Guide to Annuities Part 1
What is an Annuity?
Annuities can be very confusing; as confusing as the waterfall in the photograph. Insurance agents often sell them to people making all kinds of promises: “Save on taxes”, “Make money in the market without downside risk”, and “Create a guaranteed income stream for retirement”. There have been bad practices by insurance sales people and many clients have been sold annuities for the wrong reasons. In this two-part guide to annuities I will explain the basics, what they can do for you and what they are unlikely to do for you. I will also explain the different types of annuities and some of their features, pros, and cons. Part 2 of this guide to annuities will go over the more complex annuities in greater depth including the most intricate feature: the income rider. Annuities can be powerful tools to accomplish certain goals, but they can also be expensive boondoggles when bought for the wrong reasons.
Basic Features of Annuities
In its most basic form, the idea of an annuity is that you give an insurance company money. It invests the money. It promises to pay you money later which (hopefully) will be greater than the amount you initially gave them. The insurance company makes certain promises about when and how much they might pay you. In some cases, they can make the promise to pay you for the rest of your (and/or your spouse’s) life.
An annuity is an insurance product. That fact is very important because it implies a few things: Annuities are products which are sold by salespeople; annuities guarantees are only as good as the insurance company; insurance companies like to make profits; and the salespeople who sell annuities are paid and make money selling them.
Annuity Example: Single Premium Immediate Annuity
The Single Premium Immediate Annuity (SPIA) is one of the most basic and simple forms of annuity. Once you understand this form of annuity, it become much easier to understand other variations.
Let’s start with the premium. “Premium” is the insurance term for the money you give them to buy a product. In this case “Single Premium” implies that you will give an insurance company a lump sum. As an example, you could buy a SPIA for $100,000. Annuities are all about income and when you “annuitize” an annuity it means the insurance company starts paying you a flat monthly income stream. SPIAs are so simple because they immediately annuitize. You give them $100,000 and the insurance company starts paying you an income stream right away.
How much income will you get from a SPIA if you pay a premium of $100,000? It will depend on how long the insurance company pays you. You can select a number of payout options with a SPIA:
- Lifetime income over your life – Insurance company guarantees to pay you a monthly income over your life. The amount they pay depends on your gender and how old you are when you buy the annuity. There is no health underwriting. A recent (2/15/2018) quote shows that for a $100,000 annuity, a 65 year old NJ female could get $538 per month for life. A 70 year old female could get $608.
- Lifetime income over two lives – Income over yours and your spouse’s life. It could be someone other than your spouse. Joint income will almost always be lower than a single life and the amount is governed by the age of the partner with the longest life expectancy. For the same $100,000 premium, a 65 year old NJ female and 70 year old male would get $502 per life. This is lower than the single 65 year old female, but not by a lot.
- Period Certain – The annuity will pay an income stream for a specified period, for example 10 years. If you die before the period is complete, then the annuity will pay your named beneficiary for the rest of the period. That same $100,000 would pay $953 per month for 10 years period-certain.
You can combine some of these options, for instance lifetime with 10 years period-certain would guarantee to pay an income for the first 10 years and if the annuitant (the person whose life the annuity is based on) lives beyond 10 years, then for his/her lifetime.
Things to know about SPIAs
The most important thing to know is that once any annuity is annuitized, your lump-sum premium is gone. It’s replaced by the insurance company’s promise to pay you an income stream for whatever period you’ve selected. Even if you suddenly need whatever is left of the lump-sum premium, you simply can’t get it back. You can only get the income stream. There are a few exceptions to this, but you should think of it like you have an income stream such as a pension and no longer have that lump-sum.
SPIAs tend to pay a little more than what you can get in a bank. One of the reasons has to do with “mortality credits”. This sounds like a horrible thing, but what it means is that annuities pay people a little more because of the people who die before their life expectancy. There are always some people who buy an annuity and die right after their payments start. Because the insurance company gets to keep that premium without paying many of the payments, they can afford to pay everyone else a little more.
Remember that I said annuities are insurance products and when purchasing insurance, you are insuring against a risk. What is the risk that an annuity is insuring against? The answer is outliving your savings. When you buy an annuity with lifetime income, you’re insuring living so long that you outlive your money. That annuity is going to pay you until age 150 if modern health technology allows you to live that long. This makes annuities powerful insurance products.
