Annuities are a popular yet controversial investment choice for anyone seeking income from their money. They are a contract between an annuity owner and an insurance company in which the owner pays a lump sum or a series of payments over time in exchange for guaranteed future income.
These payments can last for a set period (think of how they pay out Lottery winnings) or be paid for the rest of the annuitant’s life. For those who want income in retirement, an annuity is a tool that provides insurance against the risk of outliving one’s savings.
While the concept of a guaranteed income stream may be appealing, the opportunity cost of this security is a trade-off between the potential for maximum return and the security provided by the annuity. Investors who buy annuities often sacrifice the maximum return potential they could get from investing on their own (and retaining their own risk) in exchange for the security of guaranteed income.
The insurance company that issues the annuity assumes both the investment risk and the risk that the annuitant could outlive their money. This means that the insurance company assumes responsibility for investing annuity premiums and managing the risks associated with those investments, as well as the risk of longevity. While this can provide peace of mind to the annuitant, it comes at a cost.
In this article, we will explore the trade-off between security and return potential when choosing between buying an annuity and investing. We will examine the role of insurance companies in managing investment and longevity risks, as well as the costs associated with annuities. We will also discuss the role of annuities in retirement planning and provide examples of how to incorporate them into a retirement plan.
Ultimately, the decision to buy an annuity or invest in the market depends on the individual’s financial goals, risk tolerance, and retirement needs. By understanding the pros and cons of each option, investors can make an informed decision that aligns with their unique financial situation.
Types of Annuities
The term “annuity” lumps several types of insurance contracts under one umbrella. This generalization makes it difficult for people to understand what an annuity is and does. Each type of annuity contract has its own unique features. Some are best for income; some are best for accumulation. The four most common types of annuities include fixed annuities, variable annuities, indexed annuities, and immediate annuities.
The main feature of all annuity contracts is that they provide the possibility of income guaranteed by the underwriting insurance company for a contracted period of time.
Variable Annuities
I will start with variable annuities because these contracts place the investment risk on the contract owner, although the insurance company provides some guarantees if the contract owner experiences investment losses.
Variable annuities allow the investor to choose from a variety of investment options, such as stocks, bonds, and mutual funds. The money invested is held in a “separate account,” so it is not part of the insurance company’s assets. Therefore, if the insurance company were to have financial troubles, the annuity holder’s money would be protected.
Variable annuities are the main type of contract Fisher Investments is referring to when it says its founder states, “I hate annuities.” Personally, I think that is a reckless statement. Therefore, before you make a judgment as to whether you, too, “hate annuities”, I want you to know what they do that investments don’t.
Income guarantees of variable annuities
Variable annuities can offer a guaranteed income stream when an income rider is added to the contract. An income rider is an optional feature that can be added to a variable annuity for an additional fee. The income rider guarantees a minimum level of income, even if the value of the underlying investments in the annuity contract declines.
For example, imagine an investor puts $1,000,000 into a variable annuity contract with an income rider that guarantees a minimum annual income of 5%. If the value of the underlying investments in the contract declines to $0, the income rider guarantees that the investor will still receive $50,000 per year in income payments. This can provide peace of mind to investors concerned about market risks. However, it is important to note that income riders come with additional fees, and the guarantees depend on the financial strength of the underwriting insurance company.
Death benefit guarantees in variable annuities
A death benefit is a feature of variable annuity contracts that provides a guarantee to the investor’s beneficiaries upon the investor’s death. If the contract owner experiences an investment loss and passes away, the death benefit guarantees that the investor’s beneficiaries will receive the full value of the premium payments, regardless of the annuity contract’s actual value at the time of death.
For example, let’s assume an investor deposits $1,000,000 into a variable annuity contract and experiences a 50% loss on the investment. If the investor passes away, the contract’s death benefit feature ensures that the investor’s beneficiaries receive the full $1,000,000, even if the contract’s actual value is much lower than the original deposit.
In contrast, if the $1,000,000 had been invested in a traditional investment account and the investor experienced a 50% loss, the investor’s beneficiaries would only receive the remaining value of the investment account at the time of death, which would be significantly less than the original investment.
Overall, the death benefit feature of variable annuities can provide a valuable guarantee to investors and their beneficiaries, particularly in the event of a significant investment loss. However, it is important to note that variable annuities typically carry higher fees and expenses than traditional investment accounts, which can affect overall returns. Investors should carefully evaluate the costs and benefits of variable annuities before making a decision to invest.
