I believe annuities are so popular because over the hundreds of years that annuities and annuity-like products, like tontines, have existed, the people who provide annuities have perfected them. They have studied and learned how human beings think about money at a gut level, and have designed annuities to cater to all of these emotions.
It is true that annuities can provide some contractually-guaranteed features that virtually no other investment product out their can match. Those features are what draw so many people to purchase annuities, and are what salespeople use to pitch them.
This article will focus on what I believe to be the 4 most common reasons purchase annuities. Those 4 reasons are:
- Tax benefits
- Death benefits
- Performance guarantees
- Retirement income guarantees
It will also dive into some of my thoughts on each of these reasons. Let’s get to it.
1. Tax Benefits
- 89% of people think the government currently does not spend their tax dollars wisely.
- 50% of people would rather serve jury duty than file their taxes.
- 24% of people would get an “IRS” tattoo if it meant never having to pay taxes again.
These stats are more for laughs, but it does show that many people dislike taxes, and will go to great lengths to avoid paying them. That’s why the tax benefits that annuities offer is so enticing.
What Are the Tax Benefits of Annuities?
In general, the growth of annuities is tax-deferred. This means that any investment income or capital gains an annuity earns are not taxed in the year they are received, as long as the investor does not withdraw them from the annuity. The logic behind this is that the income has not been constructively received per IRC Section 1.451-2.
This tax-deferred growth is notably different from the investment income received from “normal” taxable investments accounts. For example, if you invest in a mutual fund inside a taxable account and earn $10,000 of dividends, you normally must pay taxes on those dividends that same year, whether you withdraw them or not. However, if you invest in a subaccount inside a variable annuity that gives you the same/similar market exposure, that $10,000 of dividends will not be taxed solely because they were earned inside the variable annuity.
This tax-deferred growth is especially attractive to tax-sensitive investors (ie, those in high Federal tax brackets and/or those living in states with high income taxes). The opportunity to let your earnings stay invested and compound, potentially for decades, does sound very alluring. This is why insurance companies market this feature so heavily, as you can see from the composite photo below.
Are the Tax Benefits Worth It?
But is the tax deferral that annuities market so heavily really as good as they make it seem? In my opinion, it is often overhyped. The high costs of annuities can counteract some/all of the tax benefits, and there are plenty of other ways to invest tax-efficiently. Below are some other great ways to achieve tax-efficient investment growth, without the high fees that many annuities have. I personally would consider these options as potential alternatives to purchasing an annuity, and then make the decision that is best for you.
Choose Prudent Account Types
There are many account types that offer tax-deferred growth by default. Some common examples are Individual Retirement Arrangements (IRAs), 401(k)s and Health Savings Accounts (HSAs). If you haven’t already taken advantage of your existing account options, there may not be a need to turn to an annuity.
Choose Prudent Investments
There are also many types of investments that are usually very tax-efficient. Some common examples are municipal bonds, stocks that pay qualified dividends and index funds that usually have low turnover. You should consider these investments as well before turning to an annuity.
Implement Prudent Tax Strategies
There are also many investment-related tax strategies you can use to invest tax-efficiently. Some common examples include tax-loss harvesting and asset location. Implementing these strategies might be a good alternative to using an annuity for tax efficiency.
Consider Low-Cost/Investment-Only Annuities
If you do decide to use a variable annuity for tax benefits, make sure you choose a VA that makes sense for your goals. Many VAs have additional costs because they come with lots of additional features and guarantees such as death benefits and minimum income.
If you are strictly using a VA for tax-deferred growth, consider a low-cost VA that doesn’t have all the bells and whistles. One example is the Vanguard® Variable Annuity, which has a total base fee of only 0.30% (see prospectus screenshot below), no surrender charges, and low-cost investment options. This is much lower than the industry average of 2.24%, according to a Morningstar study cited by Vanguard.
Another low-cost VA is the Fidelity Personal Retirement Annuity®, which has a base fee of only 0.25% (see prospectus screenshot below).
