Annuities: The Basics, and the 2 Biggest Myths

School of Saving and Investing

Sidewalk with Facts (left) and annuities (right) person deciding which way to go - Annuities - Myth vs Fact presented by Meld University

Annuities are somewhat of an exotic creature in the investment world. Many people have strong opinions on annuities, but as you will see, those opinions aren’t always based on reality. The word ‘annuity’ has even become sensationalized in the media as of late.

In fact, some firms that you may have seen advertised on CNBC or Fox Business base their entire advertising strategy on bashing annuities and anyone who sells them. This can be a very successful sales strategy, but is it entirely based on truth? In this article, we provide the basics on annuities and explore the 2 biggest myths that surround them. We will uncover the facts, like when and how annuities could be used in an intelligent investment strategy.

But first, let’s cover the basics.

Annuities 101

Before we dive into the most pervasive myths surrounding investments in annuities, we should take some time to explain the basics.

What is an annuity?

An annuity is a contract between you and an insurance company where you make an up-front payment or regular payments in return for regular payments beginning either immediately or at some point in the future. Annuities are designed to provide an income stream later, usually during retirement. Funds that accrue are tax-deferred and can only be withdrawn without penalty after age 59 and a half, much like a 401k.

There are many different variations in how annuities are structured, and they can be quite complex. However, to make it easier to understand, they can be classified based on 1) the timing of the payout and 2) the rate at which payments are calculated.

Timing Options for Annuity Payments

When considering an annuity, you will need to determine the timing at which you will begin receiving your payments. There are typically 2 different timing models:

  1. Immediate Annuities
  2. Deferred Annuities

Immediate Annuities

This type of annuity involves an up-front, lump sum purchase, and in return, the investor receives payments until a specific time. The payments start immediately and stop at death or at another predetermined date. You can think of this as the exact opposite of a life insurance policy. You pay the lump sum at the beginning and receive smaller payments throughout the life of the investment. These annuities allow an investor to convert a pile of cash into an income stream.

Deferred Annuities

This type of annuity can involve an up-front investment and / or a stream of investment payments over a specific time-period. The payouts on a deferred annuity do not begin immediately. These payments are scheduled to begin at a designated time in the future (usually retirement) and, like immediate annuities, end at death or another predetermined date. These types of annuities can sometimes be useful for those investors looking for the predictable income stream later in life, such as that of pension income, when that option is unavailable through their employer or other means.

Payment Rate for Annuity Payments

Another factor to consider when shopping annuities is how your payments will be calculated. There is a risk / reward trade-off that must be considered when investing in annuities. You may be presented with one of the 2 following options:

  1. Fixed Rate Annuity
  2. Variable Rate Annuity

Fixed Rate Annuities

There isn’t a great deal of mystery here. Fixed rate annuities have their payments calculated based on a fixed rate of return. With this method, there is no variation in how much your annuity will pay out to you each period. This option carries a lower investment risk for the purchaser as the benefits are defined, much like a pension payment. As with most investments, the lower risk usually translates to lower returns. This is the safest, most predictable annuity configuration.

Variable Rate Annuities

As the name states, these types of annuity payments are not steady. They can vary based on interest rates, underlying investments or other factors determined by the seller of the annuity and the investment company managing the invested funds. As a part of the variable rate, these annuities can carry fees for the management of the underlying investments. Many times, these are the annuities that are “sold” to unwitting customers with high fees and commissions.

What about risk?

Just like most investments, annuities come with their own unique risks. First and foremost, the annuity is only as good as the company that stands behind it. If the issuing company were to fail, you could be at risk of losing your all or part of your investment.

In addition, annuities are generally considered illiquid investments, which means once your invested, it’s difficult to get out. Some annuities may have a “free look” provision which gives you a grace period during which you may terminate the policy and get your money back without paying a surrender charge. A surrender charge is a penalty for making an early withdrawal from your annuity in excess of any stated free withdrawal amount. If you do not have a “free look” provision or if it has expired, you may be liable for these surrender charges in addition to taxes on your gains.

