Everything You Need to Know About Annuity Investing

If your clients are looking for ways to create an income stream for retirement, there’s a good chance you’ve at least thought about annuities.

An annuity is an insurance contract through which investors pay premiums in return for a stream of payments for a specific period of time in the future. In some cases, that might include the duration of your client’s life.

There are a lot of benefits to annuities, most notably that they can create a guaranteed income stream for retirees. That said, there are nuances to consider, such as complicated fee structures and tax implications.

How Do Annuities Work/?

Clients will typically enter into an annuity contract a good while before they expect to receive the income stream from the annuity itself. This initial stage, sometimes referred to as the accumulation phase, involves their paying monthly or lump-sum premiums. The money they put into the annuity will be invested and grow tax-deferred. 

Once your client reaches a certain age or period in time, they’ll start receiving regular payments from the financial firm providing the annuity. This is sometimes called the annuitization phase.

Is an Annuity a Good Investment?

Based purely on returns, annuities generally perform worse than investing in the market directly. They also tend to extract high fees, especially when compared with simpler investment strategies.

That said, annuities are a way to guarantee income even in a market downturn. They might also offer a benefit to your loved ones if you die, and can be a good idea if you’ve maxed out other retirement accounts such as 401(k)s. Plus, if you’re concerned about spending too much of your nest egg at once, the steady stream of payments can help you pace yourself.

What Are the Pros and Cons of Annuities?

Reasons someone might get an annuity include:

• Steady income: Annuities can serve as supplemental retirement income, especially for people who may not have saved enough to cover all of their needs. 

• Deferred taxes: In the accumulation phase, clients won’t owe taxes, even while their nest egg grows. They will pay taxes only when they begin withdrawing the money.

• Predictable returns: With a fixed annuity, clients are guaranteed not to lose money. Fixed annuities typically guarantee that the annuity holder will earn at least a certain percentage of their principal investment as earnings.

• Protection in case of death: Variable annuities often include a death benefit; the client nominates someone to receive money if they were to die. In many cases, the death benefit is equal to the amount a person paid into the annuity, regardless of how their investments perform. 

Annuities can be the right fit for many people, but there are some drawbacks to consider as well:

• They can be expensive: Annuities sometimes come with hefty fees. These can sometimes exceed 1% of the account’s value. Then there are the expense ratios for the investment management of annuities tied to market performance. Fixed and indexed annuities tend to be less pricey, though most annuities have surrender charges, which are added fees if you withdraw assets or cancel the contract early.

• They might underperform the broader market: Many annuities have a participation rate; if your participation rate is 80%, then you’ll receive only 80% of the investment growth. If the investment grows massively, you can still notch large gains, but you’ll lag the performance of investing in a similar mutual fund directly. 

• They may lead to higher taxes: A long-term market investment faces the long-term capital gains tax rate when you make a withdrawal. But withdrawals from an annuity are taxed at the regular income tax rate, which in many cases is higher than the capital gains rate. 

• They are illiquid: During the “surrender period,” you’d face a penalty if you touched any of the money. In some cases this can last many years, which is why annuities may not be right for clients who are younger or have more short-term liquidity needs.

• They may be hard to get out of: Particularly when it comes to an immediate annuity, a client may not be able to get their lump sum of money back or pass it along to a beneficiary with any ease — or even at all. 

How Do I Know Which One Is Right for My Client?

Some annuities protect against loss but have a lesser upside; others have more potential for growth but more exposure to market risk. Some are deferred so that annuitants can’t take withdrawals for a certain time period, whereas some are immediate. 

Read on to see which one is right for your client.

Types of Annuities

What Is a Fixed Annuity?

Fixed annuities promise a stated, guaranteed rate of return on contributions. The annuity contract will stipulate this rate of return from the outset, and you can expect that same rate for the duration of the contract.

Pros and Cons

The most notable reason to get an annuity is because it provides predictable returns over a period of time, either a specified number of years or until the end of the policyholder’s life. The main drawback of a fixed annuity is that you’re choosing more reliable returns over potentially higher returns if you were to take on more market risk. 

Who Can Benefit?

Many retirees (or people planning their retirement) choose fixed annuities because of the predictable, guaranteed returns. If you’re going to be depending on this income for your living expenses, it may make sense to seek stability rather than the highest possible returns.

What Is an Indexed Annuity?

Indexed annuities are basically the annuity version of an index fund. These annuity contracts pay returns based on the performance of an index, so returns won’t be as predictable as with a fixed annuity. When the index declines, the annuity holder will receive a minimum rate of return, which can range from 0% to as high as 3%.

Pros and Cons

The main reason to get an indexed annuity is to increase the possible upside; if the market performs well in a given year, then you’ll see more of that benefit. One drawback is that gains are typically capped through a participation rate. Indexed annuities might also have an annual cap on how much you can earn, so if the market booms, you might still see only a piece of the earnings. Who Can Benefit?

Indexed annuities may be a good choice for people who want a more affordable annuity — indexed and fixed annuities tend to have lower fees than variable annuities — but have a higher risk appetite and hunger for market gains.

What Is a Variable Annuity?

A variable annuity is also pegged to investment performance. To the extent that an indexed annuity is similar to an index fund, variable annuities are similar to active mutual funds.

Pros and Cons

The main reason to get a variable annuity is if you’re seeking higher returns than you could find with a fixed annuity. Of course, the downside is you’re exposed to market risk. Many annuities offer a return of premium, meaning you don’t lose your initial investment, but if the value of the underlying investments plummets, you might earn nothing in terms of growth. Variable annuities also tend to come with higher fees.

