Should I Buy an Annuity?

I recently wrote a post explaining what annuities are. I admit it was pretty boring and meant to give you the basics. In this post I write about what my opinion on them is. the TL;DR: for the majority of people, annuities are not a good fit.

Here is why.

Annuities have a lot of fees… and taxes

In my last post about annuities, I described a lot of the fees associated with annuities but…

Did I mention taxes?

Annuities aren’t tax-free. They’re tax-deferred. You generally don’t owe taxes on the earnings while the money remains inside the annuity. However, taxes become due when you begin taking withdrawals or receiving payments. If you own a qualified annuity funded entirely with pre-tax dollars, your distributions are generally taxed as ordinary income.

If you purchase a nonqualified annuity with after-tax dollars, you won’t be taxed again on the money you contributed, but the earnings are taxed as ordinary income. This surprises a lot of people who assume they may get taxed at the capital gains rate because they have a variable or fixed indexed annuity. The exact division between taxable earnings and tax-free return of principal depends on whether you take withdrawals or convert the contract into regular annuity payments. And taxes aren’t the only potential drag: some annuities—particularly variable annuities and contracts with optional riders—can carry substantial ongoing fees and surrender charges.

The fees

I wrote about these fees in my last post and I want to reiterate the drag they create:

• Administrative or maintenance fees for keeping the contract active
• Investment management fees (for annuities with underlying investments)
• Mortality and expense (M&E) charges, which compensate the insurer for the guarantees they provide
• Rider fees, if you add optional features to the contract

For example, a variable annuity (VA) can combine M&E charges, administrative expenses, underlying investment expenses and rider fees. Fixed-indexed annuities (FIA) may also advertise few explicit fees while limiting your return through participation rates, index caps and spreads. Together, these can consume 2%–4% of the account value annually. Be very, very suspicious of variable or fixed-indexed annuities.

Simple income annuities work differently. A SPIA or DIA generally don’t come with a list of annual account fees. Instead, the insurer’s expenses, profit and sales compensation are built into the payout it offers you. Again, proceed with caution.

Annuities are a great payday… for your advisor

Insurance salesmen love selling permanent insurance products like whole life policies. Why? Because of the hefty commission they make from selling them. Same with annuities. When an insurance salesperson or advisor sells you an annuity, they can make upwards of 8% commissions on the sale of some of them. If you were to purchase a $250,000 annuity that had an 8% commission, that’s $20,000 going right into the pocket of the salesperson. An annuity may not be the right product for you, but certianly provides a nice payday to your sales person.

You won’t get an invoice or statement that directly says you’re paying this amount. In a commission-based sale, the insurance company structures the product so they recoup their expenses through the product they sell you. Depending on the annuity, these expenses are captured through ongoing charges, surrender periods, spreads, caps or the payout being offered.

Its common that a salesperson may even say the annuity is commission free or is fee-based. This might be technically true. However, there might be an on-going advisory fee. If you can’t make out how the compensation is structured after getting answers to the two following questions, don’t buy the annuity:

How are you compensated on the sale of this annuity?
What are the ongoing costs or limitations of the annuity?
What does the annuity itself cost?

Since the insurance company structures the annuity to recoup the costs it takes to get a new annuitant, getting out of an annuity is very difficult, and it may not be possible once annuitization occurs. Before that, it’s going to cost you if you want to end your annuity contract. Which brings me to another reason I wouldn’t buy an annuity…

Annuities are expensive to get out of

Surrender charges mostly apply to deferred income annuities (DIA). Surrender charges are designed partly to let the insurer recover sales commissions and other acquisition costs if you leave early. Whatever the corporate explanation, the effect on you is the same: your money is locked up unless you are willing to pay. They make it expensive to end your contract in the first 5 to 10 years. For people who may need access to the money they put into an annuity contract, you need to know that access is limited or otherwise costly. If you want to end a $250,000 annuity with a 10% surrender fee in the first year, it could cost you $25,000.

Surrender fees do go down and most even disapear after 10 years, but the odds are high that you might need access to that lump sum of money. Job loss, medical bills, paying for college etc. Plus, many annuities do allow for up to 10% withdrawls, penalty free, but anything over that can lead to surrender penalties/charges.

