Hello! I’m Sarah Swan, owner and Wealth Manager at Howe and Rusling. In today’s Street$marts we hope to give you a better understanding of annuities. Annuities are insurance products that are often sold to people as crucial tools for retirement planning, offering a reliable income stream in retirement in exchange for a lump sum or periodic payments. These can be bought with IRA money, to be considered “qualified,” or after-tax funds, “non-qualified,” and there is no limit to how much money you put into an annuity. I’m going to delve into how annuities work, revealing how they are different and pros and cons to consider before buying one. 

Firstly, an annuity is an insurance product that you must have a license to sell to a person. At Howe & Rusling, we do not sell annuities to our clients. If I did sell annuities to my clients, you could expect me to make as much as 6% or 8% or more in commission on each annuity sold. That is a pretty hefty incentive to try to corral people into annuities. Now that commission may not be felt directly by you, as it would be paid to me by the insurance company, but it’s important to consider what incentives I might have in selling you that annuity. However, other fees the annuitant does pay going forward, some of which they may not even realize they’re paying: 

Mortality and Expense (M&E) Fee: Covers insurance costs and administrative expenses. 

Investment Management and Administrative Fees: Charged for managing investments and administrative tasks. 

Rider Fees: Additional charges for optional features like “guaranteed minimum income.” 

Surrender Charges: There are typically sizable surrender charges imposed for the first 5-7 years to discourage early withdrawals or premature access to funds. Surrender charges normally decrease the closer you come to the end of this period. 

Suffice it to say, there are a lot of fees. And they can total anywhere from 3-5% or more annually, not including the surrender fee. Importantly, these various fees can erode returns, impacting the overall value of the annuity, unbeknownst to the annuitant. 

There are many different types of annuities, but the most common ones we see are fixed deferred annuities and variable deferred annuities. The deferred part simply means that they will pay income to you in the future, as opposed to making payments to you right away. But fixed versus variable is an important distinction. Fixed annuities offer a guaranteed interest rate for a specific period, providing predictable, steady income. Typically, a more attractive guaranteed rate of return might be offered for the first year or so, but then it’s reduced after that, sort of like a “teaser” rate. From that point on, you’d be stuck with the same lower return unless you surrendered the policy, and it’s usually a rate on-par or lower even than a rate you could achieve with a conservative bond portfolio. 

Variable deferred annuities are a different animal in that they offer the ability to grow from the fact they are exposed to stock market fluctuations, so they therefore offer a higher potential rate of return than fixed annuities. These products are appealing to people because they offer a combination of growth upside but also a guaranteed income stream. But oddly, we would say these are the annuity products we are typically most skeptical of. Let’s get into the pros and cons to consider for annuities, particularly variable annuities: 

Now if you were to read a list of pros, you might find a few, including maybe their tax-deferred nature or death benefits, but the most differentiating pro that is truly unique to annuities as opposed to a simple traditional IRA for instance, is the fact that they pay a guaranteed steady stream of income—the key word being guaranteed. Because annuities are insurance contracts, not really investment products, they can promise either a guaranteed stream of income or a minimum account value, whereas traditional investment portfolios cannot. Even though, historically speaking, over long periods, the stock market has been reliable in producing both growth and income as well, it’s never a guarantee in the sense that the stock market naturally fluctuates. The guaranteed part of annuities is a legitimate differentiator, especially if you are fairly certain you are going to run out of money in retirement. 

However, the guaranteed part of annuities is also what makes them expensive. Once again, annuities are insurance products, and insurance companies assume the risk of providing income payments to people for life. They have to protect themselves against the guarantees they make by charging enough in fees to make it worth their while to pay out “guaranteed income for life.” 

So, clearly that’s the first con I want to make known. These products are sneaky-expensive. As a general rule of thumb, the better the product sounds, or the more it offers and protects against, the more you will pay in fees, typically eroding your overall value over time. 

Now hopefully it’s also clear at this point that annuities are complex beasts. At Howe & Rusling we’re a bit skeptical of any investment or contract that would come with 60 pages of fine print—annuities fit this bill. They are confusing, and they are sold to people for a commission, which usually means much can be unclear or misleading for folks who are not experts in this stuff. 

Moving on, let’s consider their poor tax treatment in the annuitant’s lifetime and upon their death. Distributions from annuities are taxed as ordinary income whether in a qualified, or IRA annuity, or non-qualified, funded with after-tax dollars. This is different from an investment in stocks inside of an after-tax brokerage account in which long-term growth is taxed at capital gains rates, which are lower than ordinary income tax rates. Also, unlike with stocks in a brokerage account, the cost basis of variable annuities does not step up to the date of death when they are inherited. Beneficiaries will pay tax on the entire contract value that has grown from the date of the initial purchase. 

Next, let’s consider their lack of liquidity or flexibility. All annuities have an accumulation period and a withdrawal period. The accumulation period begins when you purchase the policy. Your account balance will grow at the either fixed or variable rate, and when you decide to take income from the policy, the accumulation period will end and the withdrawal period begins. During the accumulation period, you have some flexibility to get out of the policy, although you might pay a surrender charge or early withdrawal penalty for the first several years. Once you begin the withdrawal period, though, you typically don’t have the same flexibility to get out of the policy and get all your money back if you really needed it. 

As insurance products with riders, these things can come with various bells, whistles, rules, and plenty of fine print. If you are even remotely considering buying one of these products, or are curious about one you already own, I’d encourage you to bring the prospectus and an account statement to your advisor. I typically call the company with my client on the phone to ask lots of direct questions about the annuity to make sure we understand all of these factors before offering advice about it. Our clients frequently come to us with annuities they’ve been sold in the past, and I’d say the vast majority of time, we are enlightening the person about how that annuity actually works, how much they are giving away in costly fees each year, and how much better off they would have been simply investing their IRA or brokerage account in a balanced portfolio of stocks and bonds, with very good liquidity, lower fees, to participate in long-term market appreciation or growth that outpaces inflation. If our financial planning modeling revealed that you can most likely afford to withdraw 5% of your investment portfolio every year without running out of money and without paying 3-5% in annuity fees every year, is that “guaranteed” part of the annuity still as appealing? It’s a mindset shift for sure, but one we’d strongly urge you to consider before putting your money into an annuity. Every situation is different and unique, but most often when we run calculations for people on whether holding an annuity makes sense, we recommend simply investing in a balanced portfolio of stocks and bonds instead and letting the natural long-term growth of the market run its course. 

Thank you for watching today’s Street$marts! If you have any questions that weren’t covered today about annuities, please reach out to us! 

Disclosures This material is for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any securities or investment products. Past performance is not indicative of future results. Investing involves risks, including the possible loss of principal. Consult a qualified financial advisor to discuss your specific financial situation before making any investment decisions. While annuities offer certain benefits such as guaranteed income, they also come with significant costs and complexities. It is crucial to weigh these factors and seek professional advice to determine if an annuity is suitable for your retirement planning needs. This communication may include forward-looking statements.  All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”).  Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct.  Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.