Is a Variable Annuity Right for My Client?

If they’re interested in an annuity but want to have a higher upside potential, a variable annuity could be a fit.

What Is a Structured Annuity?

Structured annuities are tied to particular indexes such as the S&P 500 or MSCI EAFE, but you can change your investment strategy during the life span of the annuity.

Pros and Cons

Structured annuities allow policyholders to potentially earn higher gains than with an indexed annuity — the trade-off being that they can also cause policyholders to lose money, like with a variable annuity. 

Would a Structured Annuity Be Right for My Client?

Structured annuities may make sense for people who are retired or will retire soon because they provide some downside protection while offering an opportunity for more growth than a fixed annuity. 

What Is a Qualified Annuity?

A qualified annuity is a retirement savings plan that you can contribute to with pretax dollars, such as a 401(k), 403(b) or individual retirement account (IRA).

Pros and Cons

Retirement savings plans can be a great way to prepare for your golden years. The main drawbacks are that they’re tied to the market, so you can lose money. In addition, there are penalties for many types of withdrawals before you reach retirement age. 

Who Can Benefit?

Most people could benefit from saving in a tax-advantaged retirement account. That said, they need to have the risk tolerance to put their principal on the line. They should also have enough liquidity that they can care for their shorter-term financial needs without tapping into these accounts for liquidity.

What Is a Tax-Sheltered Annuity?

A tax-sheltered annuity (TSA) is a type of qualified annuity. It’s an employee benefit specifically offered to employees of public schools and other tax-exempt organizations such as nonprofits. 

Pros and Cons

With a TSA, you can make pretax contributions into a retirement account. In some cases, your employer can also make contributions to your plan. 

Who Can Benefit?

TSAs are available only to employees of nonprofits and other tax-exempt organizations.

What Is a Nonqualified Annuity?

Whereas a qualified annuity is funded with pretax money (for example, taken out of your paycheck for a retirement plan), a nonqualified annuity is funded with money you’ve already paid taxes on. When you start withdrawing from your annuity, you won’t have to pay taxes on the principal, only on the earnings. 

Pros and Cons

If your client will likely be in a lower tax bracket during retirement, it could be favorable to defer taxes on your earnings until you’re in a lower bracket. There are also no limits on how much someone can contribute to a nonqualified plan, whereas there are caps on 401(k) and IRA contributions. A disadvantage is you’ll need to wait to see these tax benefits, whereas qualified annuities would provide a tax break in the near term.

Who Can Benefit?

Most people buying their own annuities outside of a qualified retirement plan will, by definition, be buying nonqualified annuities. These can include fixed, indexed, variable and other annuities.

What Is an Immediate Annuity?

While many people choose deferred annuities — so there’s time between the accumulation phase and the payout phase of the annuity — that doesn’t always have to be the case. With an immediate annuity, someone can deposit a large lump sum into an annuity in exchange for  long-term cash flow.

Pros and Cons

Immediate annuities can be a good fit for those who need the money right away, like if they’re entering retirement. Compared with a deferred annuity, there will be less time for the annuity company to invest and increase your contributions, so future payments will generally be smaller than if you paid in the same amount of money but left more time for earnings growth. 

Who Can Benefit?

Immediate annuities tend to be best for those who want cash flow now, such as someone who won the lottery and wants to create a reliable income flow but doesn’t want to wait before accessing the money. Immediate annuities may be less of a good fit for those with the time to wait for their annuities to grow further.

What Is a Single Life Annuity?

Also called a straight life annuity, a single life annuity can provide for your longevity when there are no other dependents in the picture. This kind of annuity provides a monthly payment as long as you’re alive; when you die, the contract ends. 

Pros and Cons

The biggest pro is that this kind of annuity tends to offer the highest monthly payout. The reason for that is its biggest downside: It doesn’t provide a death benefit or other support to a surviving spouse or other family members.

Who Benefits?

A single life annuity is a good choice for single people or those whose spouses have other sources of income. It’s not an intuitive choice for those who want to use annuities to leave assets behind for others.

Can I Avoid Paying Taxes With Annuities?

Annuities aren’t a tax-avoidance mechanism, though they do offer tax-deferred investment growth. Withdrawals from most annuities will be taxed as income. As explained above, if an annuity is purchased with after-tax income, only the earnings are taxed.

There is no way to completely avoid paying taxes on an annuity.

How Can I Invest in an Annuity?

Once you decide on a type of annuity, you’ll need to choose an annuity provider. Because you’ll be depending on this company over the long haul, you’ll probably want to confirm that the company has strong financial and credit ratings. From there, the next step is to fill out an annuity application and pay the premiums according to the schedule you’ve chosen. 

When Can You Cash Out an Annuity?

Taking money out of an annuity early can lead to large penalties. You’ll generally want to choose an annuity term such that you don’t foresee needing to crack open the egg early. The maturity date on an annuity will depend on the type of annuity you’ve chosen; in the case of an immediate annuity, you can withdraw without penalty right away.

How to Calculate Annuity Payments

The value of an annuity will vary widely depending on what kind it is. An annuity calculator can help you and your client predict how much an annuity will pay over time, how long the withdrawals will last, how much starting principal your client needs to achieve a certain level of ongoing “income” and what growth rate would be required for them to hit their goals. 

For some people, annuities are too expensive and complicated, especially since they yield less than investing in the market directly. For other people, annuities can be a much-needed way to ensure their financial viability for their golden years.

(Image: Chris Nicholls/ALM)