The topic that seems to go hand in hand with retirement planning and investments these days is the word ‘annuities.’ You see sponsored ads about them thrown into your Google search results; you hear financial advisors hosting hour-long radio shows on Saturdays telling all about their virtues; you hear your one of your golf buddies talk about how they just bought an annuity that’s “guaranteed to go up by 7% every year for 10 years” (which it's really not). Annuities are an important consideration for a portion of your nest egg, but why? Keep in mind that almost every time you hear an advertisement about annuities, the advertiser has some ulterior motive. They are either trying to get you to buy one, or telling you that they’re crap and instead you should put all your money into whatever they’re offering. But before we really get any deeper into whether they’re right for you, let’s understand what they are and how they work.

An annuity is a contract between you and an insurance company. Because of this, annuities are technically an insurance product. They can be funded with tax-deferred money like that from an IRA, tax-free money in your Roth IRA, and even after-tax money you have in a brokerage account. In turn, depending on the type of annuity, either the insurance company then goes out and invests your money in various ways to give you certain rates of return on your money, or you choose the investments and bear the risk as well as the potential reward. In addition, annuities offer various types of guarantees*, which will be discussed later in the article.

I think the perfect analogy to an annuity is a car. There are different classes of annuities just like there are different classes of cars: sports cars built for high performance, hybrids that’ll give you great gas mileage, luxury cars that will give a smooth comfortable ride. Also, just like you can have all kinds of different accessories on cars like a navigation system, premium audio, 6-way power seats, and my personal favorite – the heated steering wheel, annuities have all kinds of features too: different indexing options, enhanced death benefit riders, guaranteed* lifetime withdrawal benefit, etc. I know this analogy is kind of cheesy, but you get the point. It can also apply when you hear blanket statements like “you should never buy an annuity.” That would be like saying "you should never buy a minivan.” Tell that to a parent with 4 kids and their never-ending excursions to the little league diamond, piano lessons, volleyball practice, and Cub Scout meetings meanwhile hauling around all their friends and equipment to boot. Each kind of annuity fills a specific need.

There are basically 3 main types of annuities: fixed, indexed, and variable.

Fixed annuities can pay you a fixed rate of interest over a fixed number of years. These are known as Multi-Year Guaranteed Annuities* (MYGAs). Or, sometimes the interest rate is locked in only for one year at a time, and can increase or decrease depending on what overall interest rates in the economy do.

Fixed annuities are provided by insurance companies so they are backed by the claims paying ability of the company. The contract term of a fixed annuity generally ranges from 3-10 years. Also, you are typically allowed to withdraw up to 10% of your balance each year, but if you withdraw more you probably will be charged a penalty called a surrender charge on the amount above 10%. During this surrender period, however, this penalty usually decreases the longer you've owned the annuity.

Where fixed annuities are the most conservative annuities you can buy, variable annuities involve the most risk. VAs usually give several types of guarantees* and insurance features because after all, they’re still an insurance product. But, instead of the insurance company taking your funds, putting them in their general account, and taking responsibility to invest to achieve returns as they do with fixed annuities, with a variable annuity you are responsible for choosing the investments using your own separate account.

VAs are the only type of annuity with investment risk, meaning you can lose money in your separate account if the investments you choose lose money. You have a number of investment choices called sub-accounts that you can choose from. These sub-accounts are similar to mutual funds and allow you to invest in securities such as stocks, bond funds, and money markets. But again, as with any other risk-reward trade-off, variable annuities generally offer the highest potential upside for any type of annuity because of this investment risk that you take.

These annuities go by many other names: fixed indexed annuity, indexed annuity, hybrid annuity, etc. However, they all refer to the same type of annuity. Like the pure fixed annuity, the insurance company is responsible for investing your funds that get deposited into their general account. But instead of giving you a fixed rate of return, the return you get is based on the performance of some type of index (e.g. S&P 500). The EIA will credit your account based on how that index performs over a certain term, usually over a one year period, but sometimes over a multiple-year period. Then the EIA locks in any gains for the term, and starts the calculations over for the next period. Keep in mind that your funds are not directly invested in the index or any other security where you can lose money, but rather your interest earning are simply based some portion on the index’s performance.