Fixed Annuities
The remaining (3) annuities are all considered “fixed” because the underwriting insurance company invests the premiums in its own “general account,” where they are part of its assets. By placing the premiums in their general account, the insurance company retains the investment risk and can guarantee a minimum level of performance.
Fixed Deferred Annuities
Fixed deferred annuities provide a fixed rate of return for a specified period. The rate of return is typically higher than the interest rates offered by savings accounts or CDs, and the interest earned inside the contract is tax-deferred.
The fixed rate of return is determined by the insurance company. It is based on a variety of factors, including prevailing interest rates and the insurance company’s financial strength. In some cases, the rate of return may be adjusted based on changes in prevailing interest rates.
Fixed annuities are popular among investors seeking a guaranteed income stream and willing to accept a lower rate of return in exchange for the annuity’s security. They are also good tools to decrease one’s current taxable income, which can decrease taxes on other incomes, such as Social Security, and/or decrease insurance premiums for Medicare Part B or even ACA plans.
Single Premium Immediate Annuities
Another type of annuity is called a single premium immediate annuity, or SPIA. A SPIA is a type of annuity where the investor makes a single lump sum payment to the insurance company in exchange for a guaranteed income stream. This income stream can last for a specific period or for the rest of the annuitant’s life.
Think of SPIAs like you would an employer’s pension. They are a popular choice for individuals seeking a guaranteed income stream without the worry of running out.
The payout rates for “life only” SPIAs are typically higher than those of other annuity types because the insurance company is fully leveraging the mortality tables to provide the highest payout. There are other payout options, such as “joint survivorship” options, where the income stream will last for two people’s lives. This option provides a lower payout because, effectively, the money deducted is used to purchase a life insurance contract of sorts to guarantee income to the survivor.
Indexed Annuities
Indexed annuities are another type of “fixed annuity” where the insurance company bears the investment risk. The performance of indexed annuities is tied to a stock index, such as the S&P 500, but the money is not invested in the index. Instead, the insurance company uses the income generated from its general account to employ an option strategy to provide the return. By managing risk with options, the insurance company can provide a guaranteed minimum rate of return (often just 0%) and the potential for higher returns than those of fixed deferred annuities.
The Tradeoff: Security vs. Return Potential
Investors face a tradeoff between security and return potential when considering whether to buy an annuity or invest in the market. While annuities offer the benefit of a guaranteed income stream and protection against the risk of outliving one’s savings, they also come with limitations on return potential. On the other hand, investing in the market offers the potential for higher returns, but also comes with greater risk and uncertainty.
Explanation of the Tradeoff
The tradeoff between security and return potential is a fundamental concept in finance. In general, investments with higher potential returns also carry higher risk. This means that investors seeking a guaranteed income stream and protection against investment risk will often have to sacrifice some potential return.
Annuities are a prime example of this tradeoff. By purchasing an annuity, investors give up some potential for higher returns in exchange for the security of a guaranteed income stream. Annuities can be particularly appealing to investors who are risk-averse and prioritize protecting their retirement savings.
Pros and Cons of Buying an Annuity vs. Investing
When considering whether to buy an annuity or invest in the market, investors should weigh the pros and cons of each option. The following are some of the key advantages and disadvantages of each approach:
Annuities
Pros:
- Guaranteed income stream: Annuities provide a guaranteed income stream that can last for the investor’s lifetime, offering peace of mind and protection against outliving one’s savings.
- Investment risk protection: Annuities transfer investment risk to the insurance company.
- Tax-deferred growth: Annuities offer tax-deferred growth, meaning investors don’t pay taxes on earnings until they withdraw the money.
Cons:
- Limited return potential: Annuities have limitations on return potential, which may be lower than those of the market.
- High fees: Annuities typically come with higher fees and expenses than other investment products, which can eat into returns.
- Limited liquidity: Annuities are often less liquid than other investment products, meaning that investors may not be able to access their money when they need it.
- Investing
Pros:
- Higher return potential: Investing in the market offers the potential for higher returns than annuities, particularly over the long term.
- Diversification: Investing in a diversified portfolio of stocks and bonds can help to mitigate risk and provide a more balanced investment approach.
- Liquidity: Investments in the market are generally more liquid than annuities, meaning investors can access their money when needed.
