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Do Annuities Make Sense For Anyone?

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Do Annuities Make Sense For Anyone?


There seems to be a lot of confusion about whether annuities are good or bad. Some of this stems from viewing products as complex and too time-consuming to learn and understand. But I don’t think annuities are more complicated than other financial products. For example, an annuity is like a pension, which hardly anyone thinks is bad.

An annuity is an insurance product. By purchasing one, you transfer the risk to the insurance company, just as you would with home, auto or life insurance. For annuity products, the insurance company assumes some, if not all, of the life or market risk and charges for it. Risk mitigation is common to all types of annuity products, but they differ significantly in other respects.

variable annuity

When people talk about contractual complexity and high fees, they are usually referring to variable annuities. I find these products are best explained as mutual funds included in insurance contracts.

For example, I can buy an annuity with the following features. If I put $1,000,000 into a variable annuity and its value drops to $800,000 when I die, the insurance company will still pay my beneficiaries $1,000,000. If I withdraw 5% of that million dollars annually and the annuity value drops, the insurance company will continue to pay me the 5% of the original amount with the appropriate add-ons on the policy even if the value of the account I purchased goes to zero terms. In both cases, insurers take on market risk.

Of course, all this comes at a price. I will pay for the risk plus fees charged by the insurance company for taking the sub-account (mutual fund). The combination of fees is usually between 2% and 4% per annum.

Variable annuities don’t look attractive right now because of the relatively high fees compared to low-rate guarantees. When interest rates rise and companies can offer higher minimum guaranteed rates (think early 2000s), then things can be quite different.

immediate annuity

An immediate annuity enables a person to put a sum into an insurance company and receive an income immediately. This is the annuity I mentioned earlier, just like a pension. The product typically offers multiple payment options, including guaranteed lifetime income benefits, where the insurer assumes all longevity risk and market risk. What if you die shortly after purchasing? Well, some payment options allow you to specify the beneficiary who will receive the payment stream.

Immediate annuities that provide regular, guaranteed income can be a good alternative to traditional pension plans that are no longer widely used. They can fill a huge gap in retirement income planning.

fixed annuity

A fixed annuity is not a CD, but it does look like one. For example, assume a fixed annuity and CD paying 3% interest for 3 years. Your principal is not at risk if you keep investing over a 3-year period. If you withdraw your money before the end of the 3-year period, you will pay a penalty.

Of course, CDs are insured by the FDIC or NCUA. The guarantees for annuities are backed by the insurance companies that issue them. It is important to purchase products from insurance companies that receive high marks for financial strength and stability from major third-party credit rating agencies.

Annuities typically pay higher interest rates than CDs due to differences in underlying investments. Annuity rates are based on long-term, illiquid investments—such as bonds, mortgages, private equity, private credit, and real estate. The illiquidity premium is higher return without higher risk.

Fixed Index Annuities

A fixed index annuity is a form of fixed annuity that does not guarantee an interest rate, but allows you to participate in an index, such as the S&P 500. Most contracts are designed to guarantee avoiding any losses while participating in some upside gain. For example, a contract might protect against losses in a year in which the index is down and credit 50% of any gains in a year in which the index is up. The assets in these annuity products have growth potential but are protected against downside losses. They are not securities, which can cause some confusion because many “anti-annuity” people analyze them as securities.

Annuities can shine in volatile markets

Volatile and unpredictable market conditions like ours today tend to increase interest in principal guarantees and downside protection for fixed or fixed indexed annuities. You may prefer bonds as an alternative to annuities, but as interest rates rise, the value of bonds may fall.

If you’ve just retired, you may be especially vulnerable to broad market volatility. Some advisors try to reduce market risk, especially return sequence risk, by allocating 35% of the portfolio to principal-guaranteed annuities and another 65% to equities. This strategy provides flexibility in choosing a source of income. When the market goes up, income can be drawn from the stock portion of the portfolio. Fixed annuities can provide income when the market falls, while stocks have time to recover.

An increasing number of 401(k) plans offer annuities that allow participants to receive guaranteed lifetime income without moving funds out of the plan. Participants who do not need income now can use the annuity as a stable value account. It allows them to lock in bullish gains and move money off the table, knowing that interest rates and their principal are guaranteed.

Don’t approach annuities with a closed mind. It’s an eye-opener to see how effective they are in protecting assets, providing guaranteed lifetime income and building a secure financial future.

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