Let’s clarify with an example: Let’s say you deposit $100,000 in an EIA that credits gains based on the performance of the S&P 500 index. On the date the contract starts, the S&P 500 index is at 2000. All the calculations are going to be based on the index value on this starting date and on anniversaries of this date. So let’s say one year later the S&P 500 is at 1800. Your account balance stays at $100,000 because EIAs do not lose money in years where the benchmark index loses money. Now, let’s say, one year later the S&P 500 is at 2070 on the policy’s 2nd anniversary date. Since the calculations reset on each anniversary for this annuity, the gain in the 2nd year is 15% (2070-1800 = 270; 270/1800 = 15%). But even though the index showed a 15% gain over this time period, your account value will generally not go up 15% because the insurance company sets limitations on the gains with things like participation rates and spreads. Just so we don’t get too bogged down in the calculation details, your account value when all is said and done may only go up 8% instead of 15%. So now that 8% gain is credited to your account, which is now at $108,000, it’s locked in, and the calculations start again for year 3.

You can see that EIAs can be incredibly complex investment vehicles. Going back to the analogy of a car, trying to understand how they work would be like taking a look under the hood and trying to understand how each of the systems under there work: engine, battery and alternator, power steering, radiator, etc. I want you to understand how the basics of the vehicle works, its pros and cons, and when it’s suitable in the big picture, rather than getting too bogged down in their inner workings.

Annuities are tax-deferred investment vehicles. Okay, so what does that mean? It simply means you don’t pay taxes on the gains until you actually withdraw money out of the account. IRAs work the same way in this respect. This is a very attractive feature, especially for variable annuities for folks in a higher tax bracket. Let’s compare an investor who has the choice to put after-tax money either into a brokerage account, or into a VA. In a brokerage account, investors will have to pay taxes every year on dividends they receive on stocks and income they receive on bonds and bond funds. They also will have to pay capital gains when they sell securities (e.g., stocks, bond funds, etc.) within this account. So unless they lose money on investments in their brokerage account (or invest in tax-free securities), they will have an annual tax bill on their gains.

This same investor could have identical securities inside a VA. He or she could buy and sell into and out of these securities to their heart’s content, and none of these transactions would be taxable. The only time the investor will pay taxes is when he or she decides to actually withdraw money from the VA. This investor could even roll over the funds to a different annuity, VA or otherwise, and this can still be a tax-free move called a 1035 exchange.

One thing to point out is that when you do decide to take a withdrawal from an annuity, you will pay taxes on the gains first. Annuities are taxed on a “last-in, first-out” (LIFO) basis. This means that when you withdraw money from an annuity, if your balance is greater than the sum of all the premiums you put in, these gains are withdrawn before any of your initial premium. I know, another confusing point, so let’s clarify with an example: You put $100,000 in an EIA in 2008. The balance has grown to $132,000 in 2016, and you haven’t added any new premiums to it in those eight years. If you withdraw $30,000, all of this will be considered taxable income. If you withdraw $40,000, the $32,000 in gains will be taxable.

With fixed annuities and EIAs, the insurance company is responsible for achieving investment gains with your premiums. They shoulder the responsibility and make the guarantees. Your money goes into the insurance company’s general account. Technically your money is not directly invested into securities, so you can’t lose money when these investments decline in value. And even though the performance of an EIA is based on the performance of a benchmark index, in years where this index declines in value, you will not lose money because of these losses but simply have a 0% gain during that period.

