Annuities: Are They the Best Choice for Your Retirement?

The TV ad sounds so attractive. Put away some money each month today and then when you retire, it flips into reverse and you get a guaranteed check each month for life, no matter how long you live.

It’s called a “fixed annuity” and it’s not a whole lot distant from the way term life insurance is priced out. You have a large pool of people and a certain amount will live a long time and keep paying into the system. This will offset those unfortunates few who die young and pull money out. As long as the actuaries do their jobs, the insurance company prices it all in and still makes money.

The major difference is with a life insurance policy you’re betting you’re going to die young and the insurance company is betting you’re going to live long (and keep collecting premiums).

With an annuity, you’re betting you’re going to live a long time and the insurer is betting you’ll die young.

Conceptually it’s all the same, a bunch of people pay into a pool and the risk is shared.

If you’re assessing whether an annuity is good for you, you need to assess yourself first. How healthy are you? Does longevity run in your family? What is your risk tolerance to investing in a variable annuity?  Are you capable of foregoing an annuity and managing your own IRA?

A Primer on the Major Categories of Annuities

There are many flavors of annuities to choose from. We’ll just summarize the most popular handful..

Deferred or Immediate

There are two basic types of annuities: deferred and immediate. With a deferred annuity, your money is invested for a period of time until you are ready to begin taking withdrawals, typically when you start retirement. You may even be making regular deposits during your working years.

If you opt for an immediate annuity you begin to receive payments soon after you make your initial investment. Think of it as a personal pension.

Fixed or Variable

Fixed Annuity basically means you will receive a set amount for the rest of your life regardless of how long you live. This is also regardless of how the stock market or interest rates perform, you’re shielded from its vicissitudes.

However, in boom years when the stock market is doing well, you will not participate in the growth whatsoever.

In contract, variable annuities allow you to participate in the fortunes of the stock market. When it goes up, your principal goes up, but also when it goes down so does your principal. Are you willing to take the risk?

The decision is personal and depends upon your risk tolerance, how long you can wait out a down market, and do you need a fixed amount of money to live off of? Soon, perhaps even today?  It’s a trade-off between safety vs. rolling the dice.

If you’re early in your retirement and have a high tolerance for risk, then you may have the right profile for a variable annuity. This means that your principal will be subject to the vicissitudes of the stock market. You can have up years but also those oh so dreadful down years.

We’ll talk later about the commissions and fees of variable annuities that erode your principal.

Equity-Indexed Variable Annuity

There are financial pundits out there espousing the merits of indexed variable annuities as a win without losing choice. But are they, too, too good to be true?

There is a tool to mitigate the risk, it’s called “equity-indexed variable annuity”. The insurance company will guaranty you have no down years, it could go to zero but not in the negatives. And, you’ll enjoy the up years but it will be capped at a certain percentage, say 7%.

You may think it’s a no-brainer, but over time you may be forfeiting large gains when there is a bull market as we are currently experiencing (2021).

For example, an equity-indexed variable annuity may have a no-loss clause. That means when the market goes negative you can only go to zero but not lose. On the flip side, when the market goes up you participate in that growth. Win/win right?

So, how does the insurance company make any money? They make money because there will be a cap on the upside, say 7% per year.  When the market exceeds that growth in any given year you will not enjoy those returns.

For the 30-year period from 1990 to 2019, compare a 7% equity-indexed annuity has an annualized return of 4.91% vs. the annualized return of the S&P 500 of 9.96%.  That’s a lot of moolah over the 30 years.

Get the Right Help

When sorting through your options of which flavor of annuity is best for you, you best get sound advise from an expert, but beware of the wolf in sheep’s clothing. Make sure the person advising you is not out for their own interests.

In the old days, there was a job description called “stock broker”. Remember them, they called incessantly trying to convince you to buy that latest hot stock.  Then, a short while later they try to convince you to sell it whether it goes up or down. They don’t make money unless you’re trading – “Churn em and burn em, baby”.

Then the world changed, trading margins shrank (today they’re zero) and a person calling you up to convince you to buy an individual stock became a dinosaur.

