Annuities – Late night TV sales pitch or an appropriate tool for the rich?

 In Blog

There is a HUGE disparity in opinion outside the industry (and frankly, within it too). Are annuities scams by the insurance companies? Are they a panacea?

Let’s dive into the reality…

What is an annuity:

In its simplest form, an annuity is a stream of payments. Here is an awesome visual:

The biggest and well-known annuity – Social Security

The most widely used, and arguably well known, annuity is Social Security. You and your employer pay into the social security system during your working years (via taxes), and when you reach your eligible retirement age, you may begin receiving guaranteed payments from the US Government.

Insurance companies create annuity products too

Like a mutual fund or ETF, there are a wide variety of annuity offerings created by insurance companies which cater to different types of investors and objectives. How the annuity is funded, how it is invested and how it is ultimately withdrawn, make up the nuance and options within this investment category.

How do you fund the annuity?

The two main options for funding annuities are:

  • Single Pay – You make one payment to fully fund the annuity.
  • Periodic Pay – You make periodic payments (ie. monthly, quarterly, annually, etc.)

How is the money invested?

Like other annuity components, you have options for how your money is invested, with pros and cons associated with each option.

  • Fixed annuity – Pays a fixed interest rate
    • Pros: Protects your principal, clarity on how much you will earn
    • Cons: Fixed interest rates tend to be lower than average due to safety provided
  • Indexed annuity – Earns interest based on the performance of an index and has a 0% floor
    • Pros: Protects your principal (0% floor), potential participation of gain in index
    • Cons: Typically come with performance caps – only participate in part of positive index performance (i.e. Annuity’s performance cap is 10%. If underlying index returns 15%, you earn 10%)
  • Variable annuity – May be invested in a broad basket of investments and will perform like an investment account (which means it could lose money)
    • Pros: Participate fully in positive returns of underlying investments
    • Cons: Participate fully in negative returns of underlying investments

How are withdrawals handled?

Once annuity owners decide to begin taking withdrawals (which can be immediately or at a later date), there are two primary options for how they receive the funds:

  • Fixed Period – Annuity company pays you a specified dollar amount for a set period
  • Lifetime Payout – Annuity company pays you a specified dollar amount for the rest of your life (and potentially your surviving beneficiary’s life too)

Who is the “right” candidate to be using these solutions?

  • Ultra-high earners – Take the case of a high earning executive. After maxing out their 401k and IRA, they are out of tax-deferred vehicles. Putting money into an annuity allows the money to grow tax deferred until the funds ultimately come out via distribution or at death if not needed during the lifetime
  • Retirees looking to reduce longevity risk – Social Security eligible retirees will go into retirement with a significant guaranteed monthly income source. For many Americans, Social Security forms the primary basis of income in retirement. For wealthier clients, their planned expenses in retirement may exceed what they will be getting from Social Security. In that case, retirees may choose to cover all or some of their additional income needs by using annuity. In that case, an annuity would serve the same function as Social Security – a guaranteed income stream in retirement. This solution is particularly attractive to conservative minded investors who like the guarantee.

There has been significant negative press surrounding annuities. From our perspective, that is likely because, like all things, there are bad actors who tout them as a cure all. They are not. They are a tax advantaged vehicle for ultra-high earners to save and a way to minimize longevity risk for retirees (among other niche uses).

Cirrus Wealth Management

Finance Napkin,

Annuities are long-term investments designed for retirement purposes. Withdrawals of taxable amounts are subject to income tax and, if taken prior to age 59½, a 10% federal tax penalty may apply. Early withdrawals may be subject to withdrawal charges. Optional riders have limitations and are available for an additional cost through the purchase of a variable annuity contract. Guarantees are based on the claims paying ability of the issuing company.

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