Any annuity can be turned into a guaranteed* lifetime income stream. Turning this lifetime income feature on is called “annuitization,” and is generally an irreversible decision. There are lots of options in which to do so too. You can be guaranteed* lifetime income based on just your life alone, or on the life of both you and your spouse (joint lives) where the surviving spouse will continue to receive income until they pass too. You can have refund provisions as well so your beneficiaries will get something if you happen to pass away soon after you annuitize. There are lots of different payout methods and guarantees if you happen to die early, and getting into all of them is beyond the scope of what I want to cover here. Just know that the more lives an annuity will continue to pay out for, and the more protections there are that your loved ones will get something if you (and your spouse) pass away early, the smaller the guaranteed income amount you will get while you’re still alive.

The amount you get is based on your age (and your spouse’s age, if applicable), gender, your annuity account value, and any of those refund provisions you chose at the time of annuitization. The insurance company will pay you a specific percentage of your balance every year when you annuitize based on these factors. They will pay you no matter how long you (or your spouse live). This is one way people are protecting against longevity risk, which is simply the risk of outliving your money. This is basically a way to take a lump sum of your retirement assets and, in effect, create your own pension.

Let’s look at another example: you are 62, male, your parents and siblings are healthy and you have a family history of long lives, and you are interested in guaranteeing more of your lifetime income in case you do live well into your 90’s, or later. You can take $200,000 and buy a single premium immediate annuity (SPIA). This SPIA will immediately begin paying you a monthly income. If you decide to base it on your life only, the insurance company will give you 6% every year. This is $12,000 annually for the rest of your life. If you decide to base it on a joint life, so either you or your wife will continue to receive income as the surviving spouse, you can only get 5%, because it’s highly likely that the insurance company will have to make income payments for a longer period of time.

One bonus feature of annuitizing is that you spread out your tax burden over a number of years, if the annuity is purchased with after-tax funds. If you simply withdraw from an annuity, as mentioned earlier, you will be taxed more up front since all of your gains are withdrawn before your initial premium. If you annuitize, each payment is a predetermined mix of gains and premium, and what is known as the "exclusion ratio". So only a minority of each income payment is taxable according to the exclusion ratio formula.

Annuities are intermediate-to-long-term investments. You should not fund them with any significant money you are likely to need in the next few years because the surrender charges can be harsh. Fixed annuities and VAs are a bit less restrictive since their contract term is usually shorter; however, some EIAs have contracts of 17 years or more! You definitely must know how long your contract is and what restrictions you have on withdrawing your own money before purchasing any annuity.

VAs are notorious for having lots of internal fees. Right off the bat, you have mortality, expense, and administration (ME&A) fees. These fees average about 1.4% annually. There are expenses on the subaccounts which can range from 0.25-2% annually. Lastly there are fees on the different riders you can choose. You can read about riders later in the article, and keep in mind that riders are popular on both VAs and EIAs. So you can see here some of the worst offending culprits of VAs could be charging you 4-5% in fees every single year.

Taxation

Wait, didn’t I mention above that annuities have tax advantages? Yep, but they also have a couple tax disadvantages too. Any gains in your annuity are considered ordinary income and taxed as such, even if the investments inside your annuity were in stocks. Had you owned stocks in an after-tax brokerage account, then your qualifying dividends and long-term capital gains would be taxed more leniently than ordinary income. Also, when you pass away and have a balance still in your annuity’s account and leave this annuity to your loved ones, they will now owe taxes on the gains. Again, had you owned the same investments inside a brokerage account, the value of the securities is “stepped-up” at death, and your beneficiaries would have inherited them as if they bought them at their value on the day you died, which effectively eliminates any taxable gains.

