Disclosure: Our content isn't financial advice. Do your due diligence and speak to your financial advisor before making any investment decision. We may earn money from products reviewed. (Learn more)
Disclosure: Our content isn't financial advice. Do your due diligence and speak to your financial advisor before making any investment decision. We may earn money from products reviewed. (Learn more)
Retirement investors are often interested in seeking out safe, blue-chip investments that offer guaranteed returns, hence the appeal of bonds and Treasury bills. However, another lesser-known type of fixed-income asset can provide even more impressive returns while offering comparably low levels of risk—annuities.
Annuities investing has become more and more popular in recent years among risk-conscious investors. Rather than securities, these assets are, in fact, a type of written contract that guarantees the delivery of predetermined payments over a long period of time. In most cases, these payments continue until the annuitant’s death.
Guaranteed money for the rest of your life is surely an intriguing proposition. But there are still risks and setbacks to annuity investing that you should know before getting started with this asset type. In this “annuities for dummies” guide, we’ve compiled all the information you need to know if you’re considering investing with annuities with no prior knowledge.
Annuity Investing 101: What Are Annuities?
In financial investing, an annuity is a contract between an insurance company (or reseller) and an investor (the “annuitant”) that guarantees the payment of a specified sum of money at set intervals for a defined or indefinite period of time. Annuities can be thought of as “reverse life insurance policies” because they involve a lump-sum payment to an insurance company in exchange for fixed payments, usually until the annuitant’s death.
Annuities can help cover basic expenses during retirement and provide crucial financial security for those without fixed pensions. The thought of outliving one’s retirement savings is a well-founded fear for many retirees. Hence the benefit of annuities, which provide peace of mind for those concerned about their financial security later in life.
As a financial instrument, annuities are rising in popularity thanks to their low-risk, fixed-income structure. In Q1 2021, global deferred annuity sales eclipsed $58.1 billion, or 28% of the previous year’s total sales figure. Nonetheless, many retirement investors aren’t aware of the investment potential of annuities because they are often overshadowed by more popular fixed-income assets, such as bonds.
Variable vs. Fixed Annuities
There are two main varieties of basic annuities: variable and fixed. Whereas fixed annuities offer guaranteed payments that never fluctuate, variable annuities vary depending on the performance of an underlying mutual fund, index fund, or investment portfolio.
The table below illustrates some of the core differences that distinguish variable vs. fixed annuities.
|Variable Annuities||Fixed Annuities|
|Rate of Return||Fluctuating interest rate based on market performance; more upside potential.||Fixed, pre-determined interest rate.|
|Risk Factors||Interest rate risk and market risk associated with rise and fall in the performance of its underlying assets.||Locked-in for many years.|
|Best Suited For||Risk-tolerant investors looking for higher earning potential.||Low-risk investors looking for guaranteed financial security.|
|Minimum Interest Guarantee||No||Yes|
|Registered as Security||Yes||No|
|Professional Management Fees||Yes||No|
Basically, those willing to take on a little extra risk should consider variable annuities. This is because they hold the potential to generate more returns if the underlying assets perform well. However, fixed annuities offer greater peace of mind and ensure that the annuity holder will receive a steady stream of payments.
Benefits of Annuity Investing
There are myriad benefits that come with investing in annuities. Below, we’ve listed some of the main reasons why annuity investing can benefit your portfolio, no matter what stage you’re at in your investing journey.
- Financial Security: Above all, there’s no greater benefit of annuities than knowing that you will receive steady, guaranteed payments. Annuities provide crucial income security for those without pensions or other income sources during retirement.
- Tax Benefits: Annuities can be contributed to on a tax-deferred basis; in other words, you won’t owe taxes on your investment until you start receiving payments. Before you start taking payments, the annuity can grow without incurring a tax event.
- Guaranteed Returns: Unlike most investment types, annuity investing offers guaranteed rates of return that can provide much-needed assurance for investors with a highly volatile portfolio.
- Death Benefits: When you invest in variable annuities, the insurance company often includes a guaranteed death benefit payable to a beneficiary in case of your early death. This way, you can invest with peace of mind knowing that those who survive you will receive financial security in the event of your passing.
