How Annuities Work...

Melissa Kolcz |

On the surface annuities sound pretty great; a guaranteed stream of income for the rest of your life. And with the volatility we've experienced in the last 12 months, the word "guaranteed" can sound very enticing, especially if you're nearing or already in retirement. But there is nothing "surface level" about annuities.

Our biggest concern with annuities is the lack of flexibility. Life is too unpredictable to lock away your money into a product that will charge you if you need to access cash in the short term.

There are many different types of annuities- ranging from immediate or deferred, fixed or variable- and you can easily get lost reading a contract trying to understand all the details and costs. In theory annuities may sound great, but in practice, they are rarely the most suitable choice for investors planning for the future.

How many of you have pictured your life 5, 10, or 15 years from now? And how many of us have historically accurately predicted what came to fruition, accounting for every twist and turn that life threw at us along the way? The chances of prediction with 100% accuracy are slim to none. Another reason annuities can be a poor choice for your savings; they require a long-term commitment and do not account for unforeseen expenses that may prompt an early withdrawal.

If you invest your life savings in an annuity product and for some reason you needed to cash out early, you'd have to pay the annuity company a fee just to get your own money back! This fee, also known as a surrender charge, is normally in place for the first nine or ten years of the contract and can be as high as 7% of your portfolio value (typically they decline by 1% per year until it reaches 0%). That means if you purchased a $350k annuity and needed the money back a year later, you'd have to pay $24,500 in fees. Not to mention the insurance broker who sold you the annuity product in the first place has already earned their commission off the sale and that doesn't get returned.

Our next issue with annuities is the word "guaranteed." The insurance broker will emphasize this word throughout their entire sales pitch, but perhaps you should be asking what's the "opportunity cost?" In other words, what are you giving up to lock in that guaranteed stream of income? How much upside are you missing out on for the downside protection? 

What you will not hear about during the sales pitch is the Performance Cap. This is the maximum return you can receive on your investment in a given year. For example, if you have a Performance Cap of 5% on your investment and the market returns 11% in a given year, you have just given up 6% to the insurance company. Theoretically you could take the money and invest it in the stock market instead, allocated appropriately for your age, goals, risk tolerance, and time horizon. Furthermore, you could invest your money in index funds that have very low expense ratios compared with the annual fees you'll find in annuities. This means you accept the risk of the market, but you also get more flexibility and lower costs.

Finally, how confident are you in the insurance company and their ability to pay you this stream of income when it comes time? Have you done your homework and checked the credit ratings of the company? Have you checked with the state insurance commissioner to see if there is any protection offered if the company defaults?

Annuities can play a role in your retirement, but they shouldn't play the lead. You need to understand the product before making a decision that is aligned with your financial goals. Before you go and sign on the dotted line, consult with your advisor at Beacon. We have a fiduciary responsibility to make recommendations that are in your best interest and we will help determine if an annuity makes sense in your full financial picture. We are here and happy to be a resource for you.

Warm regards,

Your Team at Beacon Financial Planning of Cape Cod