By Kristi De Rycke, Registered Assistant
This article has a very loooooooooong history behind it. When I started at Johnson Insurance in 2015, I hated annuities. I mean really despised them. I had a long-held belief that every annuity had high fees and was not a worthy investment option. Greg, Jo, and I have had countless discussions on annuities. They had several stories of when an annuity was the most comfortable option for clients. Greg would often ask me outright why I did not like annuities. I said the high fees. When he said you realize there are annuities called indexed annuities that do not have fees, right? Well, “No”. Then he asked me to give him a second reason why annuities are bad. I could not give him one. Well, I am not sure how many of you know Greg well, but he doesn’t do anything halfway. Since I did not seem to have all of the information, he was going to give it to me. I could hear the echo as the thick, dry books hit my desk with a thud. Then I heard him say something about a great audiobook set on annuities that I could borrow (a 20 hour one). Let me tell you what a fun ride that has been learning about a topic I really did not like. That was not the end to our arguments on annuities. When I started at Johnson Insurance, I had to fill out a long personality profile. The results used much more flowery language but came down to one word, stubborn. I can guarantee that my husband did not need a 30-page assessment to figure this out. Nicely put, I have a hard time changing my mind once I decide on something. I did read all of the information but stayed strong in my views. I just had more fire power in the heated discussions. Over time, I started to pair the information I learned with client’s stories of what they wanted or needed. I have listened to family and friends about their fears of losing what they had worked so hard to save. I have heard the relief when they found out they could have a pension like option in a world where pensions are declining. I have read other materials in a more open-minded way. The purpose of this article is to try to bring the confusing world of annuity options into a type of Cliff Note version to help you see any options that may be helpful to you.
What is an annuity? It is a contract between you and an insurance company. During the accumulation phase, you pay either a lump sum or periodic payments. During the distribution or income phase, the insurance company agrees to either start paying at an agreed upon time in the future (deferred annuity) or pay immediately (immediate annuity). The deferred annuity is a vehicle to save for the future. The immediate annuity provides as income as stated immediately in exchange for your lump sum similar to a pension plan. However, you need to be 59 ½ or pay a penalty for early withdrawal. There are 3 main types: Fixed annuity, variable and an indexed annuity. Let’s tackle the fixed first.
A fixed annuity is when the insurance company agrees to pay a set rate of interest on your money. During the accumulation phase, the company will add this set percentage for whatever time is laid out in the contract. For example, if you have a 5-year fixed annuity at 3%, you will receive 3% every year for 5 straight years. During the income or distribution phase, the company will provide you a set amount of income as laid out in the contract. These income or distribution payments can be set on a specific period like 25 years. It can also have an unspecified time frame. For example, it could be your lifetime or through the surviving spouse’s lifetime. People looking for a guaranteed income stream to supplement their retirement income may look to this option. They are not affected by market fluctuations on a day-to-day basis. The risks with the fixed annuities include that the guarantee is only as strong as the insurance company that is signing the contract with you. They are not guaranteed by FDIC, SIPC, or another federal agency. Payments do not have a cost-of-living adjustment so the inflation-adjusted value would be lower if inflation outpaces the fixed return of the annuity. You can purchase inflation protection, but it is at an additional cost. The confusing part is that the word “fixed” makes us think the rate will always be the same. This may not be true. The contract will lay out when and how often the rate can change.
Variable annuities (VAs) are a little more complicated. They are tied to the rate of return on stocks, bonds or money market funds that are defined in the investment options. Since they are tied to the market, there is a risk that you could lose money like a mutual fund. These are unlike fixed annuities that would have a guaranteed minimum that you would receive. VAs are likely to have higher fees than a mutual fund. During the accumulation phase the premiums you pay are then allocated to various investments and your account grows based on how the underlying investments perform. During the accumulation phase many contracts allow you the option to withdraw up to 10% of the value penalty free every year. There are “surrender charges” to taking additional money above the 10% out early. You also may have tax consequences if taken out too early. VAs are tax deferred but you will pay tax on the growth when you take distributions. You can choose to have a lump sum payment or payments over time during this distribution phase. Like all 3 annuity options, be sure to understand the contract. Ask a lot of questions to your agent including some of the following. How long will my money be tied up? How much could the value go up or down? What if I want to take it out early? How can it affect my taxes? Can I cancel it if I change my mind? The last question is very important for variable annuities: What are the total fees? VAs are known for higher fees and expenses. Read the contract to see mortality and expense risk fees, administrative fees, fund expenses for the subaccounts and any expenses for add-ons like guaranteed minimum income benefits and principal protection. You may not want to rule out these add-ons without looking into them first as they may be worth the added expense to you to know that you have at least a guaranteed minimum but weigh the pros and cons. Unlike fixed annuities, VAs are regulated by the Securities Exchange Commission (SEC) and FINRA.
