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Annuities: How They Work & 5 Things To Know


Ah, time seems to fly by, doesn’t it? Just two weeks ago, I wrote the first part of my series, Investments You Should Consider For Safety, outlining bonds, money market funds, and certificates of deposit. However, I left out annuities due to their complexity and controversy. 

Thus, today, I will dive deep into what annuities are and outline them so that you can make a competent decision on whether or not they belong in your retirement plan. 

Importantly, annuities are a niche product for hyper-risk-averse individuals and are not something everyone should own

What is an annuity?

Simply put, an annuity is a contract between you and an insurer where you provide funds for a specified period in return for a guaranteed return and payments in the future. 

Wait, annuities are insurance products?

Yes! Annuities are absolutely insurance products, which is why so many companies that sell life insurance sell annuities.

There are no guarantees with traditional investments like stocks, as the stock price could go up, down, or sideways. However, when you buy an annuity, you place dollars with an insurer to guarantee a future return. 

Notably, state insurance commissioners regulate two of the three types of annuities, rather than the Securities and Exchange Commission (SEC). Steve Ark of Slightly Early Retirement happily points this out, too.

Are you looking to grow or live on your wealth? 

When buying an annuity, it is essential to know that annuities will provide one of two functions: either accumulation or distribution. 

Accumulation refers to using an annuity to grow your money through the guarantees an insurer provides. These annuities are known as deferred annuities since you defer using the money into the future in return for growth. 

Therefore, distribution refers to using an annuity for immediate income. Thus, these are known as immediate annuities.

Consequently, immediate annuities are comparable to a pension plan, while deferred annuities are similar to a certificate of deposit. One provides you an income source until death, while the other incorporates growth and safety for a specified period.

(A subset of immediate annuities, known as fixed-period, exist and guarantee recurring payments for a set period, such as 20 or 30 years, instead of one’s lifetime. However, they are not as common since you are left without income or savings once they are up. Additionally, when a deferred annuity contract is up, it doesn’t immediately payout, and instead, it continues to accrue interest at a much lower rate.)

Want both?

Often, deferred annuities offer conversions into immediate annuities at the end of their contract period. When converting a deferred into an immediate annuity, the process is known as annuitizing.

Why should you buy an annuity?

Annuities provide certainty and peace of mind for those who must have the money in something insured by a guarantee. Thus, they are for risk-averse individuals. 

If you hate uncertainty and it makes you frantic to imagine a 10-20% decline in your retirement savings, then an annuity could be worth considering. However, unless you cannot sleep at night given the thought of a potential loss, an annuity is probably not right for you. 

Nevertheless, if you want certainty and minimal risk, an annuity could be worth considering. Here’s why:

•Guaranteed annual return*
•Guaraneteed payments for life (when buying an immediate annuity)*
•Protection from creditors
•Portion of payments are non-taxable (since they are a return of principal)
•At maturity, deferred annuities can offer withdrawal flexibility, being withdrawn at once or taken as needed, or annuitized

*Importantly, guaranteed means so long as the annuity provider (i.e., insurance company) is around. Notably, there are (some) safeguards for policyholders in situations where insurance providers become insolvent, which will be covered further later.

Why shouldn’t you buy an annuity?

•Annuities are complex products with high fees
•Annuities have lackluster performance compared to the traditional retirement 60/40 stock and bond portfolio
•Annuities are illiquid, locking money up for a set period or the remainder of one’s life
•Annuities are challenging to cancel early, often having high surrender charges and stipulations
•Growth is taxable as ordinary income. Some argue this is beneficial since the rich can use deferred annuities to shelter their growth until retirement. I demur since long-term capital gains are more favorable for such individuals. Thus, this is a negative, not a benefit
•And lastly, any gains are assessed a 10% penalty if used before age 59.5. That means if you decide to withdraw the funds as a lump sum at maturity, any interest earned is penalized by Uncle Sam. Thus, you essentially have to keep your money in annuity products until 59.5 or turn the funds into an immediate annuity if you don’t want the growth to be penalized. Ick!

Use qualified retirement accounts up to the contribution limits and a brokerage account for anything in excess

What are the different types of annuities?

Okay, so by now, you are surely wondering, what are the different types of annuities? I’m glad you asked! Annuities come in three flavors: fixed, indexed, and variable. 

Fixed and indexed annuities are strictly insurance products and have no SEC oversight and instead are regulated at the state level by your insurance commissioner. Variable annuities, however, are regulated by the SEC, making them an investment product in an insurance wrapper.

Now, let’s dive deeper.

Fixed Annuities

Fixed annuities are relatively simple: you provide an insurance company money in return for a guaranteed repayment and interest rate. 

With deferred fixed annuities, you agree to give an insurance company your money for X number of years, usually at least three, and during that period, your money compounds at an agreed-upon interest rate.

