Last week I hit on a financial vehicle that tends to get a bad rap – annuities. Dun dun dun dun….
I’ve seen a lot of popular financial advisers and finance bloggers preach the evils of this vehicle. For some people, that advise is solid. But for others, annuities might actually be useful. So are annuities a good investment?
Let’s Get On The Same Page Here
First, I want to make sure one thing is clear. Annuities are an insurance product. This isn’t an investment like a mutual fund. It’s very difficult to compare an annuity with another type of investment because they are totally different financial vehicles.
While there are some parallels between traditional investment options and annuities, it’s a fallacy to directly compare the two. They’re totally different products.
A lot people don’t understand the purpose of an annuity. They just think of it as part of an investment portfolio – and then start to compare it with other investment options.
In this discussion a few things always come up. These aren’t invalid points. They are in fact something you should consider. But they don’t end the argument.
Annuities Pay A High Commission
I think this is one of the big reasons annuities have gotten a bad reputation. Annuities pay a high commission.
A lot of financial advisers work on commission. Which means they have a financial incentive to sell you the product that makes them the most money. This has led unscrupulous advisers to sell annuities to people who have no business being in an annuity.
I worked as an independent life and health insurance agent for two years. Trust me when I say, that business is full of people with no morals whatsoever.
Annuities usually pay agents around 6% of the total amount of the contract. That means if you put $100,000 into an annuity, $6,000 goes in the agent’s pocket. That’s a pretty good incentive to sell you an annuity whether you need it or not.
That commission doesn’t come out of thin air – that commission will be paid out of your money. Maybe not directly, but you can bet the insurance company is charging enough via fees to cover the commission and then some.
Annuitites Have Relatively High Fees
Another reason that people hate on annuities is that their fees are much higher than other vehicles. Most charge 2% – 3% of your principal balance each year.
This typically only applies to variable annuities. Fees aren’t usually levied against a fixed annuity due to their nature. Though, the insurance company’s expenses are taken into account when they calculate what your payment will be over the life of the contract.
This can be as much a 10x what you would pay in a low-fee mutual fund. And those fees add up. Every dollar paid in fees is one less dollar that could have been invested.
Annuities Have Lock In Periods And Surrender Fees
And yet another mark against an annuity’s record are the lock in periods and surrender fees that some annuities have.
An annuity can lock you in for as many as 15 years. If you want to get out of the contract for whatever reason during the lock in period, you may pay a surrender fee as high as 10%.
Doom and Gloom! Doom and Gloom!
So far it looks like annuities really suck.
This is often where the conversation ends. The problem is, that’s only half of the story. It only focuses on the negatives.
Tax Benefits of An Annuity
One really great benefit of an annuity is it’s tax-deferred status. Like an IRA and a 401(k), gains are not taxed until you begin taking distributions.
Because of this, an annuity can be used as another retirement vehicle once you have hit the annual limit on 401(k) and IRA contributions. There is no annual cap on annuity contributions. That means you can stash away as much cash as you want and let it grow without paying taxes on the growth until retirement.
Guaranteed Income For Life
Annuities also have a benefit that few financial products can match, guaranteed income for life. These are called guaranteed annuities.
Buying a guaranteed annuity is like creating your own pension. It allows you to leave the stress of portfolio management to the insurance company and just collect your check each month.
Now you don’t get that for free. Like I mentioned above, you will likely pay hefty fees in a variable annuity or will receive a reduced payout in a fixed annuity. But, you have guaranteed cash flow for the rest of your life.
For someone who manages their own portfolio that may sound like a terrible trade-off. The seasoned investor wouldn’t have any problem structuring their own portfolio to provide regular income with minimal risk.
But, I can guarantee you that my grandmother would be totally lost if she had to manage her retirement. On the other hand, she would be thrilled to have the peace of mind that there will be a check in the mail each month regardless of what happens with the markets.
Annuities Can Smooth Out Irregular Cash Flows
Annuities can be used to provide consistent cash flow regardless of what the market is doing. This can save you from having to sell an investment while the market is down because you need the income.
This isn’t the strongest reason to invest in an annuity since similar results can be achieved with bonds, dividend stocks or CDs. But it can be used to serve this purpose.
Annuties aren’t a magical investment, but they aren’t the devil either. Annuities are a special investment that have their own place in retirement planning.
Do you have a bone to pick with annuities? Would you ever consider one as part of your retirement planning?