Several clients have sat across from me, first time ever meeting, asked how I felt about annuities, and then charitably contributed the additional disclaimer: “What you say here tells me if we can work together.” Few things in the financial world generate as strong of a reaction as annuities. Why is that? Grown men tell me stories of running for the hills at a single mention of them, while savvy little old ladies have fondly stroked their old annuity contract in my office. What is going on here?
To be clear, the foundational idea of an annuity is innocent and does not deserve all the hate. At its core, an annuity is simply a stream of payments. The basic premise is that you make a trade: you exchange a lump sum of money for the stream of payments. The payments can last for your life, two people’s lives, or a set period of time like 20 years.
Again, nothing so far is crazy or evil or frankly exciting. This could be a great situation or a bad one, depending on how big or small the payments are. So then what happened?
People started getting creative. The financial industry has created all kinds of annuities, adding things on, splicing their DNA with other financial creations, and generally creating some incredibly complex financial instruments. There are all kinds of annuities out there now with all kinds of add-ons. The complexity of some of these products is overwhelming.
Therein lies the problem. Complexity can mask all kinds of things. Sometimes if you dig enough, you can find wonderful opportunities. Other times, underneath that complexity can be little disclaimers and big fees that compromise the entire thesis of the investment.
In the words of Shakespeare’s Hamlet, “Ay, there’s the rub.”
Annuities are known for having fees–often large ones. They also tend to have “surrender periods” where your money is locked up for a certain number of years, and taking the money out early can cause steep penalties. Some of the add-on features are especially expensive, like extra income benefits. Annuities are also one of the corners of the financial world where commissions are frequently collected for selling a product.
This is why people often flee the scene–they don’t like big fees, they don’t like dense contracts easily mistaken for phone books, and they don’t like what they don’t understand. To add fuel to the fire, some investment companies have successfully marketed their distaste for annuities. We shall keep them nameless.
But wait just a moment. What about the savvy old lady who holds her annuity contract in my office and swears it’s the greatest thing since she partied with Ringo Starr? Could she be onto something?
Before you denounce me as a charlatan, hear me out. Annuities have continued to change. For many years, I never purchased annuities for clients. However, there are a few instances where they are not only a real solution, but the solution that is in the best interest of the client. This is where I pause. Conner from 10 years ago would have been up in arms at this point.
Allow me to explain. Here are a few scenarios that make an annuity not just work, but possibly excel as the best answer to some tough problems:
1. Lifetime income: there is no way about it. If you are 65 today, done working, concerned that you are going to live to 118 years old, and your investment portfolio cannot sustain income for that long, where are you left? Consider raising wealth-minded children who love you and promise to care for you forever.
My tongue-in-cheek answer aside, this is where an annuity with lifetime income payments can shine. The income may not be enough to maintain your lifestyle, but it’s something. You will almost certainly come out ahead over the annuity company, because you would blow up any actuarial table they might use if you live that long. Annuities are the original longevity hedge.
2. Guarantees: many annuities are expensive because they can guarantee a fixed rate or offer a hedge against volatility. If you refuse to weather the volatility of markets and other investments, you are left with CDs, savings accounts, bonds, and certain annuities. Annuities often deliver higher guaranteed returns than these other products because of their long timeline and the structure of the product. There is no free lunch–people pay a lot to remove the uncertainty. But in exchange, you know you will at least have lunch (as long as the insurer is still in business). And it sure beats the return of money under the mattress.
3. Medicaid planning: this is where complexity can be an opportunity, not a trap. When someone is struggling with expensive, extended long term care, a household’s assets can rapidly dwindle. With no planning, the healthy spouse’s lifestyle can be jeopardized. They are forced to spend down assets to almost nothing until their spouse can qualify for relief in the form of Medicaid paying for their care. However, an annuity can preserve assets for the healthy spouse. A Qualified Medicaid Annuity, which is a type of SPIA (Single Premium Immediate Annuity), converts assets normally required to be spent into a stream of income payments that do not count towards a couples’ resource level. We work with elder planning and estate attorneys to ensure this is structured properly–Medicaid planning is complex and varies by state. If the choice is to give your assets to a long term care facility or have an annuity paying you income, even recalcitrant annuity-haters might change their tune.