Deferred Fixed Annuity Example: A 3 year deferred fixed annuity at 3% would grow $10,000 to $10,927.27 by the end of the contract. 

With immediate fixed annuities, you make an irrevocable contract to provide an insurance company with a one-time lump sum payment in return for a stream of income with a guaranteed growth rate for the duration of your life. If you live until 70, they pay, and if you live to 120, they still pay.

Immediate Fixed Annuity Example: You provide the insurance company $100,000 at age 65 in return for $1,000 a month that grows by 3% annually for the remainder of your life until you pass at age 93.

Important pause

Out of the three types, fixed annuities are the simplest, and simplicity is king when it comes to annuities. Why? Because if you cannot understand the product, you will likely be oversold and taken advantage of by a salesperson – I mean financial advisor/consultant. 

My peers in the financial services industry will presumably have disdain for my sentiment. Still, I stand firmly, and I believe that fixed annuities are the only ones to consider. And even then, only a subset of the population should consider fixed annuities since they are for those who cannot tolerate risk.

(Because I am an advisor myself, I have to state the disclaimer that this is neither advice nor a recommendation, only informational.)

Notwithstanding the above, I will explain the two additional types of annuities. However, if you don’t care to learn about them because you don’t want to buy an expensive and complex product, which you shouldn’t, then feel free to skip down to “What happens if my annuity provider fails and goes out of business?”

Indexed Annuities

Indexed annuities, commonly referred to as fixed-indexed and equity-indexed annuities, provide increased growth potential through an interest rate tied to an index, generally the S&P 500, but with safeguards to prevent a loss of funds. Additionally, they provide a minimum growth rate each year. Thus, they offer the potential to earn more comparable returns to traditional investments over their fixed annuity brethren.

Immediate Indexed Annuity Example: You provide the insurance company $100,000 at age 65 in return for $1,000/month for the remainder of your life. During this period, the payment will grow by a minimum of 2% annually, even when the S&P 500 goes down. However, during years when the S&P 500 rises, the payment will increase by 80% of the index’s first 10% in annual gains.

That hurt my head to write, but such contracts are commonplace with indexed annuities. Essentially, they guarantee an annual minimum growth rate. Then, if the index they follow increases that year, they will follow it, but generally, not 1:1, and the maximum gains are capped.

Participation rate

The participation rate refers to how much of the index’s gains your annuity will experience. If you have an 80% participation rate, you receive 80% of the index’s gains. Thus if the S&P 500 rises by 10%, your payment would increase by 8%.

The cap

Importantly, indexed annuities have caps on returns. Commonly, if the index rises above a set amount, let’s say 10%, you will not receive gains above that amount. Thus, if you are capped at 10% with an 80% participation rate, you would only ever see your payments increase by 8%, even in years when the index rises by 30%+.

If this sounds confusing, rest assured, it is. Indexed annuities are confusing products with high fees due to the guaranteed minimums, increased complexity, and potential for higher returns. And you know what they say about high fees, lower returns!

Variable Annuities

Variable annuities are an investment product rather than an insurance one. With insurance products, an insurance company can do whatever they see fit with your money once they receive it: they can spend, invest, or even do nothing with it. All that matters is that the insurer provides the guaranteed growth rate and either the lump sum or indefinite payments. 

Thus, when money is received from fixed and indexed, deferred/immediate annuities, it is placed in the insurer’s “general” account for all customers who buy annuities, term life insurance, and other insurance products.

Ontheotherhand, with deferred variable annuities, rather than taking your money and placing it in their general account, the insurer opens and deposits your funds into a “separate” account. Then, you choose from a list of mutual funds for your deposit to be invested within. However, since the funds are literally invested, there is both stock and bond market risk. Thus, with deferred variable annuities, there is the potential to lose money. 

Note: Some insurers also offer the ability to invest in a fixed annuity as a sub-component of your variable annuity.

Now, if you choose to annuitize a deferred variable annuity into an immediate annuity, you often can decide to take it as a fixed or variable, recurring payment. Spoiler alert, fixed payments are not the same as fixed annuities.

Instead, fixed payments are where you agree to a static dollar amount that you will receive for the duration of the annuity (i.e., your life). In contrast, variable payments are where the recurring payments fluctuate based on the investment performance of your previously selected investments. 

Now, let’s be clear: it would be asinine to choose the variable payment option for most people, as immediate annuities are intended to provide income security. However, on the flip side, if you select the fixed route, your payments never increase in value, even when there is inflation. Instead, they remain the same, eroding your purchasing power over time. 

Thus, both scenarios are less than ideal, with the latter being the lesser of two evils.

And notably, once annuitized, your deferred variable annuity separate account goes away, which is acceptable since the insurer now takes on the risk of you living well past an average age and having to continue payments. Thus, a variable annuity is only an insurance product once annuitized.

