Annuities have grown in popularity, largely due to their promise of a guaranteed income stream until a client’s death. They can help investors strengthen retirement plans, defer taxes and some can protect against stock market losses, but there are caveats, says Christine Benz, Morningstar’s director of personal finance.
The questions advisors must answer: Is an annuity right for a client? If so, what kind?
In her first of a series looking at how to evaluate annuities, Benz provides an overview of how to answer these questions.
Advisors and clients first must understand the wide variations in types of annuities. Some are simple fixed annuities while others, she says, are complex, and have “opacity of fees, high commissions and advisor incentives” that can make it difficult for clients to evaluate.
Lifetime Income, but…
Guaranteed lifetime income, similar to Social Security, is better than an investment portfolio that can run out of money, Benz notes. By pooling risk with other annuity buyers, those who die early help pay for the others.
Yet an annuity’s “return” isn’t that of an investment, but rather a client’s own capital. Further, it’s not like an investment that can be sold, whereas with an investment, upon sale you at least get part of your original money back.
“Nevertheless, the combination of lifetime income plus a higher payout means that basic income annuities can be a sensible additions to retirees’ tool kits,” Benz writes. This is especially true today considering low yields on safe investments, erosion of pension funds and longer life expectancies. She adds that for married couples, especially those with high incomes, there’s at least a one in four chance that one spouse will make it to 95 years old.
There are other pluses to annuities, such as protection against stock market losses, typically with equity indexed annuities. Using options, these products protect the downside, but also cap the upside, Benz writes. “That means that returns on equity indexed annuities tend to fall between stocks and high-quality bonds. The products can also be incredibly complicated.”