Busting the Myth That “All Annuities Are the Same – And They Are All Bad”
Don’t Fall for These Untruths About a Misunderstood Retirement Income Vehicle
The following excerpt, written by Leslie Davis, is from our book, Momma’s Secret Recipe for Retirement Success. Get your copy here to read more!
It may sound silly, but I feel bad for the word “Annuity” because the poor little fella gets criticized daily! It seems like 50% of the individuals I’ve met think they hate annuities, while 50% think they love them. To me, an annuity is not just a type of financial vehicle per se, but also a collection of valuable benefits.
For example, let’s say you’re having a B-B-Q with your closest neighbors one evening. The neighbor to the right of you owns a beautiful new Tesla, it’s red add shiny, sitting on display in his driveway. You overhear the owner of this beauty telling the neighbor on your left how much he loves cars and wants four more. It just so happens that this neighbor to the left owns a Yugo from the 1980s. The Yugo’s owner responds by saying, “I hate cars, they are the worst, I never want another car!” The word car recalls four wheels that get you from point “A” to point “B”, but you can’t put a Tesla and Yugo in the same “car” category, just like you can’t put all annuities into one “annuity” category.
When you talk about or hear about an annuity, the first thing you must discern is what type of annuity is being discussed, because you don’t want to make the mistake of calling a Tesla and a Yugo the same thing, right?
Previously, we discussed the basics of a fixed index annuity with an income rider. You learned that Fixed Index Annuities with an Income Rider provide principal protection against market losses, the potential for growth through interest credits based on an external index, guaranteed income for life that does not take away the owner’s control of the asset, the ability to pass the remainder of your account value at death to your beneficiaries, and typically, a low total annual fee structure between 1.00% and 1.25%.
The late great John Wooden is often quoted as saying, “It’s what you learn after you know it all, that really counts.” So now let’s breakdown the other three main types of annuities and give each their own credit or lack thereof:
- Single-Premium Immediate Annuity
- Fixed Deferred Annuity
- Variable Annuity
Single-Premium Immediate Annuity
The oldest, and probably most recognizable, type of annuity is called a “Single Premium Immediate Annuity” or SPIA for short. Here, you pay a lump sum to an insurance company and the insurance company guarantees to pay you income monthly, quarterly, semi-annually, or annually for a specific time or for as long as you live, even if you live to be 200 years old! This payout can be established for a single-life or joint-life, single or joint-life with the remainder of the premium guaranteed to be refunded, or a guaranteed period of payments such as five years or longer. These annuities will typically pay an overall interest rate that is higher than CD rates. Most of these annuities do not have an annual fee or front-end loads. The guaranteed income payments are not affected by stock market volatility or losses. Investopedia defines an immediate annuity as:
“An immediate payment annuity is an annuity contract that is purchased with a single payment and pays a guaranteed income that starts almost immediately. Also called a “single-premium immediate annuity (SPIA),” “income annuity” or simply an “immediate annuity,” an immediate payment annuity generally starts payment one month after a premium is paid and continues for as long as the annuitant (buyer) is alive or for a specific period. The longer an annuitant lives the better their return will be. Such annuities are especially suitable for retirees who are concerned about outliving their savings.”
Like social security, you cannot request an advance paycheck or a lump sum payout. There is no opportunity for growth as this type of annuity is meant for one thing and one thing only: income. Once the insurer has your funds, you almost always lose control of your asset moving forward, save for the guaranteed payments you receive.
Depending on how long you receive income payments, you could easily “use up” all your principal over time, which reduces or eliminates the monies that could be passed on as a legacy to your heirs. In this case, your family is essentially “disinherited” because the insurer typically keeps any funds left at the time of death. This last point is where the phrase, “the insurance company keeps your money if you die” comes from.
Fixed Deferred Annuity
The second type of annuity is called a “Fixed Deferred Annuity”, in which you pay a lump sum to an insurance company; some contracts will also allow for additional periodic premiums, and your annuity is guaranteed to earn a stated minimum interest rate and could receive an even higher interest rate. The insurance company then pays you a guaranteed interest rate each year and pays you guaranteed income or your principal plus interest at some time in the future, meaning your income benefit is deferred. Your principal and income are not affected by stock market volatility or losses.
Investopedia defines a fixed deferred annuity as:
“A type of annuity contract that allows for the accumulation of capital on a tax-deferred basis. In exchange for a lump sum of capital, a life insurance company credits the annuity account with a guaranteed fixed interest rate while guaranteeing the principal investment. A fixed annuity can be annuitized to provide the annuitant with a guaranteed income payout for a specified term or for life.”
There are special types of Fixed Deferred Annuities called “Multi-Year Guaranteed Annuities” or “MYGA” for short. MYGA’s are very similar to a CD but have added benefits. MYGA’s provide a fixed interest rate guaranteed for a set number of years, for example, “4% guaranteed for 5 years.” Most fixed deferred annuities do not have a front-end load and do not assess annual fees, but almost all of them will assess a surrender charge for a specific time frame for premature withdrawals.
Almost all fixed deferred annuities will offer access to 10% of your funds per year without penalties starting after 12 months. All growth is tax-deferred until withdrawn. All growth withdrawn is taxed as ordinary income when withdrawn, unless qualified as a Roth IRA and may be subject to an additional 10% tax penalty before age 59½.
SEE ALSO: Annuities 101
The third type of annuity is called a Variable Annuity, also known as a “VA”. A Variable Annuity is considered a “Security” in the same way stocks and mutual funds is because the entire Variable Annuity value can decrease, meaning you can lose principal, from market volatility and fees. With a Variable Annuity, you pay the insurance company a lump sum of money and the insurance company allows you to allocate your money into one or more subaccounts, which invest in underlying mutual funds, but they are managed by the insurance company. Your subaccounts will increase or decrease each year providing you a gain or loss for the year. All interest is tax-deferred until withdrawn, at which time it is taxed as ordinary income and may be subject to an additional 10% tax penalty before age 59½.
Investopedia defines a variable annuity as:
“A variable annuity is a type of annuity contract that allows for the accumulation of capital on a tax-deferred basis. As opposed to a fixed annuity that offers a guaranteed interest rate and a minimum payment at annuitization, variable annuities offer investors the opportunity to generate higher rates of returns by investing in equity and bond subaccounts. If a variable annuity is annuitized for income, the income payments can vary based on the performance of the subaccounts.”
You have a potentially higher upside with potentially higher risk. Unfortunately, if you are lucky enough to benefit from a higher potential upside, the typical fees inside a Variable Annuity can be high and can eat away at your gains. There can be a death benefit, typically at an added fee, that affords some level of protection for the beneficiaries. You can also buy a rider to provide guaranteed lifetime income in many variable annuities. Most Variable Annuities do not have a front-end load, but total annual fees can reach as high as 6.5% per year, every year.
Variable Annuities seem to be responsible for most of the controversy and bad press on annuities. The problem is that many people, even respected financial professionals, lump ALL annuities into one category, and try to make all annuities sound bad so that they can promote whatever asset they are selling. I’ve seen it time and time again.
Don’t Fall for the Myth
As you can see, not all annuities are the same – and they aren’t all bad either. That’s why it is so important that we continue to educate ourselves. Although there are many opinions on what we should invest in, continued advancement changes those options so quickly that we must keep our eyes and ears open.
If you have questions about any type of annuity and you’d like an experienced, professional take on whether one of them is the right vehicle for you, contact us today. At Peak Financial Freedom Group, we help our clients design customized retirement income plans to bring them the financial freedom they desire. We would love to do the same for you!