What happens if my annuity provider fails and goes out of business?

You may be wondering, what happens to my annuity if the insurer goes belly up, and the good news is that there is insurance for your insurance product! With fixed and indexed annuities, state guarantee associations provide coverage. However, consumers are protected only up to $250,000 in payments on average (click here for a state by state list). 

Therefore, only buy from a reputable company that is likely to outlive you. The worst thing that could happen is the company goes under, and after you exhaust $250,000 in payments, you have no money left and another decade to live. (It is also why you should never rely solely on annuities for retirement, either. Diversify your portfolio!)

Deferred variable annuities and insurer insolvency

Since deferred variable annuities are an investment product, consumer protection is different when an insurer goes belly up. Instead of relying solely on a state guarantee association, you rely on your separate account, which the company was not allowed to spend since it was never theirs. Therefore, even if they go belly up, you still own your mutual funds, which are SIPC insured to $500,000. Notably, if you utilized a fixed sub-account within a variable annuity, your state insurer association would cover such a portion.

Now, once the deferred variable annuity is annuitized, you rely on the state insurer association if your insurer goes bankrupt since you solely have insurance, not an investment.

Riders o̶f̶ for the storm

A conversation about annuities wouldn’t be complete without discussing riders.

Riders refer to features that can be added to your annuity for an added cost and are essentially the optional bells and whistles available to “customize” your annuity. 

Remember, though, these bells and whistles are not free and add cost and complexity to your annuity, so be wary. Just because you can add something doesn’t mean you should.

Examples of common annuity riders include cost of living adjustments, increased disability income, and guaranteed minimum income benefits.

Because of their guarantees, annuities pay substantially less interest than what could be earned through index fund investing

Commonly asked questions about annuities – FAQs

Are annuities a scam?

No, they are not. However, it is easy to be scammed and oversold an annuity that you do not need. Most individuals do not need an annuity, and if an advisor recommends one, you should consider getting a second opinion from a fiduciary. Importantly, if you cannot understand the annuity, you should avoid the product. Period.

What happens to my immediate annuity if I die right after it starts?

Generally, most annuities have a minimum payout period in cases of premature death.

What happens to my deferred annuity if I die?

Typically, if you die while your annuity is in the accumulation phase, your beneficiaries would receive all or part of the money back.

Who Buys Annuities?

Investors who are risk averse tend to be the most suitable for annuities as an investment class.

What are the disadvantages of an annuity?

Annuities are complex products with high fees that tend to have lackluster performance compared to other asset classes. Further, they are illiquid and lockup monies for an extended period and have heft surrender charges for cancellations.

In closing

Annuities are complex financial instruments that a primarily insurance products, not investments. Despite having a bad rap in the financial independence community, which they deserve due to being oversold, annuities can make sense for highly risk-averse individuals. 

If you decide to consider an annuity, please be cautious and only seriously consider fixed annuities, and such products are generally easier to understand and have fewer fees and complexity. And remember, consider getting a second opinion from a fiduciary if your advisor recommends an annuity.

What do you think about annuities? Have you ever bought one, and if so, why? Have your experiences with annuities been good or bad? Let me know in the comments below, and as always, have a great day.

Mile High Finance Guy

finance demystified, one mountain at a time

mile high finance guy

4 thoughts on “Annuities: How They Work & 5 Things To Know”

  1. Thank you for the post it is very informative. Unfortunately I have 2 variable annuities. How do you know when to annuitize the variable annuities. Age 76 they have gmib and guaranteed death benefits. What info should I use in determining when to annuitize? Thanks

    1. Gina, I am glad you found the post informative and I am sorry to hear that you were sold such products. Regarding annuitization, most annuities are never annuitized (link). Nevertheless, it really comes down to if you need the guaranteed income stream. If you do not, regular withdraws of the balance you have accrued tends to be the more popular option, especially with GMIB riders. Since I do not know your specific situation, I would suggest using a planning tool, such as Fidelity’s Retirement Analysis tool, or seeking out a independent (fiduciary) financial planner, that works on an hourly basis or for a flat fee. Using the tool Fidelity provides (link) is free and allows you to run infinite scenarios. I think this option is great if you feel confident in your own planning acumen, since you can see the direct impact annuitizing versus not annuitizing will make. If not, the independent fiduciary route will be worth the cost for the peace of mind they can provide. But remember, you do not have to annuitize and most people do not.

      1. Thank you
        Just trying to maximize investment made
        Thanks for links these are very helpful
        Any recommendations on independent financial provider if I decide to go that way. Seems like many don’t understand the nuances of annuities

        1. Gina, I am glad you found this post of value! Regarding independent financial providers, I do not have any recommendations. But, where possible, I would recommend to find one that is a CFP (Certified Financial Planner), since they must act in your best interest as a fiduciary.

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