Cons:
- Investment risk: Investing in the market carries the risk of significant investment losses that can affect the value of the investor’s portfolio.
- Volatility: The market can be volatile, with significant price fluctuations, which can be stressful for risk-averse investors.
- No guaranteed income: Investing in the market does not provide a guaranteed income stream, meaning that investors may have to rely on other sources of income in retirement.
Examples of How Investors May Benefit from Each Option
The decision to buy an annuity or invest in the market ultimately depends on the individual investor’s financial goals, risk tolerance, and retirement needs. Here are some examples of how investors may benefit from each option:
Annuities
An investor nearing retirement and prioritizing a guaranteed income stream may benefit from purchasing an annuity. By purchasing an annuity, the investor can ensure a steady stream of income throughout retirement, providing peace of mind and protection against outliving their savings.
Investing
A young investor with a longer investment horizon may benefit from investing in the market. By investing in a diversified portfolio of stocks and bonds, the investor can potentially earn higher returns over the long term, which can be reinvested to generate even greater wealth. The investor can also take advantage of tax-advantaged retirement accounts, such as IRAs and 401(k)s, to maximize their retirement savings.
It is also important to note that investors do not have to choose between buying an annuity and investing in the market. Rather, they can use a combination of both strategies to achieve their retirement goals. For example, an investor may choose to purchase an annuity to provide a guaranteed income stream during retirement, while also investing in the market to generate additional wealth.
Ultimately, the decision to buy an annuity or invest in the market requires careful consideration of the individual investor’s goals, risk tolerance, and financial situation. It is important to seek guidance from a financial advisor to determine the best approach to retirement planning.
In conclusion, the tradeoff between security and return potential is a fundamental concept in finance. Investors who prioritize a guaranteed income stream and protection against investment risk may benefit from buying an annuity, while investors who prioritize higher returns and long-term growth may benefit from investing in the market. Ultimately, the best approach to retirement planning will depend on the individual investor’s unique circumstances and goals. By carefully considering the pros and cons of each approach and seeking the guidance of a financial advisor, investors can make informed decisions to help achieve their retirement goals.
How Insurance Companies Manage Investment Risk
To manage investment risk, insurance companies typically invest annuity premiums in a mix of fixed-income securities, equities, and alternative investments. The exact mix of investments will depend on the insurer’s investment objectives, risk tolerance, and other factors.
Insurance companies often invest in fixed-income securities such as government and corporate bonds, which provide a predictable income stream and help to manage interest rate risk. They may also invest in equities and other alternative investments, such as real estate, private equity, and hedge funds, to generate higher returns and diversify their portfolios.
Insurance companies also use asset-liability matching strategies to manage risk. Asset-liability matching involves investing in assets whose cash flows match the insurance company’s liabilities. For example, an insurance company may invest in long-term fixed-income securities to match the long-term liabilities of the annuities it has sold.
Restrictions Insurance Companies Have When Investing in Their General Accounts
Insurance companies are also subject to regulatory restrictions when investing the premiums they collect inside their general accounts, which are used to pay out policyholders’ claims. These restrictions are designed to ensure that insurance companies maintain the financial strength necessary to meet their contractual obligations.
For example, insurance companies must comply with capital and reserve requirements set by state insurance regulators. They are also subject to investment restrictions that limit the amount of risk they can take on in their portfolios. In addition, insurance companies must maintain a certain level of liquidity to meet policyholder demands and to pay out claims when they come due.
Overall, insurance companies manage investment risk in their annuity products by investing premiums in a mix of fixed-income securities, equities, and alternative investments. They also use asset-liability matching strategies to manage risk and maintain the financial strength necessary to meet their contractual obligations. Insurance companies also have regulatory restrictions on investing inside of their general accounts, designed to ensure the long-term financial stability and security of their policyholders. It is important for investors to understand these investment strategies and regulatory restrictions when considering annuity products. Seeking the guidance of a financial advisor can help investors make informed decisions about their retirement planning needs.
Comparison of Investment Strategies Used by Insurance Companies and Individual Investors
Insurance companies use a different investment approach than individual investors due to their unique financial position and regulatory environment. While individual investors can (and typically do) take on more risk to potentially earn higher returns, insurance companies must balance the need for higher returns with the need to maintain the financial strength and stability necessary to meet their contractual obligations. Therefore, insurance companies employ a variety of sophisticated hedging strategies that reduce volatility but also lower returns.