Types of Annuities
I am going to explain the details of the more complex annuity types in part 2 of this blog post. But I will list the types and a short description here:
- Single Premium Immediate Annuity – Pay one premium and the insurance company pays a fixed income stream to you over a specified time period which could be lifetime. Income stream is guaranteed.
- Deferred Income Annuity – Pay one or multiple premiums. Funds will gain by a fixed interest rate (which could change). Once annuitized, payments will be over a specified time or lifetime. Income stream is guaranteed, although growth in value depends on length of time invested and interest rate.
- Variable Annuity – One or more premiums. Funds are directly invested in mutual funds approved by or provided by insurance company. Later, you may withdraw the account value or you can annuitize, creating an income stream. There are no guarantees unless a separate rider is bought.
- Fixed Indexed Annuity – One or more premiums. Gains are linked to, but funds not actually invested in securities markets. A typical FIA will link your gains to the S&P 500, but other indexes are used too. Later you can withdraw the funds (although often not the gains) or create an income stream. Usually sold with riders.
There are other types of annuities, but are less common.
Goals for Buying an Annuity
There’s a saying in the insurance world: Annuities are sold, not bought. What that means is that insurance sales agents sometimes aggressively peddle annuities and may sell them to clients for the wrong reasons. This is really unfortunate because clients are ill-served when they buy annuities they don’t need, but at the same time many clients can benefit greatly from the right annuities bought for the right reasons.
Best Annuity Goals
Goal 1: Longevity Insurance
The most powerful reason to buy an annuity is to ensure you don’t run out of money. If you annuitize an annuity (or use a rider) to provide lifetime income, you will never totally run out of money. An annuity can be used to pay assisted living or nursing home costs or fixed living costs. Note there is still the risk of inflation. Your expenses may rise, but your annuity payments are fixed. So an annuity is probably part of the strategy, but may not be the only strategy to make sure you don’t run out of money.
Goal 2: Guaranteed Income Stream (Pension)
An annuitized annuity creates a guaranteed income stream like a pension. Many workers no long get a pension from their employer. An annuity can create the equivalent, guaranteed by an insurance company instead of your employer.
Goal 3: Investing for the Risk Averse
If you are willing to take a little risk, its much cheaper to invest in the security markets directly in a diversified portfolio which matches your goals and risk tolerance. But if you are really risk averse, where the risk of your funds going down in value stops you from any investing, you can use an annuity to mitigate the risk. For a price, insurance companies are willing to invest your money while limiting your downside risk as well as your upside potential using variable annuities with riders or fixed indexed annuities. If you are petrified of losing money and thus not investing, you should definitely consider the right annuity.
Suspect Annuity Goals
Here are a number of goals that insurance sales agents use to push annuities which I don’t agree with.
Goal 4: Tax Free or Deferred Investing
When you buy an annuity with after-tax funds, any gains in the value of the annuity are not taxed until you withdraw the money or annuitize. Insurance agents like to tout this advantage of annuities, but when the money is withdrawn and the gains are taxed, they will be taxed as ordinary income. A properly tax-managed investment portfolio would provide mainly long-term capital gains which are taxed at a lower tax rate. So annuities trade a low tax rate for a deferred higher tax rate. This doesn’t sound like a great deal to me! There may be cases where the income deferral might be very helpful, but for most people this tax deferral is a dubious benefit.
Goal 5: You only get the Upside and Never the Downside of Investing
This is annuity sales at its worst. Many of the complex annuities where this promise is made, have features that actually cause the promise to be false. I will explain in part 2. Suffice it to say that whenever the insurance agent is promising no downside, at best the upside is limited considerably. At worst, they may be misleading you and it could be quite hard or impossible to get the promised results.
Preview of Part 2
In part 2 of this guide to annuities, I will explain the two phases of annuity life: Accumulation and Income. I will also explain in much more detail how variable and fixed indexed annuities work and how income riders work. You will learn what to look out for when you evaluate an annuity (it may not be what you think). You will also learn how you pay for annuities.
I am a Certified Financial Planner™ and investment adviser. I am also insurance licensed in several states. I don’t sell a lot of annuities, but occasionally I do work with my clients on existing or new annuities. If you are considering buying an annuity or wondering what to do with an annuity you already have, I may be able to help. Follow the link to find my contact information: Contact Cereus Financial Advisors