- No Contribution Limits: Unlike IRAs and 401(k) accounts, there are no contribution limits to annuities, so you can continue to grow your annuity in perpetuity.
- No Mandatory Withdrawals: Planning on a late retirement? No worries. Annuities don’t require you to start taking minimum withdrawals at the age of 72 like an IRA or a 401(k) would.
Although they share many similarities, note that the annuities pros and cons between fixed and variable assets are not identical. Refer to the table in the section above for a list of the key differences between these two annuity types.
What Are The Risks of Annuity Investing?
Technically, a fixed annuity is not a true “investment” like a security, bond, cryptocurrency, or physical commodity. This is because there’s no (or, at least, very little) variability in how the annuity will pay out over time. In other words, there’s no financial risk.
Annuitants know exactly how much they will be paid from the contract, and at exactly which times during the year. Therefore, there’s no real uncertainty in the playout of the contract. The only variable is how long the annuitant will live. Indeed, the 50-year-old annuitant buyer who lives until the age of 100 will net a larger “return” than the annuitant who lives until 80 but who buys at the same age.
The risk of dying prematurely is a false risk, in that some believe that dying before one recoups the value of their lump sum investment is considered “losing” on the deal. However, one shouldn’t be overly concerned with their portfolio performance after their death.
In fact, the annuitant, even in the case of early death, still “wins” their side of the deal because they still received the lifelong financial security they initially sought. Only the insurance company also wins because they paid less than they received from the annuitant.
Annuities and Counterparty Risk
The only genuine risk assumed by annuities is counterparty risk. Like virtually all paper-based investment vehicles, annuities rely on the counterparty (e.g., the insurance company) upholding their end of the deal. If for whatever reason, the annuity seller files for bankruptcy and can no longer honor their contractual obligations, the annuitant may see their payments cut off.
Investors can minimize their counterparty risk simply by choosing a trustworthy annuity company that’s been in the business for a long time. Beyond that, you should have an attorney or qualified financial professional review any annuity contract to ensure that the counterparty is backed by a state regulator.
What Are Secondary Market Annuities?
Secondary market annuities (SMAs) are structured settlements in which an annuitant sells their collection rights to a secondary buyer. In other words, it’s like a regular annuity contract, but with a middleman.
Factoring firms legally reassign the annuity from the original owner to the annuity purchaser. From that point forward, all payments will be sent to the investor and not the original annuitant or settlement claimant.
Technically, secondary market annuities are not true annuities. Rather, they’re almost always repackaged lottery winnings or tort settlements (i.e., lawsuit settlements) that are sold for a lump sum or structured payout via a legal qualified order by a state court.
Often, secondary market annuities are paid out in a lump sum to the annuity buyer at a discount. In effect, SMAs take a guaranteed long-term payment structure and sell it for a lesser lump sum payment. Therefore, SMAs don’t technically qualify neither as investments nor as annuities—rather, they are aftermarket financial products.
For more information about purchasing or investing in SMAs, read our full guide to secondary market annuities.
What Are Equity Indexed Annuities?
Certain types of fixed annuities are pegged to the underlying performance of an equity index, such as the Dow Jones Industrial Average (DJIA) or the S&P 500. Investors willing to take on some risk in their annuity investing strategy often opt for equity-indexed annuities because they hold the potential to generate higher returns.
To illustrate how an indexed annuity would work, let’s take the example of an annuity invested in the S&P 500. The total return of the S&P 500 during FY2020 was 18.4%. Therefore, the annuitant would realize some of those gains. How much the annuitant benefits, however, depends on something called the participation rate.
Indexed Annuity Participation Rates Explained
The participation rate is the percentage by which the insurer will multiply the gains of the underlying index, which is then credited to the annuity.
Therefore, an index annuity with a typical participation rate of 80% would credit 14.72% (18.4*.8) to the annuitant’s contract. This, of course, assumes the 2020 S&P 500 return of 18.4% as a baseline. In this case, the indexed annuity would generate an impressive yield (14.72%) but could elicit equally dramatic losses in a down year.