Indexed annuities can also be called equity-indexed annuities or fixed-indexed annuities. They are sort of a blend between fixed and variable annuities. They offer a minimum guaranteed interest rate plus an interest rate linked to a specific market index. This option gives you more risk than a fixed annuity but less than the variable annuity. It also can potentially give you higher rate of return than a fixed annuity and lower than a variable annuity depending on market conditions that year. You may receive a guaranteed minimum return of your principal but if the index that your contract is linked to declines, you could lose money on the investment. FINRA warns that this option can be complicated. Just because there may be a guaranteed minimum return does not mean that you cannot lose money. The guaranteed rate is typically at least 87.5% of the premium paid at 1 to 3 percent per FINRA.com. However, if you take this contract out earlier than the surrender period, you could have to pay a surrender charge and a 10 percent penalty. Be certain to ask a lot of questions and fully understand the contract before committing. The way they calculate the gain in the index can vary so one indexed annuity can perform much different than the next including participation rates, spread or margins or interest rate caps. Participation rates mean that if the market goes up you would be credited a certain percent of it. If the market goes up 10% and your credit is at 80% of the market, your account will go up 8%. A spread or margin means that a certain percentage will be subtracted from the market gain. If the same market index went up 10% and you had fee of 4% then you would only make 60% of the market gain or a return of 6%. Interest rate caps are a max that you can gain no matter how high the market may go. If you have a cap of 8% and the market goes up the said 10% you still only get the 8% gain. Make certain to ask if your company can change the participation rates, spread/margins, or interest rate caps at any time. Many can change annually or at set intervals. Indexed annuities are regulated by each state.
Here are some additional things to think about with annuities. You cannot just cancel your contract at any time. There is a surrender period. During this time, you will have to pay charges. These typically start higher and decrease over typically 6 to 8 years but sometimes higher. For example, your surrender charge may start at 7% and then decrease by a percent every year until year 8. There are certain annuities that you are actually trading your lump sum for payouts over time or for your lifetime. This means you are giving over that money to pay for the service. Many contracts will allow you to take out up to 10% of your account value every year without paying the surrender charge. Depending on the contract, there may not be a surrender charge if the owner becomes terminally ill or is in a long-term care facility. Since the annuity is a retirement savings vehicle and the government lets it grow tax deferred, you have to wait until 59 ½ before taking it out or you will have a 10% early penalty. If the annuity is held in a pre-tax account like a traditional IRA or 401k, you will be required to take out required minimum distributions when you reach the age of 72 (This is a change since the passing of the SECURE act up from 70 ½). While growth in the annuity is tax deferred, withdrawals are taxed as ordinary income. This is similar to other retirement vehicles. Please be sure to look at the fees to determine if it is the right choice for you.
In a nutshell, you do have to be careful and watch details in every contract for an annuity, but annuities can be a great option for some people that may prefer a potentially lower return that if they were to invest directly into stocks or bonds in exchange for the guarantee of preserving their principle. Are they right for everyone? No, nothing is right for everyone. Was I wrong that annuities are a bad investment? Yes, I absolutely was…. but please don’t tell Greg. I hate admitting when I am wrong!
*www.finra.org/investors has all of the above information and anything else you could want on annuities.
By Greg Johnson
Annuities like many investments are not the easiest to understand but working with a qualified financial advisor can help you determine if they are suitable. Some come with fees and some do not. Some provide income guarantees and some do not. Some provide conservative growth options, and some do not. At the end of the day annuity contracts can really be useful in a financial plan, but only if they are good fit for the client’s needs and objectives. Make sure you do your homework before purchasing one and if you need help reach out to our team as we have looked at many different contracts over the years.
Material presented and hypothetical scenarios are meant for general illustration and/or informational purposes only and do not represent actual or future performance of any specific product or investment strategy. Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk, including the possibility of loss of principal. Annuities generally contain fees and charges which include, but are not limited to, mortality and expense risk charges, sales and surrender charges, administrative fees, charges for optional benefits and riders, and annual contract fees. Annuity guarantees, including guarantees associated with benefit riders are subject to the claims-paying ability of the insurance company. Surrender charges may apply if money is withdrawn before the end of the contract. All withdrawals of tax-deferred earnings are subject to current income tax, and, if made prior to age 59 ½, may also be subject to a 10% federal income tax penalty. Additionally, if purchased within a qualified plan, an annuity will provide no further tax deferral features. The contract, when redeemed, may be worth more or less than the total amount invested. All other benefits are available for an additional cost. It is important to weigh the costs against the benefits when adding such options to an annuity contract.
Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk, including the possibility of loss of principal. Annuities generally contain fees and charges which include, but are not limited to, mortality and expense risk charges, sales and surrender charges, administrative fees, charges for optional benefits and riders, and annual contract fees. Annuity guarantees, including guarantees associated with benefit riders are subject to the claims-paying ability of the insurance company. Surrender charges may apply if money is withdrawn before the end of the contract. All withdrawals of tax-deferred earnings are subject to current income tax, and, if made prior to age 59 ½, may also be subject to a 10% federal income tax penalty. Additionally, if purchased within a qualified plan, an annuity will provide no further tax deferral features. The contract, when redeemed, may be worth more or less than the total amount invested. All other benefits are available for an additional cost. It is important to weigh the costs against the benefits when adding such options to an annuity contract.
Fixed index annuities are long term retirement savings programs. Investors should understand that these products have the potential to offer returns that may be greater than that of fixed annuity products, however, they are not direct investments in the stock market and will not produce returns consistent with the underlying index that they are based upon. Fixed index annuities typically subject an investor to surrender charge periods that last several years and withdrawals made prior to age 59 ½ may be subject to a 10% federal tax penalty. Additionally, if purchased within a qualified plan, an annuity will provide no further tax deferral features. All guarantees of an Fixed index annuity are subject to the claims paying ability of the issuing insurance company. The contract, when redeemed, may be worth more or less than the principal amount invested. Fixed index annuities vary greatly and investors should seek the assistance of a financial professional to determine if an Fixed index annuity is suitable for their personal situation.