Individual investors also typically have greater flexibility in their investment choices than insurance companies, as the latter must comply with regulatory requirements and maintain a certain level of liquidity to meet policyholder demands. Additionally, individual investors may have different investment goals and risk tolerances than insurance companies, which are focused primarily on long-term stability and financial strength.
How Insurance Companies Manage Longevity Risk
Longevity risk is the risk that annuitants will outlive their life expectancy, resulting in higher payouts for the insurance company. This risk is particularly relevant in the context of annuities, which provide a guaranteed income stream for life or a specified period. If the annuitant lives longer than the insurance company anticipated, the insurance company will need to pay out more in benefits to that contract owner than it originally anticipated. To manage this risk, insurance companies employ various strategies to ensure that the premiums collected from policyholders are sufficient to cover the expected payouts.
How Insurance Companies Use Mortality Tables to Manage Risk
The first line of defense for insurance companies to manage longevity risk is the utilization of mortality tables, which provide information on the probability of individuals dying at different ages. Mortality tables show past data and help insurance companies calculate the odds.
Insurance companies use these tables to estimate how long annuitants are likely to live, which helps them to determine the payout amounts for premiums collected to help ensure they have sufficient funds to cover those payouts.
The insurance company employees who carry out this assessment are known as actuaries. Actuaries use mortality tables to create models that estimate the probability of annuitants living to certain ages, which helps insurance companies to manage the risk of unexpected payouts.
Not only do actuaries look at annuitants’ life expectancy to manage the longevity risk of their annuity business, but they also look at other blocks of business, such as life insurance.
By offering both life insurance policies and annuity contracts offer two products that hedge one another. Life insurance policies provide a death benefit to beneficiaries if the policyholder dies while the policy is in force. Annuities, on the other hand, provide a guaranteed income stream to the annuitant for life or a specified period.
To manage longevity risk, insurance companies balance their life insurance and annuity portfolios to ensure that the premiums collected from policyholders are sufficient to cover the expected payouts in both lines of business.
This way, if people live longer than expected, insurance companies can continue to receive life insurance premiums while paying out more annuity payments. This means that the insurance company can maintain the balance of its portfolio by using the excess funds from life insurance premiums to cover any shortfall in annuity payments.
Similarly, if people die earlier than expected, insurance companies may pay out more in death benefits for life insurance policies but may pay out less in annuity payments. This allows the insurance company to use the excess funds from annuity payments to cover any shortfall in death benefits.
To ensure the balance of their portfolios, insurance companies may also use reinsurance, which involves transferring some of the risks to another insurance company. By transferring a portion of the risk, insurance companies can reduce their exposure to longevity risk and maintain the balance of their portfolio.
The Cost and Fees of Annuities
While annuities offer certain advantages, they also come with fees and charges that can impact the returns that investors receive. This section will provide an overview of the fees and charges associated with annuities, compare them to those of investment accounts, and examine how they can affect returns.
Explanation of Fees and Charges Associated with Annuities
Variable annuities come with various fees and charges, including mortality and expense (M&E) fees, administrative fees, surrender charges, and investment management fees. M&E fees cover insurance guarantees, while administrative fees cover contract administration. Investment management fees may apply when the variable annuity is invested in mutual funds or other investment options. (Note: variable annuities have the option for the policyholder to invest into the insurance company’s general account, where no investment management fees will be deducted.)
All types of annuities may include surrender charges that apply if the investor withdraws funds before a certain period. These charges depend on the length of the contract and are typically used to help the insurance company recapture its selling costs (i.e., commissions paid to agents)
As fiduciaries and a registered advisory firm, Decision Tree Financial offers “commission-free” annuities in our managed accounts, which decreases the upfront cost of acquiring annuities and eliminates these surrender charges.
The specific fees and charges associated with an annuity will depend on the type of annuity and the insurance company offering the product. It is important for investors to review the contract carefully with their agent or advisor so they understand the fees, charges, and contractual guarantees associated with the annuity before making an investment.
Comparison of Fees and Charges for Annuities and Investment Accounts
Fees and charges associated with annuities tend to be higher than those associated with investment accounts, such as individual retirement accounts (IRAs) or 401(k) plans. This is because annuities offer additional benefits, such as insurance guarantees and guaranteed income streams.