2. Death Benefit
Death benefits are another common feature of annuities. They are built into annuities for 2 main reasons:
- Many people have a strong desire to pass wealth on to the next generation.
- Many people fear “not getting out what they paid in” when they consider an annuity.
Annuity death benefits come in many flavors. The “basic” ones are usually fairly low cost, or even included at no extra charge for an annuity. The richer death benefits generally provide increased protections, and thus cost more. Below are a few common types of death benefits.
Types of Death Benefits
Payout Options for Income Annuities
Death benefits are pretty simple if you purchase an income annuity, or if you’ve already chosen to annuitize. You can choose a payout option that will continue to make payments, even after you pass away. Below I’ll show a few examples of this, all from the Brighthouse Income Annuity.
- Cash Refund: Usually something like, if you pass away before receiving at least the amount of your contributions, the difference will be given to a beneficiary of your choosing. See screenshot below.
- Period Certain: Usually something like, payments will continue for a set amount of years, even if you pass away before those years are complete. Any payments after your death will go to a beneficiary of your choosing. See screenshot below.
- Joint Life Payout: Usually something like, payments will continue as long as either you or another beneficiary of your choosing is alive. Once the final person passes away, payments will stop. See screenshot below.
The next 3 forms of death benefits apply to annuities that are still in their accumulation phase.
This death benefit is pretty straight forward. If you pass away, your beneficiary will receive whatever the contract value is on your date of death. The contract value will usually be your any contributions you made + earnings – fees – any withdrawals you made.
An example of this is the death benefit on the Global Atlantic SecureFore3 Fixed Annuity. See screenshot below.
Return of Premium
This death benefit offers more protection than the standard contract value death benefit. It usually states that your beneficiary will receive the greater of:
- The contract value on your date of death, or
- The amount of your net contributions (contributions – withdrawals)
This type of death benefit is applicable for those who purchase variable annuities where your investments have the potential of decreasing in value. For example, let’s say you contributed $100,000 to a VA, but it then dropped in value to $70,000 because of a bear market. You then passed away. Your beneficiaries would still receive $100,000. An example of this is the AIG Polaris Platinum® III Variable Annuity. See screenshot below.
Notice this death benefit comes with an added fee.
Enhanced Death Benefits
This type of death benefit offers even more protection, and usually costs the most. They provide some sort of formula to calculate the death benefit amount. Below are a few examples.
- High Water Mark: Usually something like, your death beneficiaries will receive the highest value your account ever reached on a policy anniversary. This amount will of course be adjusted for any withdrawals you took. Since VAs fluctuate in value, this type of benefit is usually the most beneficial for VAs. See the screenshot below from the New York Life Premier Variable Annuity — FP Series.
- Guaranteed % Increase: This death benefit is common with fixed index annuities. You can see an example below from the Pacific Life Pacific Index Foundation® Index Annuity. It usually goes something like, your beneficiaries will receive the greater of:
- Your contract value, or
- The Guaranteed Minimum Value (GMA), which is usually your contributions grown at some minimum guaranteed rate.
Are Death Benefits Worth It?
This is a somewhat subjective question, and each investor will put his/her own value on providing for the next generation. That said, here are some things to keep in mind.
You’ll notice a lot of annuity marketing material highlights how your heirs can avoid probate when inheriting an annuity. Avoiding probate can be accomplished in many ways besides purchasing an annuity (naming beneficiary on your TOD account or IRA or creating a trust).
Taxable Death Benefit
Unlike the death benefit on life insurance policies, which is usually received income tax-free by your heirs, the death benefit of annuities is considered taxable income. This makes the benefit far less valuable. It’s true that your heirs would owe income taxes anyways if they inherit a Traditional IRA from you, but if they inherited a taxable account, they could possibly owe $0 in income taxes because of the step up in cost-basis upon death.
Contract Value Death Benefit
Your beneficiaries almost always receive any remaining assets upon your death. So this benefit doesn’t provide anything above and beyond the normal protections you get with most other investments.
