Considering an annuity? Know the facts first

Kyle Thompson, CFP®, CPA

Mention the word annuity to anyone and you’re likely to get a mouthful of fervent advice. One person will tell you annuities are the best and only way to ensure guaranteed lifetime income. Another will warn you to stay far (far!) away from any annuity and anyone who tries to sell you one. As a Certified Financial Planner™, I believe the truth lies somewhere smack in the middle. Whether an annuity makes sense as part of your overall plan or not depends entirely on one thing: you.

The biggest problem I see with annuities right now is that lots of salespeople are selling lots of annuities to lots of people—regardless of whether the products are a wise fit. Sales of annuities reached nearly $32 billion in the second quarter of 2018, up more than 25% compared to the prior three months alone. While those pushing annuities would love to credit rising consumer demand for the increase, it’s far more likely that the dramatic rise in sales has much more to do with the demise of the DOL fiduciary rule and rising interest rates. Regardless, advertising for annuities is skyrocketing, which makes it more important than ever that you understand the pros and cons of annuities before jumping on the bandwagon.

The topic struck close to home this week when I was reviewing the investment holdings of a couple that has just started working with us. As we always do with new clients, we began by closely analyzing their current portfolio and making recommendations based on their needs and goals. I was immediately surprised when I saw two annuities included on their list of assets. Why? To begin with, they have a sizable portfolio and are accustomed to and quite comfortable with market volatility. Their portfolio also includes ample diversification of account types, including a smart mix of taxable, tax-deferred, and tax-exempt investments. Knowing all of that, annuities just didn’t make sense. To make matters worse, one of the annuities was tucked inside an IRA account, effectively erasing the attractive tax benefits of tax-deferred growth of the annuity while effectively limiting the opportunity for growth. When I asked why they had annuities—and why one was held in their IRA—they didn’t have a clear answer. It had been recommended and the words “guaranteed lifetime income” sounded great, so they signed on.

Luckily, in this case we have plenty of time to redirect the assets to be in alignment with their overall financial plan. We will hold on to the annuity that’s sitting in the IRA until the surrender charges expire and then reinvest those assets more appropriately. The taxable annuity will be transferred to a lower-cost annuity using a tax-free exchange to significantly reduce the fees.

In this case, the problem isn’t the annuities themselves, but the fact that they don’t make sense for a couple who is comfortable with investing, has a solid retirement income plan, and has a comprehensive, tax-efficient financial plan designed to grow their assets over time. That said, an annuity can be the right choice in a few unique situations, including:

  • Your #1 concern is guaranteed, predictable retirement income. If you are not seeking to grow your assets but are concerned only about the need to receive guaranteed, predictable income in retirement, a fixed annuity may be the answer. Unlike CDs or savings accounts, annuities offer slightly enhanced returns with tax-deferred growth. While your portfolio will grow at a much slower rate than if it were invested in the market, you will have the security you’re looking for with an annuity product.
  • You’ve already maxed out every other tax-advantaged savings option. If you have a sizable net worth, it’s possible that you’re already contributing the maximum allowable amount into your 401(k), IRA, HSA, Roth IRA, or other retirement savings vehicles. In this case, investing in a variable annuity may provide a welcome option to help shelter your leftover cash assets in a tax-deferred manner.
  • You’re terrified of the stock market. The financial crisis created a lot of fear—especially among people in or near retirement who now feel they can’t risk another dramatic downturn. If that’s you, a fixed annuity is certainly a better option than burying your cash in the backyard or tucking it into a low-interest CD. Again, it won’t help you significantly grow your assets over time (which the stock market has demonstrated its ability to do long before and after every past correction), but it will keep your money safe while offering some valuable tax benefits.

Why aren’t annuities an appropriate option for nearly everyone else? Here’s the short list:

Annuities tie up your assets for 6 to 10 years (sometimes even longer). Your money is completely inaccessible to use for unexpected healthcare expenses, a smart investment opportunity, or to fund a long-held goal.

Most annuities do not transfer benefits to your heirs. If you die younger than hoped (or planned), your assets go to the insurance company instead of being transferred to your loved ones. That’s how annuities reward the seller rather than the buyer.

Annuities aren’t usually needed for tax-deferred growth. While they are marketed as a great vehicle for this purpose, most people who buy them already have more than enough of their assets invested in other more benefit-rich vehicles like 401(k)s and IRAs.

Annuities are the most expensive investment options on the market! Yes, your money is protected, but to offer that protection, insurance companies must charge a premium that guarantees not only your retirement income, but also their profits.

Any good financial advisor will tell you that how you choose to invest your money depends on you. Your needs. Your goals. And your comfort with risk. If you understand the downside of an annuity and still feel it’s the best choice for you, do your homework. Look for a low-cost option that keeps fees to a minimum to help maximize your income. Also keep in mind that your approach doesn’t have to be all or nothing. Consider investing just 10%-15% of your assets in an annuity and the remainder in vehicles that provide greater opportunities for growth.

All that said, in almost every case I can think of, annuities really only make sense if you’re not working with a trusted financial advisor whose job it is to create a comprehensive financial plan designed to deliver all the income you need in retirement. Without that ongoing guidance, it can be all too easy to fall prey to your emotions and make poor financial decisions at the worst possible time. With that guidance, you can have confidence that your portfolio is structured to help you meet your long-term goals while taking full advantage of the power of the capital markets. The decision is up to you.

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Wondering if the annuities that you have were the right decision for your financial situation? Give me a call to speak more about how annuities may or may not fit within your financial plan!

Kyle Thompson, CFP®, CPA
Senior Financial Planner & Partner


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