surrender Fee. The fee starts at a high % in year 1 and trickles down to 0% as the contract gets older.
2) Penalty waiver benefits: There are usually some circumstances that allow the owner to withdraw more than the free 10% without a penalty. Common examples include: Long-Term Care benefit, death, financial hardship waiver, or some other type of life-changing event.
3) Guaranteed rates vs. contract rates: The rate you receive will be a contractual guarantee on the front end. So, if you purchase a 5 year annuity, you will know up front what rate you’ll receive each year for those 5 years. However, once the contract matures, the rate normally drops to a guaranteed rate. That rate normally isn’t very attractive to an annuity holder. What you can do at that point is roll the annuity balance into a new annuity contract, without penalty, and get a new contract rate just like before.
4) Since the growth is tax-deferred, the IRS withdrawal age rules apply: The withdrawal rules are the same as a Traditional IRA. As of this article, that age is 59 ½.
Bottom line
If you like guaranteed growth with extremely low risk, these are for you. These are very popular for people older than 65 who don’t want the risk of losing their money in investments. The biggest hangup I’ve seen on these is the fact that they aren’t backed by the FDIC; they are backed by the insurance company that issues it. I’ll add two final thoughts if this is you. 1) Insurance companies with high ratings are extremely strong and are obligated, by law, to match your annuity deposit dollar-for-dollar in a general fund. That means that there is a lot of cash accessible to disburse when funds are needed. 2) What do you think the “I” in FDIC stands for? It’s still insurance either way you go.
3. Variable Annuity
How it works: The setup is just like the Fixed Deferred Annuity. The major difference is the return isn’t guaranteed. Instead of a guaranteed rate stated up front, the funds are invested in various types of investments. This means that the account could either go way up or way down, depending on performance.
Some things you need to know
1. The investment options can vary greatly. You can likely invest in anything from a general money market fund all the way to highly speculative stocks and everywhere in between. You can choose how risky or conservative you want to be.
2. These are the annuities I mentioned earlier that carry a bad reputation. The reason for this is because of the numerous fees and high risk associated with them. These annuities carry what’s called an “M&E Charge” on top of whatever the investment charges. For example, if you choose to invest in a mutual fund that carries an annual expense of .5%, then the annuity is going to add something like 1.5% on top of that. So, right off the bat, you’re down 2% for the year. You have to earn greater than 2% to offset the loss(I’m using rough numbers to illustrate the point). Over the course of many years, that 2% per year adds up to a lot of lost growth. If you had purchased the same mutual fund outside of the annuity, your annual charge would’ve only been .5%. Also, many people who buy these are ignorant of how to invest, so they pick a fund that is more aggressive than they realize and lose a lot of money in a down year. Now, the fund could do really well in a good year too. But if someone has 5 good years and 2 bad years—they’ll focus on the bad years and what could’ve been. You could also have some additional riders on the policy that charge annual fees on top of what I’ve already discussed. So, it’s not out of the question to be down 4-5% for the year right off the bat. Granted, these extra riders are optional, so your cost is less if you don’t take them. I’ll discuss the positive sides of this in a moment.
3. These usually carry a death benefit rider. The big appeal with this is the death benefit tends to be greater than the account value(you’ll need to clarify this with your agent on any potential purchase). The way this usually works is that the annuity will look at the account value at year-end and “lock in” the number. Let’s assume that number is $115,000. If the stock market tanks throughout the year and your value goes to $80,000 and you die later that same year, how much do you think your beneficiary receives? The $80,000 or the $115,000? The answer is usually $115,000. The specifics vary from policy to policy on the death benefit, but most of them carry some version of this.
4. Some of them have unique riders that you won’t find on any other product. Two examples that come to mind are what I’ll simply refer to as the “Up Front Boost” and the “Lock It In” riders. The “Up Front Boost” means you’ll receive an immediate credit for a certain amount as soon as you buy one. You could purchase a $100,000 annuity and this rider kicks in and your immediate account value would be something like $110,000. This boosts the value and the death benefit right off the bat. It costs an annual fee to do it, but it’s there. The other example, the “Lock It In” rider, allows you to lock in the account value every year against a future loss. Let’s say your value is $115,000 at year-end and you lock it in. One year later, your value is $100,000. You can activate this rider and the account gets boosted right back to the $115,000 instead of the $100,000. Again, there’s an annual cost, but it’s an option. There could be other unique riders out there, but you would need to ask on a case-by-case basis.
5. They typically carry the same “penalty waiver benefits” and “10% free withdrawals” that I listed on #2 under the Fixed Deferred Annuity section.
If they are so unpopular, why would anyone buy one?
Going back to #2 in this section, I mentioned a lot of fees that tend to turn people off or give people a bad taste in their mouths if they’ve been negatively impacted by one. I’ll play devil’s advocate for a second and ask the question, “Why do you think those options exist?” For everyone who bought a bunch of riders that cost an annual fee total of 4% and they got zero benefit from it, do you think there is someone out there who benefitted greatly from it? Is there a chance someone died after the account value tanked, but the death benefit provided a tax-free boost of tens of thousands of dollars to the beneficiary? Are there people out there who bought the “Lock It In” rider and had their entire retirement saved during 2008 because of it? Absolutely! Just like anything else, there are horror stories and there are feel-good stories resulting from the same product. It’s no different here. The truth is that more horror stories have gotten out there than the feel-good stories. The result is that these tend to have a bad reputation. However, that shouldn’t scare EVERYBODY from looking at one. They make sense in plenty of circumstances. These are case-by-case and your agent can help you decide what’s right for you. Hopefully you have an honest agent. An honest agent is an extremely valuable person to have in your life. An agent who is only out for commission can usually be sniffed out, in my opinion. Variable Annuities tend to pay a good commission rate to agents, so you need to do your due diligence before you buy one to make sure it’s actually a good purchase for you. When I was an agent, I lived through this temptation first-hand and know what it’s like to do the ethical thing and make a $10 commission vs. talking someone into a variable annuity that pays $4000 for the same deposit. Agents I trained would get angry with me when they received their commission checks and I would always say the same thing: “Did you do right by the customer? Can you put your head on your pillow at night knowing you did the right thing?” The agents who aren’t commission-driven are the types of people you want in your life.
Bottom line
Variable Annuities do have a bad reputation. However, they make a lot of sense for the right person. Don’t automatically blow them off because your friend’s brother’s nephew’s cousin’s grandmother had a bad experience. Look into it yourself.
