The Pros and Cons of Annuities

Understand the nuances before signing on the dotted line.

By Chris Wang On May 1, 2017

Since the Great Recession, investors – especially those nearing retirement – have been faced with a difficult environment. With short-term interest rates near zero, retirees could not rely on their savings to generate a safe return, so they were forced to look at other investment vehicles. This has led many to consider buying an annuity. With long surrender periods and stiff penalties, it is imperative to understand what is being purchased and who annuities best serve. Let’s look at three types of annuities.

Fixed Annuities – A fixed annuity contract is defined by its set interest rate and can be compared to a CD. With some fixed rate products, investors can get a guaranteed interest rate for a specific period, typically 3 to 10 years, which also equals the surrender period. The key benefit to a fixed annuity is that the principal is protected and the type of income stream it will deliver is clear.

Fixed Indexed Annuities – Another flavor of fixed annuity is the fixed (or equity) indexed annuity, which has exploded in popularity in the last 10 years. This type of annuity provides the contract owner with an investment return that is a function of the change in the level of an index, such as the S&P 500. This appeals to people looking for higher potential growth, but also looking for downside protection. Owners of fixed indexed annuities do not actually own any underlying stocks or bonds. Rather, the return is a based on a mathematical formula that is controlled by caps and spreads set on an annual basis by the issuing insurance company. Indexed annuities provide principal protection with higher interest rates than a CD. However, buyers should never expect equity type returns.

Variable Annuities – With a variable annuity, investors need to make investment decisions by placing funds into sub accounts, which are mutual funds. Returns will vary depending on the performance of the underlying investments, therefore there is downside risk. To make variable annuities more attractive, they are often sold with other bells and whistles (at a cost) like death benefits and income riders. The main problem with variable annuities is their high costs. Once underlying fund fees, rider fees, and administrative fees are considered, total costs can run more than 2 to 3 percent annually.

Pros and Cons – One of the major downsides of annuities is their illiquidity. These investments often carry long surrender periods with high fees. Because of this, it makes sense to limit one’s investment to only a part (25 to 30 percent max) of the overall portfolio. On the positive side, they offer tax deferred growth and the lifetime income is attractive for those in good health who will live a long time. Just remember that annuities are complex products. It is important to understand the product and its nuances before signing on the dotted line.

About the Author: Chris Wang is director of research at Runnymede Capital Management. In addition to researching stocks and bonds, Wang has written reviews of different annuity products to help clients make informed decisions. 

 

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