However, the fees and charges associated with investment accounts can vary widely depending on the investment options selected and the investment provider. For example, actively managed mutual funds tend to have higher fees than index funds or exchange-traded funds (ETFs). Additionally, investment accounts may incur account maintenance or transaction fees.
Examples of How Fees and Charges Can Impact Returns
Fees and charges associated with annuities and investment accounts can significantly impact returns over time. For example, an annuity with an M&E fee of 1.35% and administrative fees of 0.4% may have a total annual fee of 1.75%. If a variable annuity earns an average annual return of 10%, the investor’s net return after fees would be 8.5%. You are making money, but what is the cost of these fees? I will discuss that shortly.
Similarly, an investment account with an expense ratio of 0.75% and transaction fees of 0.25% may have a total annual fee of 1%. If the account earns an average return of 10% per year, the investor’s net return after fees would be 9% per year.
Let’s look at what those fees mean in terms of wealth lost…
Let’s assume an investor has $1,000,000 to invest over 30 years and earns a gross return of 10% per year. If the investor selects an investment account, like with us here at Decision Tree Financial, with an expense ratio of 0.25%, the net return after fees would be 9.75% per year. In contrast, if the investor selects an annuity with an M&E fee of 1.35% and administrative fees of 0.4%, the net return after fees would be 8.25% per year.
Over 30 years, the investor in the investment account would earn a total of approximately $16,298,000, while the investor in the annuity would earn a total of approximately $10,785.000. The difference between the two investment options is about $5,513,000, which is a substantial amount.
This illustrates the significant impact that fees and charges can have on investment returns over time.
Should you incorportate annuities as part of your retirement plan?
This is the million-dollar question, and the answer for you right now is, “It depends.”
I have spent the bulk of this article discussing how annuities work, but I would like to take a minute to discuss some psychological and health-related considerations as well.
A few years back, I had a doctor client who hated the idea of sacrificing return and paying fees. He loved the idea of taking risk! As I talked to him, I realized he didn’t want to be bored…
After he participated in our Financial Freedom Process, we found that incorporating an annuity and life insurance strategy, he would be able to increase his after tax income, increase the amount of money he would be able to give to his children, but, most importantly (for him), it gave him a “slush fund” of $25,000 a year that allowed his to take trips to Vegas and Tunica, MS to gamble with…and make him feel alive!
In the 14 years since we put that plan in place (2009), he has taken over 80 trips. He has been “comped” by the casinos so many shows, meals, and rooms, too, allowing him to feel he is earning a return that “gambling in the markets” just won’t do!
So what are some psychological and health-related considerations to think about when buying annuities?
Peace of mind: An annuity can provide peace of mind by offering a guaranteed income stream that is not affected by market fluctuations or the economy.
Stress reduction: The uncertainty of retirement income can be stressful for many individuals. An annuity can help reduce stress by providing a reliable source of income in retirement.
Longevity risk: An annuity can help mitigate the risk of outliving retirement savings by providing a guaranteed income stream for life.
Health concerns: Individuals with health conditions may benefit from an annuity that provides a guaranteed lifetime income stream, regardless of their health.
Cognitive decline: Individuals with cognitive decline may benefit from an annuity that provides a reliable source of income without ongoing management or decision-making.
Loss aversion: a psychological phenomenon in which individuals are more sensitive to losses than to gains. An annuity can help mitigate loss aversion by providing protection against investment losses.
Future planning: An annuity can provide peace of mind and reduce stress, allowing individuals to focus on their retirement and enjoy it.
Social isolation: Retirement can be a time of social isolation for many individuals. An annuity can help reduce the stress associated with retirement income and provide a sense of security, allowing individuals to focus on social engagement and other aspects of their retirement.
It is important for individuals to carefully consider the psychological and health-related factors associated with purchasing an annuity. While an annuity can provide many benefits, it may not be suitable for everyone. It is important for individuals to seek the guidance of a financial advisor to determine the best approach to retirement planning and to find the right balance between guaranteed income and potential investment returns while considering psychological and health-related factors.
This is where the Financial Freedom Process comes into play. If you want to make informed decisions that are aligned with your values, I encourage you to check it out by clicking here. In it, we make sure all your decisions are aligned so you receive the maximum benefit from every dollar you own, enabling you to create the life you desire.
