What is an annuity?
An annuity is a contract through which you pay money now to receive a stream of income in the future. While some begin payments shortly after the contract is signed and paid for, most pay only after much time has passed.
There are many types of annuities, all of which entail the negative aspects outlined below. For simplicity and space, the description here focuses on the most heavily promoted product, the variable annuity.
A variable annuity is presented as an investment platform with an array of fund choices. The time gap between paying your premium and later receiving your income is called the ‘accumulation period’ during which the value of the funds within the annuity theoretically grows. When you decide to start receiving payments, the accumulation period ends. On that day, the day of annuitization, the accumulation value is tallied by combining all assets. This accumulation value is multiplied by a factor to determine how much money the annuity will pay you going forward.
Some annuities offer the ability to lock in a fixed dollar amount of income. Others offer minimum amounts of income which could be exceeded if your funds perform better than expected. Many are sold with minimum growth rates of your accumulation value whereby two balances are tracked: your actual investment balance, and a phantom balance that benefits from the minimum growth rate.
Annuities are not bad, conceptually. Arranging for an assured flow of funds streaming in for a given period, perhaps even for the rest of one’s life, is tempting. The problems with annuities relate to their execution.
Why you should avoid Annuities
Sales commissions
One reason annuities are hawked so hard is the huge sales commission, often in the area of 5-10% of the amount invested. If you buy a $100,000 annuity, $5,000 or more of your money can go directly to the rep.
High fees
Administrative costs charged to annuities are notorious, often 2-3% of assets annually. No matter what investments are held in the underlying account, reducing returns by that much each year will crush long-term performance.
Misleading growth guarantees
To counter concerns over high fees and market uncertainties, many annuities are sold with a guaranteed minimum growth rate. However, this minimum growth rate pertains to a nominal accumulating value, the “phantom” balance referred to above. If you want to pull your money out, you only have access to your actual, fee-damaged, market impacted account value. The guaranteed amount is just a number that might be used for calculating payments upon annuitization.
Misleading income guarantees
Following the previous point, you might think the guaranteed growth feature works well as long as you do not pull out early. Unfortunately, the amount of income you receive depends on two figures: the accumulation value and a factor. This factor comes from a table in the annuity contract. A typical table might indicate that for every $1,000 of accumulated value, you could choose to receive $4 per month for life, or $3.50 per month for life with 20 years of payments guaranteed, or some other combination of amount and guaranty. To the point, when annuities offer a guaranteed accumulation growth rate, they usually provide two factor tables. The table used with the guaranteed value will have factors far lower than those in the table used with the actual investment value. After applying these factors, one can estimate real rates of return based solely on cash invested and cash received. As of this writing, annuities advertising guaranteed accumulation growth of 6-7% actually provide returns in the 2-3.5% range. The levels in the guaranty quotes are shams.
Penalties for changing your mind
Exiting an annuity is not cheap. For the first several years after purchase, you will have to pay a surrender charge to get your money back. Penalties often start in the 5-8% range and decline annually until they vanish. The surrender charge provides the seller enough of your money to pay all sales commissions and still leave a healthy profit.
Poor performance
Administrative fees alone impede performance to the point where the underlying portfolios in annuities are destined to do poorly. Additionally, since the underlying funds used in many annuities do not compete directly for assets, fund management is often lackluster.
Lack of control
When you have money in a bank or brokerage account, you can access it at any time. After you purchase an annuity, you have hurdles. Early withdrawal/surrender penalties mean you will not be able to get all of your money back during the first few years. Once the surrender charges finally cease, the amount returned to you will have been depleted from excessive fees paid over all those years. Finally, after the annuity switches from the accumulation phase to the paying annuity phase, you have no access at all to any money beyond the payment stream.
Figure 8-1 demonstrates the net effect of an annuity’s harmful features. Two choices are modeled; an investment account that earns 5% annually and an annuity entailing 1.5% fees (well below average) whose underlying investments also earn 5% annually. After 30 years of accumulation (growth), both choices start paying cash; the annuity using a factor of 6% of the account value on the annuitization date, and the investment account at a pace that leaves nothing at the end of 30 years.
Briefly, lower fees with the same investments allow the investment account to generate 80% more cash flow than the annuity. Given a beginning balance of $100,000, the investment account described provides a 30-year stream of $29,520 per year; the annuity just $16,841 per year. As important, during the life of the investment account, the owner has access to the entire balance. With the annuity, during the accumulation phase the owner has access to a penalty reduced amount in the initial years, fee damaged amounts until annuitization and only the payment stream thereafter.
What you should do instead
If you are considering annuities as a one-stop solution to your investing needs, execute a proper investment regimen instead. Click here for an easy-to-execute plan.
If you are considering annuities as a source of steady cash flow, seek sources of income that avoid all those negatives associated with annuities. Bonds and high dividend stocks or stock funds could make sense. When evaluating these investments, do not be discouraged by yields that seem lower than advertised annuity rates. Annuity yields are not comparable to other yields. With annuities you never get your principal back.
Finally, if you are considering annuities as a retirement / end of life vehicle, know that the annuity dies when you die. There are optional terms you can add to guarantee a certain number of payments should you die soon after payments start, but the cost of these options reduces the rate of return from bad to pathetic.
* Data sources:
The “Regular Investment Account” assumes a deposit of $100,000, 5% annual growth for 30 years, and constant withdrawals calculated to eliminate the balance in 30 years. Given the assumptions, monthly payments are $2,460.05. Over 30 years they add up to $885,618. The annuity assumes a $100,000 purchase with underlying funds earning 5% annually and a 1.5% expense rate. The balance available assumes an early withdrawal penalty of 8%. Cash flow assumes a “factor” of six. Given the assumptions, monthly payments are $1,684.08. Over 30 years they add up to $606,267.