Although you can invest in securities like stocks that have unlimited upside within a VA, as mentioned before the high fees can take a lot of your gains. Fixed annuities have just that, a fixed rate-of-return. EIAs have much of the best of both worlds, but even EIAs that are “uncapped” (which means there is no maximum placed on your potential annual return) have gains that only capture a portion of the upside of its benchmark index. Also, EIAs base their gains on the index return not including dividends. Lastly, some EIAs have participation rates and spreads that again serve to water down returns. So, for example, if your EIA uses the S&P 500 as the benchmark index, has a participation rate of 70%, a spread of 1%, and the S&P 500 goes up 20% in a given year, your gain would be 13% (20% x 70% = 14%; 14% - 1% = 13%). If you would’ve invested simply in the S&P 500 for the same period, you would’ve gained 20% plus dividends which are currently averaging just over 2% annually for the S&P 500. Of course, you cannot invest directly in an index but could invest in a mutual fund or UIT which mirrors the index.

Annuity guarantees* often come in the form of riders. So going back to the car analogy, annuity riders are like car accessories. Sometimes they come at no cost with the contract, other times you can purchase them for an annual fee. There are many different types of riders, and each different type has different variations, but I’ll try and stick to the basic versions of the most popular riders. Keep in mind that a particular rider may be the same thing when comparing different insurance companies’ annuities, but simply go by a different name.

Guaranteed Lifetime Withdrawal Benefit (GLWB)

A GLWB basically allows you to do the same thing as annuitizing, but with a bit more control over your money. Annuitization is almost always irreversible, so as soon as you elect to do it, your account value no longer is considered an asset but is now a lifetime income stream. Instead of annuitizing, you can get a GLWB rider which also gives you guaranteed lifetime income on a single or joint life. But, if there is anything left in your account value when you (and your spouse) pass, your beneficiaries will inherit this asset. Also, if you absolutely need the money later on, you can take more than the allowed GLWB income payment. Be very cautious about taking out more than allowed though, because doing this can cause the lifetime guarantee of this feature to be eliminated or affect your monthly payments if and when you do annuitize.

A death benefit rider will allow the amount left to your beneficiaries to grow by a certain guaranteed* amount every year, or over the life of the annuity. This may be a good solution for those who wants to leave a lump sum to their beneficiaries, but are not healthy enough to get life insurance in a cost-effective manner. The death benefit amount could grow by a certain fixed percentage every year, or by the greater of a fixed percentage or the performance of the account value due to investment gains or a benchmark index increase. Also, some annuities will give a beneficiary the “high water mark” amount of an annuity’s account value. This would allow them to inherit more than the account value when the owner passes if the last few years saw a decline in the account value due to losses. In this case, the highest the account value ever was would be the death benefit amount.

This could also be considered as equivalent to a long-term care rider. The way this rider typically works is that the insurance company allows you to increase the amount of funds you can withdraw if you need custodial care. Sometimes you have to be admitted to a nursing home to qualify; other times you simply need to be eligible for custodial care even if you receive it at home. This rider can be paired with a GLWB where your monthly or annual income amount can be doubled as long as you still qualify. There is usually a limit on this payment acceleration though and may end after a period of 3 years, for example.

Now that you’ve learned about annuity basics, you may have a better idea if one is right for you. Just as with any other financial or insurance product, there is a right fit for each kind of annuity in a variety of situations. But even though we’ve talked about the good and the bad of annuities, it makes the most sense to make your purchasing decision based not only on your particular situation but also on what other retirement products you already have or will purchase. For example, if you already have a large pension, you may want to be more aggressive investing your retirement assets and don’t need an annuity. If you already have long-term care insurance, you don’t need to pay extra for a nursing home rider. Each of these kinds of factors should be taken into account when considering the purchase of an annuity.

I always recommend taking a holistic approach in retirement planning. Annuities are an important piece, but they are only one piece of the puzzle. A solid retirement plan will show the proper pieces of a plan and how much should be allocated to each piece. Each product in your retirement income plan should have a specific job, and annuities are no different. If you’re interested in discussing how best to integrate an annuity into your situation, or if you don’t have a retirement income plan documented, written down, and on paper, then just let me know who you are and the best way to get a hold of you using the form on the right and we can set up a time for a consultation when you’re available.