Return of Premium/Enhanced Death Benefit
These types of death benefits provide your heirs protection against declines in the market. But remember, your enhanced death benefit value isn’t liquid and isn’t available for you to access. The only way to receive it is if you die. So if providing for your heirs is a top priority, this can make sense. But this benefit usually comes with a fee, so it comes at the cost of providing for your own retirement.
3. Performance Guarantees
“Upside with no downside.” “Good returns, no risk.” “The best of both worlds.”
One of the big appeals of many annuities is their performance guarantees. It’s these performance guarantees that draw in investor after investor. Insurance companies are incredible marketers. There’s no doubt about that. Take a look at how hard they focus on how annuities can offer growth AND protection at the same time in this composite photo.
So how exactly do annuities provide these 2, seemingly contradictory benefits of protection and growth? Let’s take a look at how the 3 main types of annuities each do this.
According to FINRA, with fixed annuities, “often the interest rate is fixed for a number of years and then changes periodically based on current rates.” In this manner, they are often compared to certificates of deposit. Fixed, guaranteed interest is about as safe a type of growt as you can get.
Your annuity contract will usually state the:
- Initial interest rate: the rate your money will earn
- Initial interest rate period: the length of time your money will earn that rate.
This rate is guaranteed by the claims-paying ability of the insurance company and will be earned regardless of market performance. The stock market could go up, down or sideways, and it will have no impact on the interest rate your fixed annuity earns during your initial interest rate period.
If the interest rate period is longer than 1 year, you may hear the annuity referred to as a multi-year guaranteed annuity, or “MYGA” for short.
After the initial interest rate period is finished, you will receive a “renewal rate” that will depend on market conditions at that time. However, another guarantee that is usually built into fixed annuity contract is guaranteed minimum interest rate. No matter what interest rates are when it comes time for renewal, it will never be lower than the guaranteed minimum interest rate. Below is a screenshot from the AIG American Pathway® SolutionsMYG Annuity that shows how the interest rate period and the guaranteed minimum interest rate are talked about.
Fixed Index Annuities
Again, according to FINRA, “indexed annuities offer a minimum guaranteed interest rate combined with an interest rate linked to a market index, hence the name.”
Fixed index annuities offer principal protection by capping your upside and capping your downside. Usually, if the index goes up, you get a portion of the gains, and if the index goes down, your performance is floored at 0%. You get some upside if the index does well, but no downside if the index does poorly.
In addition, you can choose to put some of your money in the fixed account portion, which we described above. Below is a screenshot from the Pacific Life Pacific Index Foundation® Annuity that shows these 2 options.
Again, according to FINRA, “a variable annuity’s rate of return changes with the stock, bond and money market funds that you choose as investment options.” At first, this may not sound like there is any protection or performance guarantees. But let’s dive a bit deeper into variable annuities.
Again, you can allocate a portion of your money to the fixed account that will earn a guaranteed rate for a specific time period.
There are also optional riders you can purchase that can guarantee you will always be able to get your net contributions to the plan. Keep in mind these usually cost money. Below is an example from the New York Life Premier Variable Annuity–FP Series. It has an optional rider called the Investment Preservation Rider–FP Series (IPR). This rider “protects 100% of the amount invested in the first policy year—and potentially some growth—against market declines after completion of the holding period selected.”
Riders like this, commonly referred to as guaranteed minimum accumulation benefit (GMAB) riders, offer investment protection that you typically can’t find with mutual funds or stocks.
Are Performance Guarantees Worth It?
Whether you’re looking at the guaranteed interest rates of fixed annuities, the no downside of fixed index annuities, or the guaranteed minimum accumulation benefit riders of variable annuities, they all sound attractive.
But are they worth it? Let’s play devil’s advocate for a second.
Markets Usually Go Up
Yes, the stock market is volatile. According to JP Morgan, the average intra-year drop in the S&P 500® since 1980 is 14%. Prospect theory also tells us that “individuals dislike losses more than equivalent gains.
