Annuities provide a great way to ensure financial security throughout life.
What is Old is New Again?
Prime time TV is saturated with commercials aimed at senior citizens, extoling the virtues of reverse mortgages promoted by none other than Die Hard 2 actor Fred Thompson (oh yeah he’s also been a Congressman, attorney, and lobbyist) or “The Fonz” (Henry Winkler). In between their promotion of reverse mortgages you might see annuity commercials but few ads pitching annuities get airtime.
Annuities in History
The concept behind annuities has developed over thousands of years. The Roman Empire compensated its soldiers in the form of an annuity payable for life. The first actuarial table was created in Rome. After the fall of the Roman Empire, annuities continued into the middle ages, although they more resembled a contest to see who could live the longest and win the kitty after all the other contributors to the fund died.
By the eighteenth century, annuities were in the United States. However, not until after the 1929 stock market crash did annuities really came into their own, offering wary investors a safer option. By the fifties, variable annuities appeared, and since then, annuities have grown and morphed to include many features. As of 2011, annuity sales were more than $200 billion per year.
Why Annuities Are Considered Insurance Products
The Securities and Exchange Commission (SEC) identifies three general types of annuities: fixed, indexed, and variable. All three types are the same in one respect, however; all are contracts made between an insured individual and an insurance company. Annuities function to provide income at some future date, usually for retirement, and are funded by the insured through a lump sum payment (sometimes they involve payments over time). They offer tax-deferred growth, and withdrawals made during the payout period are not taxed at capital gain rates but at normal tax rates.
Annuities take into account considerations associated with insurance policies, such as age. If the recipient is older, they may receive more money per payment since their life expectancy is shorter. Younger people would likely receive less in the regular payouts. This leads to many seeing annuities as insurance for their retirement.
Discussing the Risk Element of Annuities
No matter who issues them, all investments carry a risk. Fixed annuities are generally “safer” than variable annuities because fixed ones invest in very stable assets. Investors need education about annuities and the risks associated with specific types of annuities.
- Corporate Insolvency: Catastrophic failure of large financial institutions is possible, and no business is infallible or immortal. Clients must understand that an annuity is only as good as the insurance company issuing it. After paying money into an annuity, if an insurance company either fails or is in dire financial straits at payout time, the annuity investment could be lost.
- Inaccessible Assets: Once money goes into an annuity, getting it out prior to the set payout date is difficult and costly. Taxes on early withdrawals from annuities are substantial. In most cases, in addition to paying regular tax on the income earned on the annuity, early withdrawal results in a 10 percent penalty tax as well. On top of taxes, many companies charge penalties for early withdrawal.
- Undersized Nest Eggs: Annuities are not perfect, and may not grow into the comfortable nest egg many anticipated. Even the best calculated annuity plans might provide insufficient income in future years. Additionally, the possibility that an investor may receive only a few payments prior to dying exists, and the insurance company may have no obligation to pay out more to any survivors.
Clients who understand the risks associated with annuities better grasp the role they play in retirement investing, and their value as an investment vehicle. Annuities, like most other investment vehicles, should not be looked at as the perfect investment tool, but instead as a part of a larger, more diversified portfolio.
Annuities Are Becoming More Popular
Despite the above concerns about annuities and their risks, they still belong in many individuals’ portfolios and have enjoyed a steady increase over the last several years. Factors including 9/11, “The Great Recession”, oil and gasoline prices, social security, and rising healthcare costs have certainly played their role in helping support their popularity but mostly because people are getting savvy about their future retirement needs and the information about annuities is in no shortage.
The IRI recently reported that sales across the industry reached $229.4 billion in 2014 representing a 3.8% increase from 2013 and an 8.2% increase from 2012.
Highlights that encourage people to leverage annuities include:
- Money earned in annuities is tax deferred until the time of withdrawal, and there is no limit on the amount invested in an annuity, a great selling point for wealthy clients in need of a way to shelter assets.
- A life payout annuity guarantees a payment until the time of death, even if the payouts exceed the value of the contract.
- Creditors generally cannot access annuities to pay of a decedent’s debts, and annuities do not go through probate.
- Annuities are not considered assets in terms of student financial aid applications
Annuities “…indemnify individuals against the risk of outliving their resources." No wonder many think of annuities as a DIY pension plan.