Should I Buy An Annuity?

By: Brian Seay, CFA

In this article and podcast episode, we discuss Annuities. Are they useful financial tools or are they terrible products?

Annuities are like any other financial product, they are useful in some situations and useless in others. The real issue with annuities, like other kinds of insurance, is that they are often sold and promoted by salespeople masquerading as “financial advisors.” So here we are going to shine the light on annuities. Watch the podcast episode or read the article below!

Should I Buy An Annuity Video in Huntsville

Transcript:

Instead of taking their word for it, if you are considering your financial situation, you need to work with an advisor that is a fiduciary. A fee-only fiduciary can help you assess your situation and determine the right solutions to meet your needs. When you think about your retirement situation, you need to start with your income needs, assets and tolerance for risk. A real advisor can help you assess those dimensions and make a recommendation on whether an annuity, or some other solution, would be most beneficial for your situation. Perhaps you have heard that you must work with an insurance agent to buy an annuity or insurance product. There are now multiple insurance platforms that work with fee-only investment advisory firms to help clients acquire the insurance and annuity products they need…after the right planning analysis has been done upfront! In fact, most of those products are commission-free. So, before you even start thinking about whether an annuity makes sense, start by making sure you are getting your advice from a fiduciary and not an insurance salesman.

There are probably as many types of annuities as there are investment types. So we can’t cover every possible situation in this episode. Broadly, there are Variable Annuities, Fixed Income Annuities and Indexed or Fixed Index Annuities. When you think about an annuity, you probably think about a Fixed Annuity. In a fixed annuity, you pay the life insurance company an amount, say $500,000, and they provide monthly income for your lifetime. You know the rate and the term upfront. So, you have a very high degree of certainty that your initial contribution is going to produce a certain amount of income over the course of your life. Fixed Index Annuities work in a similar way, except that instead of a fixed payout, you receive returns based on an index like the S&P 500, but with limited upside and downside. Meaning if the index goes up say 15%, you only receive 10%. But if the index goes down 10%, you might not lose anything. Lastly, Variable annuities combine insurance with more traditional mutual fund investments. The owner receives returns from the investments and has some form of income guarantee as well.

The major drawback of annuities is the fee structure, which is usually much higher than earning returns and income through ETFs or index funds. Annuities layer in commission, administrative fees and underlying management fees for investment options. The benefit of those extra fees is generally a lifetime income guarantee, which doesn’t apply to traditional investments. So the trade-off is higher fees for more certainty.

So when might an annuity make sense? In my view, annuities are useful in two situations.

The first is for risk-averse individuals that are willing to pay the higher fee-structure to secure an income guarantee. The second is for very high-income individuals or individuals looking to avoid estate taxes.

The first group is a use case we see more often so let’s start there. If your risk tolerance is very low, an annuity might help you be a better investor and achieve higher risk adjusted returns. One key for this to work is that you need to be able to buy an annuity and still have remaining assets left to invest. The income certainty you gain from an annuity contract might allow you to invest the remainder of your assets in stocks or other growth-oriented investments that have volatility. There are three other items to keep in mind for this strategy to work. First, make sure you aren’t over annuitized. If you have social security plus another pension or other income source, its worth considering whether you really need more guaranteed income. Second, interest rates need to be high enough to generate income. If rates are lower, stocks and other assets like real estate will likely provide better return profiles. Third, you should have outside assets. Annuity rates are fixed and not adjusted for inflation long-term. That means you monthly payout will decline over time on an inflation adjusted basis, as prices go up, that fixed payout will buy less and less stuff. So you need other investments that will hedge against rising inflation and protect your real income level over time.

A good test on your risk tolerance level is your prior history. Have you been a long-term investor in the stock market? Have you sold out during prior market declines? If you haven’t been a long-term stock investor or if you have tended to panic during declines, you might be a good candidate to replace some of your portfolio with an annuity. Remember, even a low cost, commission free annuity will likely be more expensive than more traditional investment options, you are trading higher costs for more certainty from an insurance company. So, if you are very concerned about generating retirement income, and your asset mix and the rate environment are conducive, then a fixed annuity may be an option for you.

The second scenario where an annuity may make sense is as a tax planning tool. Much like whole-life insurance, here we are really talking about individuals with very high incomes or asset levels. Annuities are often sold as a “great way to build tax-deferred asset growth.” That’s a myth for most people. If you have a high income, you can contribute north of $60,000 to retirement accounts. So if you aren’t contributing more than $60,000 each year to a combination of 401ks, IRAs and ROTH accounts, then you don’t need an additional income deferral source. If you are contributing more than $60,000 to retirement accounts, then you need to do an analysis to determine whether you really want to defer taxes into the future. Sometimes, it makes sense to save via traditional taxable investment accounts and pay lower capital gains tax rates on future gains. Deferring all your taxes to a later date can result in a really high effective tax rate down the road. So if you have a really high income and are thinking about annuities as a potential way to defer income taxes, talk with your investment and tax advisors about whether they make sense for your situation. A good indicator is that your CPA, Financial Planning and a potential Annuity agent are all aligned on the strategy. If they are not, think twice.

I haven’t covered Fixed Index Annuities or Variable Annuities. That’s intentional. I see very few situations where these are the “best” option for investors. Variable annuities combine mutual fund investments with some form of insurance or return guarantee. Total fees tend to be high because the annuity fees are layered on top of mutual funds with high fees. If your goal is growth, you can likely achieve that in a more cost-effective way by investing in equity markets through low-cost index funds and ETFs. Fixed Index annuities are a hybrid of sorts. As I mentioned earlier, they offer limited upside and downside. This is essentially a portfolio insurance or option strategy. The insurance company is buying the reference index and then using derivatives to manage risk. Investors can do the exact same thing. Investors can buy index funds and then use options or other derivatives to limit losses on the open market. My view is that the annuity wrapper is unnecessary here unless there is a specific tax reason.

In conclusion, I don’t view annuities as good tools for generating long-term growth. The research shows that annuities are potentially a good tool for generating income for risk averse investors when combined with other types of assets. And back to where we started, a good advisor that is a fiduciary will have multiple tools to help you find the ideal solution for building a retirement portfolio. That includes traditional investments, insurance and annuity options. If they only do one thing, that’s a good sign that they may not be evaluating the options and recommending the one that is in your best interest. So work with a fiduciary and they can help you sort out the complexities of the annuity market and whether they make sense for your unique situation.

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