Stories speak louder when you talk about people. There was a woman who was crying in my office. She was crying because her husband needed long term care and they were spending over $18,000/month on his care. She was watching their hard-earned life savings bleed out, convinced it would only stop after almost everything they had was gone. By implementing a Medicaid annuity with the help of myself and a seasoned estate attorney, however, she shielded several hundred thousand dollars from the Medicaid spenddown requirements. The payments from the annuity did not count towards their resource limits, allowing her to preserve her lifestyle and not run out of money herself. Her greatest fear was, in her words, becoming a “bag lady”. An annuity kept her fear from becoming reality.
4. Exchange into low cost, flat-fee annuities: this is one of the more exciting situations to use an annuity. Yes, I just used “exciting” and “annuity” in the same sentence. Many of our new clients near retirement already have annuities that are ten or twenty years old. One bright spot of annuities is that the growth is tax-deferred, much like an IRA or 401(k). The growth is eventually taxed at ordinary income rates, which isn’t friendly, but the deferral is a big deal over time. However, many clients arrive with older, often very expensive annuities. Between death benefit fees, income benefit rider fees, advisor commission fees, mortality and expense fees, administrative fees, and every other oddly named fee you can shake a stick at, clients often pay 2.5-4% or more per year. It doesn’t matter if your growth is tax deferred—your growth is hamstrung by the fees!
Our first instinct might be to get out of the darn thing and stop paying the fees. The problem: after ten or twenty years, even low performing investments can have considerable tax deferred growth. If we surrender the annuity, we could inadvertently trigger a large income tax bill! Depending on the gains in the annuity, we could face a serious setback on the compounding growth if we surrender the annuity.
So what do we do? Are we stuck?
Fortunately, the industry has evolved. Some annuity companies read the writing on the wall and created new, flat-fee variable annuities that are much lower cost and more transparent than their commission-based counterparts. If it is in the best interest of the client, we can exchange one annuity into this lower cost annuity, trigger no tax at all, and significantly reduce expenses. This is known as a 1035 exchange.
And for clients with fixed annuities who may be trapped with a 3% interest rate, for example, this exchange can allow them to invest the proceeds inside a variable annuity in pursuit of higher potential returns. We have clients where the exchange into the lower cost, flat-fee annuity dropped their costs by 50% or more, translating into tens of thousands of dollars of savings per year.
And also most wonderful: there are flat-fee annuities that do not lock up a client’s money. In most cases, the early surrender penalties for annuities I mentioned earlier are not there for these flat-fee annuities. You can remove your money without being subject to a surrender or withdrawal charge. There are also no up- front commissions. Clients can have us manage the annuity and invest them just like one of their typical investment accounts.
Are there any other reasons to hang onto annuities? Sometimes. Don’t be too eager to surrender mom’s ancient annuity with yellowed contract pages that looks like one of the Dead Sea Scrolls. Sometimes old annuities were designed with actuarial assumptions that turned out to be completely wrong, back when the annuity company thought people wouldn’t live as long. The income benefit might be absurdly high, or there might be a death benefit that is unusually good. Insurance companies make mistakes too. Have us take a look at a statement and the contract before you jump to any conclusions. The devil really is in the details when it comes to annuities.
To wrap up, I do not pretend to tell you annuities are good, bad, or ugly. Some are bad. Some are good. Some are so ugly they make onions cry. But the takeaway, no matter which category one falls into, is this: the details matter. We have deep experience in these details. Sometimes I liken annuities to art: the difference between a nice painting of a lady and a Mona Lisa is not apparent to the untrained eye. We can tell you if an annuity is yardsale material or worth proudly displaying in a museum. And across the life of the annuity, the stakes are surprisingly high. Maybe not quite as high as Hamlet’s existential ponderings about life and death, but it can certainly define what kind of income and lifestyle you live.
This information is for educational and informational purposes only and should not be construed as personalized investment advice or a recommendation to buy or sell any specific securities. All investments involve risk, including the potential loss of principal.
Variable annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Guarantees are based on the claims-paying ability of the issuer. Withdrawals made prior to age 59½ are subject to a 10 percent IRS penalty tax, and surrender charges may apply. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. The investment returns and principal value of the available subaccount portfolios will fluctuate, so the value of an investor’s unit, when redeemed, may be worth more or less than the original value. Optional features available may involve additional fees.
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