- 75% of 1-year periods
- 88% of 5-year periods
- 95% of 10-year periods
So over the long run, stocks have a very high likelihood of having positive returns. But to reap those benefits, you must have patience and discipline when times are rough. That’s why having a good head on your shoulders is so critical with investing. In fact, Vanguard estimates that behavioral coaching can add around 1.50%/year to your returns.
The protection of annuities sounds like a nice security blanket for your investments, but do you need it? That’s a personal choice, but if you keep a long-term focus, and stay disciplined, you have a very high chance of earning positive returns from the stock market.
Other Ways to Reduce Risk
Despite the fact that stocks do tend to go up over the long-term, many investors just may not be able to stomach the volatility. Maybe you are a risk-averse investor. Or maybe you are close to retirement. Whatever the reason, there are many other ways to reduce your risk besides an annuity.
Diversification: You’ve probably heard of the phrase “don’t put all your eggs in 1 basket.” That applies to your investments as well. Spreading your money out across various investments helps minimize your chance of total loss, and can smooth out the ups/downs of investing.
The Callan Chart below helps visualize this very well. It’s difficult to predict which types of investments will perform the best from year to year. By owning a piece of many investments, you’ll never be the best performer, but you’ll never be the worst either.
Asset Allocation: Another way to reduce your risk is by choosing an appropriate asset allocation for your personal situation. A good way to do this is by controlling the amount of stocks and bonds you hold in your portfolio. This is a bit oversimplified, but a good rule of thumb is that:
- More stocks in your portfolio will likely mean more risk and more return.
- More bonds in your portfolio will likely mean less risk and less return.
A good example of this is to look at Vanguard’s LifeStrategy Funds. They have 4 funds that each have different asset allocations.
- Income Fund: 20% stocks / 80% bonds
- Conservative Growth Fund: 40% stocks / 60% bonds
- Moderate Growth Fund: 60% stocks / 40% bonds
- Growth Fund: 80% stocks / 20% bonds
We can look at the historical returns (provided by Vanguard website) and the maximum drawdowns (provided by Morningstar website) of these funds to get a good understanding of how risk and return are connected. The graph below shows the average annual return and the maximum drawdown over the past 10 years of each of these funds.
We can see that the funds holding a larger percentage of stocks had higher returns, but also larger drawdowns. This tells us that lowering your stock allocation, and increasing your bond allocation, is an effective way to reduce the risk level of your investments. Thus annuities are not the only method to reduce market risk.
Guarantees Can Change
Oftentimes, the performance guarantees offered by annuities only last for a finite period of time. For example, if you have a fixed annuity, the initial interest rate you earn might last for 5 years. After that, the company will issue you a renewal rate that may be lower. That’s why it’s good to ask about an insurance company’s renewal rate history before purchasing a fixed annuity.
With fixed index annuities, you run into a similar renewal rate issue. The formula used for calculating your return is usually subject to 1 or more of the following formulas:
- Caps: This is the maximum return you will get credited. For example, if the index returns 10%, and your cap is 5%, your return is capped at 5%.
- Participation Rates: This is the percentage of the index return that you will get credited. For example, if the index returns 10%, and you have a 70% participation rate, your return will be 7%.
- Spreads: This is an amount that the insurance company “takes off the top” of the index return. For example, if the index returns 10%, and you have a 4% spread, your return will be 6%.
The tough part is that these formulas are only locked in for your guaranteed period. Oftentimes, this is only 1 year. So each year your cap might change, or your participation rate might change. Again, you should ask to see the renewal history before purchasing a fixed index annuity.
This is all to say that some of the performance guarantees annuities provide only last for a certain time. You should be aware of this before purchasing one. Here is an example fro Allianz.
At What Cost
There’s no such thing as a free lunch. When an insurance company gives you performance guarantees, you can bet you are giving up something in return. Below are some of the costs commonly associated with annuities.
- Liquidity Cost: Most annuities have a surrender period, during which access to your money is limited. There are still ways to access at least some of your money, but in general, annuities are not a liquid investment.
- Missed Dividends: Often the indexes used in fixed index annuities to determine your returns use only price return. This means you don’t get to count any dividends towards your return.
