Annuities are typically considered illiquid, long-term investments. In general, I don’t think anyone would disagree with that view. After all, annuities are designed to be lifetime contracts. However, it would be wrong to assume all annuities are created equal when it comes to liquidity. Instead, it’s important to recognize the differences.
Why Are Annuities Considered Illiquid?
It’s not hard to read statements from both the Financial Industry Regulatory Authority and the Securities and Exchange Commission and conclude that they view annuities as illiquid, long-term investments. In multiple variable and indexed annuity Investor Alerts, both regulatory bodies list liquidity as a consideration and emphasize the long-term nature of these investments.
In addition to the regulators’ views on annuities, these considerations make annuities illiquid too:
- Commission-based annuities with surrender charges will carry a cost to get out of the contract in the first 5 to 10 years.
- Nonqualified annuities will carry tax consequences if liquidated early.
- Optional living and death benefits may be too valuable to surrender the policy.
Can Annuities Be Liquid?
Even with these instances of illiquidity related to annuities, viewing all annuities as automatically illiquid is simply an invalid assumption. Consider the following circumstances:
- Nonqualified annuities beyond the surrender charge period: Without surrender charges, the policy owner can receive the entire value of the annuity at any time. Therefore, the annuity is as liquid as any other investment asset that would create taxable gains upon liquidation.
- Qualified annuities beyond the surrender charge period: Since these investments are taxed the same as other assets in a qualified account, the annuity is as liquid or illiquid as any other investment within the account. If the client truly needs liquidity, there is no advantage or disadvantage to liquidating the annuity as opposed to another asset in the qualified account.
- C-Share and advisory annuities: These carry no surrender charges. Therefore, these annuities can be liquidated by the policy owner at any time at no cost.
- Fixed annuities with a return of premium guarantee: With a fixed annuity guarantee of premium, surrender charges cannot decrease the initial amount invested. At most, the policy owner will sacrifice interest. While this is never a desired outcome, it’s similar to a Certificate of Deposit.
While each client situation is different, the above examples show the potential liquidity available from some annuities.
Why Does This Matter?
Why not just accept the fact that annuities are not a great source of liquidity and, for simplicity sake, categorize them all as illiquid? It matters because suitability rules are built around the concept of concentration.
Most distributors set a maximum annuity concentration guideline of 30%-50% of an individual’s assets, based on liquidity. Within the guidelines, every annuity, no matter what the type and tax status, is illiquid. Here are a few examples with this view:
- An individual with several nonqualified annuities might be prohibited from purchasing an annuity with a living benefit in an IRA because of concentration limits. Additionally, the annuity could ensure a stream of income to satisfy required minimum distributions.
- An individual with a relatively heavy concentration in annuities out of surrender charges could be prohibited from buying another annuity to solve an income gap.
- For someone lacking retirement income, the best retirement solution may be to purchase an immediate or deferred income annuity to provide guaranteed income for life. Despite academic research supporting such a solution, it’s unlikely any distributor would allow such a purchase because of concentration guidelines.
So Where Does This Leave Us?
Let me be clear, I am not advocating for annuities to be considered liquid investments. I am advocating against a one-size-fits-all categorization. Immediate, indexed, fixed and variable annuities all have differences. Nonqualified annuities should be viewed differently than annuities in qualified accounts, as should annuities beyond the surrender charge period or without surrender charges. Last, but not least, it’s crucial to understand the value of any riders before thinking of an annuity as a potential source of liquidity.
With so many different factors to consider between the different types of annuities, it’s difficult to make statements pertaining to annuities in general. This applies to concentration and suitability guidelines as well. While annuities have features individuals need to understand before investing, all disclaimers aside, if we are going to help more clients navigate retirement with limited assets, we must provide a more thoughtful view of annuity concentration.
Withdrawal of taxable amounts from annuities are subject to income tax, and if taken prior to age 59½, a 10% federal tax penalty may apply. Early withdrawals may be subject to withdrawal charges. Partial withdrawals may also reduce benefits available under the contract as well as the amount available upon a full surrender. While certificates of deposit are guaranteed by the Federal Deposit Insurance Corp. up to $250,000 per depositor, annuity guarantees are based on the claims-paying ability of the insurer.
— Related on ThinkAdvisor:
- Fee-Based Annuities Get IRS Nod
- IRS Rules for Nationwide and Lincoln on Annuity Advisory Fees
- The ABCs of Structured Annuities
Scott Stolz is senior vice president, Raymond James Private Client Group Investment Products and Wealth Solutions.