Disadvantages of Equity Indexed Annuities
The rather obvious disadvantage of investing in equity-indexed annuities as opposed to regular fixed annuities is that the former can incur losses. If the underlying index (e.g., DJIA, Nasdaq Composite, or S&P 500) declines in value, your annuity payments will come in lower than their baseline value.
In short, indexed annuities assume more risk than other types of annuities. Investors who seek out annuities as a “safe” asset that generates a guaranteed return would do well to stick to fixed annuities rather than variable or indexed annuities.
There are also several other key disadvantages that potential investors should be aware of before getting started with indexed annuities, including:
- Capped Earnings: Upside gains can be capped out according to terms specified in the contract and therefore not reflect the true performance of the index.
- Surrender Charges: Additional charges apply to those who withdraw their annuity payments prematurely.
- Fee Opacity: Some insurers are not transparent about their fee structure and can tack on hidden or unexpected fees that are taken out of each payment.
- Sales Commissions: High commissions in the 5-8% range is common among indexed annuities and are paid out to the seller by the buyer.
Taken together, these drawbacks to indexed annuity investing shouldn’t necessarily preclude anyone from investing in this asset class. There are still substantial benefits to be gained from purchasing indexed annuities, and they are unique among annuities for having the ability to significantly appreciate in value.
Examples of Top Annuity Investments
There are many trusted annuity companies that can help you invest in annuity products. While your typical brokerage account provider, such as Fidelity or Vanguard, might be able to facilitate annuity transactions, there are also dedicated insurance companies with whom you can deal directly.
Below, we’ve provided a short list of some of the most well-known and trusted annuity providers in the United States.
- AIG Annuities: Specializing in 401(k), 403(b), and 457 Plan annuities.
- John Hancock Annuities: Specializing in variable annuities.
- Jackson Annuities: Specializing in fee-based variable retirement annuities.
- DCF Annuities: Specializing in commission-free “safe growth” annuities.
The companies listed above offer fairly diversified subaccount offerings for annuity investors. For example, Jackson National Life Insurance currently has 110 managed investment options for their variable annuity plans. Therefore, investors have the freedom to choose which funds they want to underlie their variable annuity.
Should You Hold Annuities Within an IRA?
Investors and advisers alike are often torn between holding annuities independently, or within one’s tax-advantaged retirement account.
If you have a self-directed IRA or an employer-sponsored 401(k), it may be tempting to add an annuity so you can take advantage of tax-free or tax-deferred growth. However, we sometimes do not recommend investing in annuities via an IRA.
This is because annuities of all kinds already appreciate on a tax-deferred basis, so there’s no need to waste valuable contribution room on annuity funds that are already tax-sheltered. That is, if you’re only investing in annuities for their tax advantages. However, as we’ve already discussed, there are several other key benefits of annuity investing.
When to Purchase Annuities Within an IRA
Still, there are scenarios in which you might benefit from annuity IRA investing. For instance, those who are close to retirement (i.e., <5 years) might benefit from having the “guaranteed living benefit” of their annuity contract sheltered within an IRA.
The guaranteed living benefit is a rider added to most modern annuities that ensures that a return-of-premium can be invoked while the annuity owner is alive. These riders do two things. First, they ensure that income security is provided while the annuitant is alive. Second, they don’t require annuitizing upfront.
When these kinds of annuities first hit the market in the late 90s and early 2000s, they changed annuity investing forever. Whereas in previous eras annuities were sought exclusively by investors looking for tax deferral benefits, they’re now widely used as a retirement income guarantee.
Suddenly, with the arrival of guaranteed living benefits, investing in annuities through an IRA became popular. This is because, if you want guaranteed income without annuitizing, you would have to put IRA funds into an annuity. Therefore, putting IRA funds into an annuity offers guaranteed lifetime income security on a tax-deferred basis, whereas non-IRA annuities do not offer the same income protection.
The “Don’t Buy an Annuity in an IRA” Myth
If you’re told that, as a rule, you should never invest in an annuity via an IRA, you’re getting outdated information. Before the 1990s, this was generally true in the sense that guaranteed living benefits had not yet been added to most annuity contracts. These days, however, around 60% of annuities are funded by IRAs.
In fact, the chart below (Fig. 1.) indicates the extent to which fixed-rate and variable annuities are being funded by IRAs. By 2012, the majority of indexed and variable annuities were funded by IRAs and 39% of fixed-rate retail annuity sales were also IRA-funded.