- Spreads/Caps/Participation Rate Cost: With fixed index annuities, you give up some of the upside in return for limiting your downside. This might be a smart move, but it’s important to be aware that you aren’t getting the downside protection for free.
- Fees: Annuities are notorious for high fees. M&E fees, rider fees, subaccount fees, and more. High fees means more money for the insurance company, and less money in your pocket.
Maybe for Part of Your Portfolio
I believe that certain types of annuities, particularly fixed annuities or annuities with guaranteed growth on an income base, can have a role as part of your overall retirement portfolio. But make sure you understand the performance guarantees you are getting, and at what cost.
4. Retirement Income Guarantees
Another common reason investors purchase annuities is because of the income guarantees they provide. Running out of money in retirement is a common fear. According to a 2018 Transamerica Retirement Survey, “outliving my savings/investments” was the largest fear amongst retirees. No wonder annuities are so common.
Let’s take a look at some reasons this guaranteed income (subject to the claims-paying ability of the insurance company, of course) may not be as great as it seems.
Are Retirement Income Guarantees Worth It?
Do You Need More Guaranteed Income?
If you already have enough fixed income sources to cover your basic living expenses, you may not need additional guaranteed income. People who have Social Security, pensions, and other fixed income may already have their fixed expenses taken care of.
Often, getting the guaranteed income from an annuity reduces or eliminates your upside potential. That’s why it’s usually only recommend for a portion of your portfolio.
Is Your Income Inflation-Adjusted?
Many times the guaranteed payout is not adjusted with inflation each year. That means over time, that guaranteed income will purchase less and less.
Can You Undo Your Decision?
If you choose to annuitize, this decision is usually difficult, if not impossible, to undo. I call this a “one-way door.” So make sure the income benefits outweigh the liquidity benefits for your situation.
How Long Until You Start to Benefit?
With many income riders, it can take years before you actually start to benefit. Here’s why.
Most times, when you begin receiving income payments, those payments first come from your own accumulation balance. Only after your accumulation balance is depleted does the insurance company start to pay out-of-pocket.
For example, if your accumulation balance is $1 million, and your income rider pays out $50,000/year, it would take 20 years to deplete your account. Only in year 21 would the insurance company begin to actually have to pay you anything. And that’s assuming no growth in you account at all. Even if we assume a modest 2% growth per year, it would take 25 years to begin benefiting from the rider.
That is a long time to wait, which is one of the reasons insurance companies make money. They know that they won’t have to pay any money from their own pocket for many years. All the while, they get to collect the rider fee.
In my opinion, 4 of the common reasons investors purchase annuities are:
- Tax benefits
- Death benefits
- Performance guarantees
- Retirement income guarantees
Tax deferral can be a powerful benefit, but oftentimes investors forget to consider types retirement accounts that also provide tax advantages, investments that are tax-efficient, tax strategies available to manage your taxes, and if the cost of the annuity outweighs the tax deferral benefit.
Death benefits are very important to some retirees wanting to provide for their beneficiaries. However, there are other ways to avoid probate, part of the annuity death benefit can be taxable to your heirs, your survivors will usually receive the remaining account balance anyways, and the enhanced death benefit riders are usually expensive
Performance guarantees can help retirees sleep at night. But markets usually go up anyways (although never in a smooth fashion), there are other ways to reduce your risk such as diversification and choosing an appropriate asset allocation, the insurance company can change the guaranteed interest rates, caps/participation rates/spreads, and the fees are usually very high. Annuities can in some cases make sense, but usually only for a portion of your portfolio.
Guaranteed retirement income sounds great. But some people already have their base expenses covered from other fixed income sources like Social Security and pensions. Annuitization is often very hard, if not impossible to undo, many times the income is not inflation-adjusted, and some guaranteed income riders don’t begin to pay off for many years.
In conclusion, annuities may make sense for you, but they may not. Make sure you understand your reasons for purchasing an annuity, which benefits matter to you and which do not, and consider your alternatives before moving forward.