I began questioning how many people understand the difference between different types of annuities after I received an email this week from one of my Snider Investment Method™ Workshop graduates. Annuities come in a thousand different flavors and colors. No two are exactly alike.
I think most people lump them together without understanding the difference. Or maybe they just think I automatically think all annuities are bad. That is not true. I think MOST annuities are bad and the rest have very limited application.
Annuities are basically either fixed or variable and either immediate or deferred. Beyond that, the permutations become endless. That is one of their drawbacks. They are very complicated, almost impossible to compare apples to apples, and very few people understand what they are buying when they buy them. Nowhere in the investment world is buyer’s remorse more prevalent, in my experience, than with buyers of annuities.
A fixed annuity is an insurance contract that promises you, or you and your spouse, a predetermined income for as long as you live–no matter how long that might be. For example, you pay the insurance company a lump sum of $100,000, say, and they promise you $3,000 to $6,000 a year for the rest of your life.
The advantage of a fixed annuity is that it provides you with a guaranteed cash flow indefinitely – provided, of course, the insurance company remains solvent. If you live a long time after buying the annuity, you may even receive more in payments than you put in. The second advantage is its consistency. You know exactly how much you are going to get. The amount does not fluctuate with market conditions or interest rates.
The downside is, when you die, the remainder of your initial payment belongs to the insurance company. Your heirs get nothing. Another disadvantage is that most fixed annuities are just that – fixed. The amount you receive each year remains constant so the purchasing power is eaten away, over time, by inflation. Finally, it is highly likely that even a conservative investor can get far better returns than the annuity.
When is a fixed annuity appropriate? The only time a fixed annuity makes sense to me is for an extremely risk-averse investor. An example would be someone who has almost no retirement savings, no other sources of income, and for whom the loss of even a single dollar would be catastrophic. Even then, the problem I have is you can do so much better with just a smidgeon of extra risk using CDs and bonds.
A variable annuity, on the other hand, is very different. The initial investment is invested in a range of investment options, usually mutual funds, called subaccounts. The amount of money you receive is, as the name implies, variable, and is based on the performance of the investments.
Variable annuities are generally reviled by all but those who sell them. The problems are legion and I won’t go into them here. If you are interested, you can check out my previous posts on the subject, my interview with Gary Schatsky, chairman emeritus of the National Association of Financial Planners on the subject, or get a quick run down of the problem from two good articles here and here.
I never, ever, ever recommend a variable annuity. Bring on the angry email from the insurance salesmen. I don’t care. You can’t convince me otherwise.
The other characteristic of annuities is immediate versus deferred. An immediate annuity begins paying out immediately.
A deferred annuity has an accumulation phase and a payout phase. During the accumulation phase, you contribute to the annuity and hopefully give the principal time to grow. When you reach retirement age, you can elect to annuitize the principal, in which case you would begin receiving regular periodic payments, like a fixed annuity, or you can request a lump sum distribution.
While I admit there may be specific scenarios in which an annuity makes some sense, my general advice is, be they fixed or variable, immediate or deferred, annuities are an investment you can probably do without.