Figure 1. Source: LIMRA
Clearly, the days of non-IRA-funded annuities are over. This is because more and more investors are choosing annuities for their income security benefits rather than tax benefits.
Even though the tax benefits of IRAs and annuities are redundant, it’s still both logical and appropriate to invest in annuities through an IRA if you’re looking to take advantage of the guaranteed living benefit—and most annuity investors are.
What Is An Annuity Exclusion Ratio?
In the context of annuity investing, an exclusion ratio is the percentage of an annuity payment excluded from one’s taxable income. In other words, it represents how much of your annuity you will owe taxes on.
The exclusion ratio is simply one’s premium divided by their expected return.
As an example, let’s assume someone purchases a $200,000 annuity before their retirement, and the insurance company estimates that you have a remaining life expectancy of 25 years and agree to a monthly benefit of $775. They also assume that your $200K investment will grow to $275,000 in that amount of time.
In this case, your $200K principal over 25 years would amount to a $667 monthly payment. However, your annuity entitles you to more than that: $775 monthly. The IRS does not consider the first $667 of your annuity payment taxable because it’s simply a return of your initial principal. Only the remaining $107 is taxable.
Therefore, in the example above, we would have an exclusion ratio of about 86%, simply by dividing one’s principal and dividing it by the expected return (e.g., $200K divided by $775*300 months). In other words, 86% of the annuity payments are excluded from taxes.
Investors must note that annuities funded by IRAs, 401(k)s, or any other retirement account do not have exclusion ratios. Rather, these are fully taxable payments.
Don’t Outlive Your Money: 1 Rule for Lifelong Financial Security
Before investing in annuities, it’s important that you ask yourself why you want to invest in them. If you’re like most investors, it’s probably because you want the peace of mind that comes with a guaranteed income during retirement. However, you can avoid needing to invest in annuities if you simply take better care of your retirement savings.
Many investors fear outliving their retirement nest egg. After all, only saving for a 30-year-long retirement but then living an additional 10 years after that would cause a lot of anxiety and hardship during the last decade of that person’s life.
Fortunately, there’s a simple spending rule you can follow to ensure that you don’t spend more than you can afford during your retirement—the “4% Rule”.
The 4% Rule: The Key to a Secure Retirement
The 4% rule (or the “four percent rule”) is a retirement spending rule based on the results of a landmark 1998 research paper entitled the Trinity Study. In short, the study proved that a well-diversified retirement portfolio can be withdrawn at the rate of 4% per year (i.e., 4% of the portfolio’s starting value) without the investor ever running out of money.
Since the Trinity Study is now over two decades old, some investors doubt whether its findings still hold true. Fortunately, RBC Royal Bank ran a subsequent analysis that tested whether the study’s conclusions still hold in the present day. The study found that the 4% rule worked 92% of the time for a 40-year-long retirement in a 75% stock portfolio.
For more information about this crucial spending rule, check out our full-length guide to the 4% rule of retirement withdrawals.
The Final Word on Annuity Investing
When the topic of annuity investing comes up in conversation, before all other questions we’re often asked “Are annuities safe?” The answer, in short, is yes. Annuity investing provides a safe and secure way of generating a consistent income during one’s retirement.
However, not all annuities are created equal. For instance, variable annuities and equity-indexed annuities are inherently riskier than fixed-income annuities. The risk is compensated for by the potential to earn higher returns if the underlying funds perform well.
Risk-conscious investors might want to consider investing in fixed-income annuities, whereas riskier investors could consider variable or indexed annuities. This is because those willing to take on a little extra risk can be rewarded with higher returns, but lose out on the guaranteed income security of fixed annuity contracts.
For Peace of Mind During Retirement, Invest in Annuities Today
Your golden years should be spent doing what you love, without having to fear for your financial security of longevity. Annuities can make that possible.
If you’re interested in getting started investing in annuities, check out our exclusive list of the top annuity companies on the market. There, you’ll find low-fee annuity providers with a wide selection of variable and fixed-rate contracts available, so you can find a policy that matches your risk tolerance and retirement goals.
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