The world of finance has a number of “four-letter words” that people consider dirty. Among them:
But here we want to focus on another word—a longer word—used in financial planning that some people regard as especially bad. It’s the word “annuity.”
Why do so many feel this way? And should they? Are annuities a bad idea? Or, are they a smart, conservative option for some people?
One definition of “annuity” is “a payment for the rest of your life.” Some federal employees, when talking about their pensions, will say, “I have an annuity.”
Another definition of “annuity” could be “a bucket of assets that you have set aside in a conservative manner.” This would be an accumulation of assets that aren’t at any risk of loss due to stock market exposure.
Here, we’re going to be talking about that second kind—not the “income for the rest of your life” type of annuity that federal employees have. Usually, people who have a pension, Social Security, and a spouse’s Social Security aren’t looking for another guaranteed check for the rest of their life. They’re looking for a safer investment of their other assets.
So, we’re going to look at the kind of annuity that is essentially an accumulation of assets invested conservatively, and we’ll try to answer the question “Is that something you need in your portfolio?”
Three Types of Annuities
There are three basic types of annuities:
- A fixed-income annuity
- A fixed index annuity
- A variable annuity
The three have similarities, but they’re different. We’re focusing here on a fixed index annuity.
The Pros and Cons of Fixed Index Annuities
The Benefits of Fixed Index Annuities
What are the benefits of a fixed index annuity? One advantage is that you get to participate in the market in the indexes that are inside your particular fixed annuity program.
Another pro is that there is no risk of loss due to stock market performance. In other words, there’s kind of a “floor,” where you know that what you have now—the premium you put in originally—is safe. It’s not at risk based on how the stock market performs.
The Downsides of Fixed Index Annuities
What are the cons of a fixed index annuity?
One is that it has a time limit attached to it. When you choose an annuity, you enter into a contract with the insurance company and that contract specifies how long you have to keep your money in the annuity. So, there are five-year annuities, eight-year annuities, 10-year annuities, 14-year annuities—we could keep going on and on.
When you’re considering an annuity, that should be a consideration. Make sure that the specified time horizon works for you. Is there a chance you may need those assets in the near future? For some people, that’s a downside.
The money in an annuity is not 100% liquid. You can’t get to 100% of your money without paying a penalty. Most will give you access to 10% of your money. So, let’s say, for example, you have a $100,000 annuity. Next year, you’d only be able to get to $10,000 of that money (without paying a penalty).
Common Annuity Questions
Annuities definitely raise a lot of questions. Here are four common ones:
1. “What if I don’t want my money tied up for that long?”
One way to get around an annuity’s contractual time provisions is simply to have other funds set aside in other investment accounts that are 100% available.
At Christy Capital, we like to use the imagery of having “financial buckets.” In this case, you’d want to have a bucket of assets that’s 100% available. Maybe that money has a certain tax status like nonqualified or it’s in a traditional IRA. The idea is not to have just one bucket of money.
Another question that confuses people is…
2. “When I die, what happens to the money in my annuity?”
With an income annuity where you’ve turned on a payment for the rest of your life, let’s say you collect that payment for five years and then die. There is some gray area about how much your beneficiary may receive.
But with the fixed index annuity we’re talking about here, you’re not turning on a payment. It’s just an accumulation bucket. Generally, your beneficiary will get whatever the balance is at the time of your death. So, that doesn’t have to be a point of concern.
We’ve lived through this with clients who’ve passed away. Their beneficiaries received 100% of the balance in the account just like they would in a mutual fund. There’s no difference.
Here’s another question people have:
3. “Isn’t an annuity basically just life insurance?”
Life insurance companies do two things. They offer life insurance, and they offer annuities. But with an annuity, you’re not paying for a death benefit (and being charged for that). You’re simply putting an amount of money in a conservative investment bucket so it can grow. It’s not in the stock market, but its growth is tied to how certain stock market indexes work. So, it’s a great option. It’s not a dirty word.
One fact to be aware of…when you enter into an annuity contract, it’s a legally binding agreement between you and the insurance company. Therefore, the contract will be a bit lengthy. All that paperwork can be intimidating, but it’s there for your protection.
4. “So, should I add a fixed index annuity to my portfolio?”
You have choices. And some may not be most suitable for you. As you look across the spectrum of conservative options that are available to you—bonds, cash, annuities, you’ll want one that makes sense not just from a numbers standpoint, but also from a suitability standpoint.
That’s why it’s wise to sit down with a fiduciary (i.e., a financial advisor who is sworn to seek your best interests.) A good one will look at your goals, find out what your risk tolerance level is, and make sure you have the right buckets in your plan as well as the right strategy for filling them.