Finally, there are other external factors that can create risk with annuities, such as rising interest rates. For example, if you are locked into an annuity and interest rates rise above your rate of return, you could be missing out on making more money in a less risky investment like government bonds. This never feels good. Some annuities can even be tied to the market, so you could risk losing principal when the underlying investments lose value.

Cutting Through the Noise on Annuities

As we mentioned earlier, annuities have become somewhat of a sensationalized talking point among money managers and investors alike. The salesmen at the big banks want nothing more than to keep the status quo, where they can earn hefty commissions on the sale of annuities – even if they aren’t the best investment available for their clients. Conversely, independent investment advisors are always harping on the dangers of investing in annuities to try and pull those customers away from the large, institutional banks. With all this noise surrounding annuities, it can be difficult to sort the myths from the facts.

Let’s give it a shot.

Myth #1: There’s ALWAYS “a better way” to invest than using annuities

First, it’s important to be careful when dealing with “always” and “never.” Just like with annuities, it’s very rare that absolutes hold true in every case. While it is a well-established fact that the use of annuities is abused in many ways by profit seeking “money managers” whose only drive is making money for themselves, there are some very specific cases where an annuity can be a great investment choice. The internet is rife with cases of large institutional firms steering their clients into high-cost annuities with huge commissions that only serve to enrich themselves. Many firms even incentivize this behavior. We acknowledge that this is a serious issue in our industry, but a smart investor can avoid these problems by paying attention to the detail.

Fact: There is a time and a place for using an appropriately selected annuity

Despite what you may have heard on the internet and tv, annuities can be a good addition to your portfolio in the right situation and when there aren’t huge fees or commissions involved. In most cases, there is a better way to invest, but not always. Only an experienced financial professional can determine if your situation is one of the use cases for an annuity. For example, immediate and deferred fixed annuities generally do not carry high commissions and can provide steady and safe income when that is important. But, there are many other factors to consider, most importantly taxes. You should always seek the advice of an independent financial advisor or private wealth manager before making an investment in annuities. Don’t forget that many annuities include excessive fees and sales commissions, but some are well structured for specific investing situations. Sometimes it may make sense to get a second opinion before making your investments, especially if annuities are a part of the plan.

Myth #2: Annuities are too complex for me to understand.

We agree there are many different options in the annuity universe, and this can be intimidating to the average investor. While some variable rate annuities can be tied a host of different benchmarks to determine their payment rate (which can make these calculations very complex), many fixed rate annuities are fairly straight-forward.

Fact: With proper research and a strong financial advisor, you can get an understanding of how your annuity will pay out.

If you haven’t learned by now, nothing in this world comes easy, especially when there is money at stake. Having said that, you should be confident that you can, with the help of the proper financial professional, understand the ins and outs, risks and rewards associated with any annuity investment. It may not be easy, and it may take a lot of painstaking work, but what is more important that your financial security?

Never be intimidated by financial jargon or sales tactics. If a particular investment product seems too complex to understand, postpone it. If your advisor can’t explain your investments in a way you can understand, find a new advisor. Enlist a wealth manager that you trust and be sure you aren’t being duped into high-commission, high-fee annuities that only serve to enrich the salesman. By understanding the basics and seeking the proper advice, just about anyone can get a good idea of how the investment will pay out, without needing a Master of Finance.

Final Thoughts

It is true that annuities can range from simple, easy to understand investments to complex financial instruments. It takes more than a short article to understand everything you need to know before investing your nest egg, but we hope this information points you in the right direction. For more valuable information on annuities, stay tuned to our website and the Meld University page. If you have questions about this article or other inquiries, don’t hesitate to contact us and set up a no-cost appointment.

At Meld U, our goal is to educate the public on financial matters, so we can all grow wealthy and retire comfortably together. We have an extensive library of financial information online, and we provide no-cost classes on various financial topics to our neighbors in Birmingham on a regular basis. Join us at our next event – view upcoming events.

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