With a DIA you mitigate one risk (longevity risk) and open yourself up to the risk of being cash poor in the short term. There’s another risk annuities have that is not often talked about during the sales pitch.

It takes years to breakeven on an annuity… if you ever do.

Let’s take for example a DIA life only, no death benefit annuity that a recent retiree, Jim 62, purchases for $250,000 that will start paying out when Jim turns 72 for the rest of his life. This seems like a great option for Jim because his parents lived into their 90s. Unfortunately, Jim passes at age 70. So what happens to his annuity? The following:

Jim received no income payments.
His estate receives nothing.
His beneficiaries receive nothing.
The insurer keeps the entire $250,000 premium.

Now there is an argument to be made that Jim could have purchased a return-of-premium death benefit. However, that would have reduced Jim’s monthly payments. Plus, his beneficiaries would generally receive only the specified premium amount. They would not get ten years of investment growth or compensation for the time value of his money.

The above example seems harsh and points out the main risk of a DIA. Let’s look at SPIAs.

Is the breakeven better with a Single Premium Immediate Annuity?

$150,000 is the average annuity contract amount according to Annuity.org. A $150k SPIA will payout ~$800 to ~$1,350 per month depending on age, gender and the options/riders chosen. If you bought a SPIA at 65 that provided $11,000 in payments a year you would have to live to about 80 to breakeven. If you add riders like survivor protection, refund guarantees or inflation adjustments those lower the payments you receive, sometimes by as much as 30%. Oh, and BTW this is your pre-tax amount.

But there’s another issue… if you’re worried about running out of money, is ~$920 a month giving you piece of mind?

Let’s assume a modest mortgage free retired couple has expenses of about $5,000 a month. If an annuity is supposed to mitigate longevity risk, is trading $150,000 for $920 a month worth it?

SPIAs at $250,000 – $500,000 would provide more meaningful payments. According to immediateannuities.com a 65 year old man/woman should expect about $627/$599 per every $100,000 in single life premium purchased without riders. That’s roughly ~$1,500 a month for a $250,000 single life annuity to ~$3,000 a month for a $500,000 single life annuity. You’ll breakeven after about 14 years when you’re close to 80. Seems reasonable, right?

The annuity paradox

So, if you can afford a $250,000+ annuity without feeling a cash crunch you’re likely solving for a longevity risk you’re not truly at risk for. If you can afford an annuity of this amount, you probably don’t need one. And that brings me to my philosophy on annuities; if you can afford an annuity you probably don’t need one and if you need one you probably can’t afford one.

That is intentionally oversimplified, but it captures the annuity paradox. If purchasing an annuity leaves you short on liquid savings, you cannot afford the loss of flexibility. If you have plenty in liquid assets, you may not need the guarantee an annuity offers. Buying an annuity in this scenario is possible over-engineering.

Do this instead of an annuity.

Before jumping to buy an annuity, make consistent contributions to your retirement accounts and invest in boring indexed S&P 500 or total market indexed funds.

Even if you’re late to the game and start your investing journey at 40, investing $1,000 a month for the next 25 years will get you ~$800,000 at 65 if we assume a 7% interest rate. If you continue investing for two more years you’ll be close to a cool $1,000,000. Ample investment accounts plus Social Security payments (that are like an annuity) could provide a very comfortable retirement.

Another thing you should consider is solving for your biggest expense – housing. Pay off your mortgage before you retire. Grandma and Grandpa Moneyaire retired with very modest retirement savings but they had a paid off house. Being mortgage free has made their retirement comfortable not only from a financial perspective but also a psychological one. We’ve taken a page from their book and also paid off our own mortgage. Though I didn’t think it was the best mathematical move, it’s lifted a huge psychological burden.

Mr. Moneyaire and I do not own an annuity, and one is not part of our current retirement plan. We prefer a paid-off home, liquid savings and a diversified portfolio that we understand and control.

That does not mean every annuity is bad. A simple SPIA or DIA can make sense for someone who has sufficient liquid savings, wants guaranteed income to cover a specific gap in essential expenses and understands exactly what they are giving up in exchange.

But I would never buy an annuity from someone who promised “market upside with no downside,” flashed a guaranteed 6% or 7%+ figure or told me the product had “no fees.” Doubly if the contract cannot be explained clearly. For now, I am keeping our money out of annuities.

Cheers!

Mrs. Moneyaire