Don’t feel sorry for them, those stock brokers were retooled to become “financial advisors”.  Now instead of getting a commission on buying and selling individual stocks for you, they convince you to let them invest your entire IRA with them in mutual funds and/or annuities.  They can only make money if they sell you their company’s products.  And, some products offer far higher commissions than others. Which ones do you think they’ll suggest?

It’s like giving the keys of the henhouse to the fox.

When it comes to sorting out the complexities of the various annuities, it’s best to hire a “fiduciary”. They’re highly trained, and legally must give you the soundest prudent investment choices. They charge a fee for advice and do not make commissions.

85% of financial advisors are not fiduciaries, so make sure you know what you’re talking to.

Purchase an Annuity or Go it Alone?

Retirees always have the option of foregoing annuities and managing their own IRA. Going this self-managing route incorporates three important considerations:

1. Stock Market Risk Mitigation
2. Proper Asset Allocation
3. Withdrawal Calculations

Having any portion of your retirement funds in the stock market carries a certain amount of risk. The risk is compounded by individual investors trying to pick their own stocks and trying to time when to buy and sell. Most are terrible at this. However, the risk can be reduced by buying indexed funds such as the S&P 500 where you’re not beholden to the performance of any one stock.

Proper asset allocation is key because if you’ve experienced anything like the financial setback in 2008, you realize that when the next one happens, it could take as long as 5 years to fully recover your principal. If you’re in your late seventies, can you endure that prolonged dip?

The solution is to have two buckets of investments, one for growth and the other for safety. The mix changes in accordance with your age and risk tolerance.

For more on Asset Allocation Read:

Don’t Outlive your Money in Retirement

IRA withdrawal calculations are also somewhat of a crystal ball consideration. You have to predict, on average, what the growth rate of your IRA will be over the next 20 years or so. Then calculate how much you can withdraw each year while not eroding the principal – you may need it for end-of-life expenses.

For more on IRA withdrawal formulas read:

Flipping the Switch — When to Start Spending Your Retirement Savings — Guilt Free

 

Can you, as an average investor, manage your own investment portfolio to account for:

• Early death — and not enjoying your money while you’re alive.
• Living a long life – and then run out of money when you’re really old.
• Having your surviving partner inherit your IRA with minimal taxes
• Riding through an extended stock market correction as in 2008?

If you don’t have a pension and you have a small social security payment and have to rely on your IRA for necessary expenses, the fixed annuity option looks more favorable than going it alone.

Conversely, If you have a pension (or perhaps some business income) and substantial social security, own your home outright, are debt free, then you can afford to forego the annuity option and try and increase your wealth by self-managing your IRA.

Commissions and Fees the twin Piranhas that Eat Away at Your Wealth

The variable annuity route on the surface looks like a chance to participate in the market’s growth while giving you disposable income. However, there a couple of differences to self-management.

In all likelihood someone sells you that annuity and that someone is not going to do it for nothing, she or he will be getting a nice commission, as high as 8% and that comes out of your pocket.

Also, the insurance company will debit your account for their numerous fees, most of which are buried deep in your statement. You’ll be paying upwards of 2% per year of your hard-earned dollars for their performance or lack thereof.

One fee is the management fee for managing the portfolio. This is interesting since 93% of mutual fund managers cannot beat the S&P 500. They may be able to show winnings in the short run but over time they lose yet they still charge you.

Simple math, 2% of a $500K principle is a whopping $10,000 per year – Sayonara.

Then, if you get sick of this madness and want to pull your money out, there are surrender penalties of up to 10% for early withdrawal protected by an iron clad contract.

Caveat Emptor

Some aspects of annuities are favorable such as the concept of a fixed annuity for life without ever fearing outliving your money. That offers peace of mind as you age.

However, a lot of insurance companies hire aggressive “financial advisors”, a/k/a salespeople, that push their most profitable products, namely variable annuities.  According to the U.S. Bureau of Labor Statistics, there are about 218,000 “personal financial advisors” in the U.S. as of May 2020. It’s a lucrative profession.

If you want to venture into the arcane world of variable annuities, it would be best to avoid a commission based financial advisor, and hire a fee-based fiduciary to help you sort through your options and avoid costly mistakes – mistakes that can cost you tens of thousands of dollars over the life of your annuity. To complicate matters, depending upon your age and employment, there are complicated tax angles that a fiduciary can help you sort through.