I have been fielding more questions from clients over the past year with respect to annuities. Generally, I believe that annuities are sold, not bought. In other words, annuities are pitched by an insurance licensed salesperson as a safe and predictable investment to an uninformed public. Often the sales pitch is something like, “don’t risk your money in the stock market when you can get stock market returns without the chance of losing money”. Who wouldn’t want to make stock market returns without any downside risk? Everyone would, but unfortunately, that is the problem with annuities; they are not what is typically promised or presented to the public. As we often say, if it sounds too good to be true, it probably is. And in these volatile times, this pitch can be very appealing, especially after stock markets dropped more than 30% this past March and economic fears and concerns about political outcomes seem to be constantly on the minds of investors.
There are a variety of annuities, but I am focusing today on fixed and equity-indexed annuities as they seem to be the ones most misunderstood by investors. When it comes to considering any investment, it is important to understand the answers to a few key questions.
What are the benefits of annuities? The main benefit with fixed or equity-indexed annuities is that there are guarantees on your principal. If you hold the annuity for the length of the contract, generally 5, 7, or 10+ years, you will receive your principal back at the end of the contract plus a minimum return. Thus, it is true that you cannot lose money on fixed or equity-indexed annuities like you could with an investment in the stock market. In addition, fixed annuities will generally pay a fixed rate of return over the length of the contract and equity-indexed annuities will pay a return that is related to a stock market index.
What are the potential risks or downsides of annuities? The fixed return or the index-related return you earn, may be significantly lower than the return of a broadly diversified portfolio of stocks and bonds. Thus, you may have trouble keeping up with inflation over the long-term. For instance, the highest paying fixed annuities as of November 2020 are paying 3.20% if you commit to a 10-year contract. With an equity-index annuity, you typically receive only a portion of the return of an index and do not receive any dividends.
Detailed Example: In a point-to-point annuity with an annual reset, based upon the S&P 500 Index, if the S&P 500 return was 8% in a given year, you might earn 4.8% in an equity indexed annuity. Equity-index annuities have caps on your earnings, and it is common to see the cap at 80% or less of the index return, not including dividends. Since the dividend return on the S&P 500 Index is roughly 2%, the index return would be only 6% in the example above and thus, your earnings may be only 4.8% (80% of 6%). An investor in a fund such as the Vanguard Index 500 Fund would have earned 8% over that same time frame as the expense ratio on Vanguard’s Index 500 Fund is almost zero.
It is also common to see a flat percentage cap on earnings, for instance, a 4% or 5% cap annually which is a real bummer when stocks climb significantly like in 2019 when they rose over 30%. Conversely, if the S&P 500 Index declines during any year, you receive no return on an equity-indexed annuity and unlike an investment in an S&P 500 Index Fund, when the market declines, you are at least still receiving dividends which help offset some of the decline in the index. Another potential downside, as you can see from what I have outlined above, is that equity-indexed annuities have a complex structure and can easily be misunderstood by the unsuspecting investor.
What fees are involved in getting into or out of the investment? Usually, you do not pay an upfront sales charge to invest into a fixed or equity-index annuity. However, because you sign a contract between you and the insurance company, you are committed to the investment for a long period of time. If you want access to the money prior to the length of the contract, you will typically pay significant surrender charges to access your investment. For instance, it is not a surprise to see a 10% surrender charge for a fixed annuity if you cash out in year one of a 10-year contract. As an example, an investor who invested $50,000 in an equity-indexed annuity with a 10-year contract and surrender charges of 10%, would pay $5,000 in surrender charges (ouch!) if they changed their mind in the first year and liquidated the annuity.
What are the tax consequences? Unlike traditional stock and bond investments (or mutual funds), annuities cannot take advantage of long-term capital gains rates. Your earnings are instead subject to ordinary income rates. With a non-qualified annuity (an annuity purchased outside of an IRA), the taxation on earnings is deferred until you eventually withdraw money from the annuity. In this way, a non-qualified annuity functions much like a traditional IRA when it comes to taxes. You are gaining the benefit of deferred taxation until withdrawal, but you will pay a higher rate of tax on earnings at the time of withdrawal. For instance, an investor in the 22% ordinary income bracket would pay 22% on their earnings when eventually making withdrawals from a non-qualified annuity. That same investment in a diversified portfolio of stocks and bonds, or mutual funds, would pay only 15% in tax on most of their earnings as they would be able to take advantage of long-term capital gains rates.
I have come across situations where investors were sold a fixed or equity-indexed annuity within an IRA or a Roth IRA. This is particularly damaging to the investor as the benefit of tax deferral is wasted. You would receive tax deferral for free when investing in an IRA or Roth IRA and would not be subject to the investment limitations and potentially high surrender charges associated with annuities.
Does this investment fit my goals and objectives? When I think of how to position a fixed or equity-indexed annuity within a portfolio, I would typically treat that money as part of the fixed income portion of the portfolio, much like a bond, bond fund or CD. As a one-off investment, you need to consider whether you can commit for a long-term and whether you will be happy with returns that are generally lower than the return of a diversified stock and bond portfolio. For most investors, I don’t think the advantages of annuities outweigh the disadvantages. However, for a very conservative investor who is not willing to take any risk with their portfolio, is willing to earn a lower return and is not as concerned about keeping up with inflation, annuities could be suitable. As investors, one of our biggest challenges is keeping up with and surpassing inflation over the long-term so we can preserve or enhance our purchasing power. If you don’t keep up with inflation, eventually your portfolio will not be able to meet your long-term goals and objectives, especially during retirement. I am finding that many of our retired clients spend almost as much time in retirement as they did working!
If you currently own an annuity and would like Bloom Advisors’ opinion on whether that annuity is suitable for your portfolio, please contact me via phone at (248) 932-5200 ext 413 or via email at firstname.lastname@example.org.