A few years ago, a well-known investment firm ran ads on all the major financial news networks in which the founder and president said the following: “I’d rather go to hell than sell an annuity”. There are not many other concepts or products in the finance industry that cause as much controversy as annuities do. So, what’s the deal with them anyway?
An annuity is a type of investment product that also has insurance components. The main purpose of using an annuity is to provide a stream of income in retirement that the investor cannot outlive. There are many types of annuities, but they all serve this function. The most common type of annuity is the variable annuity. Here, there are two “phases”: the accumulation phase and the annuitization phase. The accumulation phase works a lot like a 401(k), you make monthly or bi-weekly contributions, and the money gets invested in some type of risk asset on a tax deferred basis. If the annuity is “qualified” then your contributions are made pre-tax. The annuitization phase is when you essentially give up the money you have saved and invested over the years in exchange for a fixed, monthly stream of income that is guaranteed by the company issuing the annuity.
Since running out of money in retirement is a big concern for almost all people, an annuity can sound attractive and, in some cases, they make a lot of sense. But there are some features to annuities that are inconvenient to say the least. First, they usually have high fees. This is because you are paying for some unique features that a traditional IRA or 401(k) do not have; the ability to annuitize, and many annuities have death benefits like life insurance policies. Second, the investment options are usually limited. I have seen some with only a dozen options. Third is the infamous “surrender period”. When you contribute to an annuity there is a penalty period associated with each dollar invested. So, if you want to move or transfer the account you are usually stuck paying a “surrender” penalty. Which can be as high as 8%. Who came up with that name anyway, "Surrender"? lol
When dealing with annuities it can be tempting to label them as “good” or “bad”, but a more appropriate way to think about them is through the lens of utility. Is the product useful to you considering your goals and circumstances? If you are well capitalized, have a pension, and strong social security benefits in retirement, then an additional stream of income may not be that useful to you. However, If you are in the opposite situation and are uncomfortable with risk assets, an annuity may make sense for you because it provides a level of “guarantee” much like a pension.
Annuities can be very confusing and are sometimes sold with a commission which can sometimes cause a conflict of interest between the customer and salesperson. If you have questions about an annuity, be sure to seek the advice of a fiduciary, like a CERTIFIED FINANCIAL PLANNER™, who is required by law to put your interest above their own.