Annuities: The 'Bad,' the 'Good' and the 'Misunderstood'

For some investors, annuities have an image problem. Read the headlines on the advertisements from a few marketing-focused financial advisers to understand why. They often include words like “scary,” “avoid” and often just plain “bad.”

The problem with this characterization is the total failure to distinguish between the broad categories of annuities and to analyze the features of each. As I said in a recent seminar, you don’t drop your life insurance because you are unhappy with the claim adjuster on your automobile insurance.

In the business of annuities, there are vast differences between “savings annuities,” which are designed to accumulate savings, and “income annuities,” which are designed to pay out income for life. Since, as an insurance executive, I’ve led major innovation in both categories, I believe I’m equipped to set the record straight.

Let’s look at the differences between these annuities, and then you can decide whether they are good, bad or just misunderstood.

Are savings annuities ‘bad’?

Variable annuities are one of the annuity products most often criticized, with some measure of truth. The variable annuity’s main objective is to enable investors to build after-tax savings on a tax-deferred basis through a choice of underlying mutual funds or ETFs. They are sold by brokers. The word “annuity” signifies that the investor has the opportunity (and in some cases a requirement) to convert to an income annuity.

Another series of popular products coming under attack are index annuities sold by insurance agents. Investors’ savings grow by an interest rate that can reflect the performance of a particular stock index. Again, as an annuity, they can be converted to a lifetime payout.

As financial products, these annuities seem neither good nor bad. So, what’s the critique?

1. Complexity. I don’t like using a broad brush, but annuity companies add bells and whistles to differentiate their annuities from their competition, which often confuses the investor.
2. High annual fees and/or back-end surrender charges. Investors need to evaluate whether the fees defeat the value of the benefits for the intended use of the product.
3. High commissions. Brokers and agents tend to receive commissions that are higher than the commissions they get for income annuities or for load mutual funds and bonds.
4. Too good to be true? The downside protection most of these annuities provide requires the companies to adopt complex hedging strategies. That may concern some investors about the risks assumed by annuity companies.

Are these annuities bad just because some advisers say they are? You decide. My concern is that most investors do not fully understand the risks and rewards of savings annuities, and in my opinion, there are often better options, particularly for the mass affluent Baby Boomer.

Are income annuities the ‘good’ annuities?

Income annuities have existed for over 100 years. They are offered by insurance companies that survived not only the Great Recession in the 2000s but also the Great Depression of the 1930s.

They are designed to pay out a guaranteed income, continuing for the life of the annuity holder. And they uniquely assume the risk of the investor of living too long.

With income annuities, you don’t pay management fees or other hidden charges. You hand over an amount of your savings and in return the insurance company makes a monthly payment to you for the rest of your life. The payments are guaranteed, and if you live a long time, you can receive much more than you paid to the insurer.

The insurance company does not invest the money in the stock market. Instead, it generally invests in fixed-income securities and uses “asset-liability” matching based on actuarial tables of people’s longevity. Not everyone lives to a ripe old age. Some die before the average longevity. The insurance company can use that pooling of actuarial risk to afford a larger payment than just paying out interest. It’s called a "survivor credit."

More ‘good’ benefits from a customized income annuity

Consumers can customize an income annuity to their personal situations. You can make sure payments continue to your spouse if you pass away first. You can choose to receive payments adjusted for inflation. Or you can arrange to leave a lump sum to your heirs.

Another feature that facilitates advanced retirement income planning is the ability to select the date income payments start. With a deferred income annuity, you can buy more income to start in the future. One form of deferred income annuity, called a QLAC, purchased out of a rollover IRA, has unique tax benefits.

Income annuities purchased out of non-rollover IRA accounts also offer special tax benefits.

And while you want to shop the market after you customize your annuity, you’ll find the highest-rated companies offer the best rates. If you choose your annuity from a company rated “A” or higher, your guaranteed payments are backed by financially strong companies.

My advice: Read beyond the headlines

Don’t be afraid of income annuities because they share part of their name with savings annuities. Just as life insurance and auto insurance are completely different products for singularly different needs, income annuities and savings annuities are different, too.

I do sometimes recommend a low-cost variable annuity with no living benefit guarantees as long as the annuity is purchased with personal (after-tax) savings. That purchase is followed by a subsequent conversion to income annuities. Otherwise, we manage income risk through carefully considered withdrawals from savings. And to provide true longevity projection, we propose income annuities, both immediate and deferred.

You, of course, should consider your options here very carefully and read beyond the headlines.