In tough economic times annuities often become much more attractive to investors than they normally would.  But do you really need an annuity?  What about all those fees associated with annuities?  Let’s take a deeper look. 

An annuity is basically an insurance product that wraps around some form of traditional investment option or investment fund.  An investment option could be a growth fund, or income fund.  They are specifically designed to provide some form of guaranteed payment over a specific period of time, or for life.  So far, so good, but why would you want one?

For retirement you should have various sources of income to combine for your total “retirement income”.  The most critical element of your retirement income is a guaranteed income portion which you cannot outlive, and which meets your most basic living needs.  Social Security usually fills a portion of this guaranteed element, as do many public pension plans such as CALPERS.  However, we find that most people will only complement Social Security with a non-guaranteed supplemental income element like their 401(k). 

As we’ve recently seen 401(k) assets can be subject to the whims of market forces which can seriously impact one’s overall retirement income.  For this reason annuities are important in that they can add to Social Security to form a wider base of guaranteed income which is not subject to market fluctuations.  401(k) assets can be used for the discretionary portion of your retirement income which is generally used for fun activities and extras.  It is possible, of course, to construct a steady income using highly rated bonds and CD’s but there is no guarantee the assets will last for the rest of your life. 

Since guarantees are so critical to this discussion let’s touch on them here.  Remember, annuities are insurance products and offer an additional layer of protection to not outlive your assets subject to the claims-paying ability and financial stability of the issuing insurance company.  If the insurance company goes belly-up, there is no longer any guarantee.  So when investing in an annuity the financial stability of the insurance company is paramount to the annuity purchase decision.  This can be contrasted with Social Security and other public pension plans which are backed by the taxing authorities of US, State, and City Governments.  In other words, annuity guarantees are only as good as the insurance company’s financial stability whereas Social Security guarantees are backed by the US government.   

Annuities are not for everyone.  First, if you have another form of guaranteed retirement income like a defined benefit plan (CALSTRS, CALPERS), that generates sufficient income for basic needs you probably don’t need an annuity.  However, over the last few decades we have seen the erosion of employer provided defined benefit plans.  They have been replaced by defined contribution plans like 401(k)’s which do not guarantee retirement income.  So for folks with just Social Security and a 401(k), an annuity can make financial sense. 

What about the surrender charges and “other” fees typically charged on annuities?  Annuities come in two basic forms; deferred annuities and immediate annuities.  There are no surrender charges on immediate annuities.  An immediate annuity is purchased with a lump sum of cash in exchange for a set guaranteed series of payments over a number of years or for life.  There is no going back once you purchase an immediate annuity (there is generally a 10 to 30 day right of cancellation depending on the specific product and legal requirements).  Deferred annuities do not provide a set guaranteed series of payments until they are “annuitized”.  Prior to annuitizing, the insurance company will place a “surrender charge” on the assets invested to discourage you from withdrawing your money early. 

Insurance companies do this for two reasons.  First, annuities are fairly conservative investment vehicles.  Underlying assets are generally invested in less liquid, safer investments.  In other words, it’s not a simple thing for the insurance company to just sell an underlying asset and give it back to you without incurring some loss on their side.  Secondly, insurance companies must recoup their upfront sales costs.  They cannot do this if you cash out early.  The good news is that annuities will waive or reduce surrender charges after a pre-determined number of years. 

Yes, there are “other” fees associated with the insurance element of the annuity contract.  Remember you are purchasing a guarantee to not outlive the annuity assets and these fees are basically the insurance cost for this protection.  These fees can range from 2-3% per year.  Not bad considering you have a guarantee not to outlive your retirement income. 

In the end, annuities are not a rip-off and actually serve a valid purpose.  We are not suggesting you run off and place all of your retirement assets into an annuity.  We still have to consider diversification over all asset classes.  So if an annuity makes sense for you, maybe 5% to 25% of your retirement assets are appropriate to place in an annuity. 

Like cars, there are many makes and models of annuities.  Once you’ve determined the need you should call your life insurance provider and discuss your annuity options.  Also, Mark Allen is California Insurance licensed (#0G29808) and can answer any questions or concerns about your life-insurance and annuity needs. 

Any discussion about annuities requires specific disclosures to protect you the investor.  Thus, please read the following disclosures:

Variable annuities involve risk and may lose investment value.  Investment returns are not guaranteed, Investors must consider the investment objectives, risks, charges and expenses of the investment company carefully before investing.  Make sure you know the financial strength of any company before investing. 

Without a proper IRS approved plan, withdrawals prior to age 59 ½ may be subject to a 10% Federal Tax penalty and a 2.5% California State Tax penalty.  Withdrawals may also be subject to ordinary income tax. 

A variable annuity may have higher expenses than some other types of investments.  These expenses pay for additional benefits and riders.  These benefits may not be available on other types of investments.