Why This Topic Matters
My wife Cindie suggested that I write a blog post about annuities. My mother had annuities, so I started learning about them when I was helping her. Since that time, I have reviewed more annuities of friends who came to me for advice. An annuity is an investment with an insurance company, so I have seen more than one annuity in the mix. Sadly, most of the annuities sold to my friends were not worth the money, especially if the friend was younger than 65. As a general rule, if you are younger than 65, I would encourage you to avoid any annuity. You should have a different perspective. If you want life insurance, buy term life insurance. Don’t buy an annuity.
You should navigate slowly through this piece of your investment puzzle. It is not my intention to say that annuities are evil or that they should never be considered. However, most of the people who plan for retirement using an IRA, ROTH IRA, 401(k), and even Social Security, probably don’t need an annuity. If you have Social Security and perhaps even a decent pension, the need for an annuity is questionable if you have been doing a good job saving for retirement.
Because there is a lot to cover, this will be the first in a series of articles about annuities. Each one will shed some light on this type of insurance investment.
Worry and the Annuity
On March 27, 2017, I wrote a piece called “Worry and the Annuity.” It was related to some of the things I learned about annuities as I was helping mom with some of her financial decisions. I talked about some basics about annuities and questions the prudent person should ask the annuity salesman, their financial advisor, and even a wise investor who doesn’t sell them. There are a lot of different flavors, just like there are a lot of ice cream flavors. That is one of the reasons annuities are hard to understand. LINK to WORRY and the ANNUITY.
An Annuity is an Expensive Life Insurance Product
When we were newlyweds, an insurance salesman sold us a “whole life insurance policy.” It sounded like the best of two worlds. 1) It was life insurance. Most husbands care about providing for their bride. 2) It had the potential to grow just like an investment does.
However, after more thought, we decided to cancel the policy. It seemed better to buy term life insurance and invest the difference in real investments. An annuity is a similar product. It combines some income for yourself and/or your spouse with the possibility for some growth in the value of the annuity. I touched on some of my concerns in a November 2018 blog post.
Understand What you are Buying
In the November 2018 blog post I said, “Don’t buy an annuity voluntarily unless you completely understand that you are buying a life insurance product that essentially will benefit the insurance company and their agents far more than you will benefit. The additional ‘riders’ to make the annuity better are expensive. Riders are optional enhancements that are available on your annuity contract at an additional cost. Often these include an income component or death benefit you must pay for. The standard death benefit is often ‘return of premium.’ Think of that as the worst possible return you could get. If you are paying into Social Security, you already own an under-performing annuity. You don’t need another one.”
That paragraph might have been a tad bit unfair, but for most people, it might be enough to get them to go slowly when considering alternatives to investments they already have.
Let’s Get Started
What have I seen that has caused me to be hesitant to recommend annuities to family and friends? Here we go…
- Is Income for Life Needed? Most retirees who did a good job saving during their working years don’t need an annuity. Are you being told you should buy an annuity to have “income for life?” There is a fear element in this approach to get you started down the annuity road. Everyone, even the wealthy, are concerned that they might outlive their resources or that a major stock market crisis could destroy their wealth and income stream. Fear is a great motivator that is used by those selling anything. New car extended warranties, appliance extended warranties, dental insurance, and even the warranties Amazon offers on many low-cost products are often fear based. If something breaks (my tooth or my car), I want a free replacement. Understand this: the insurance company plans to make money and they do make money. Do you know why these solutions are offered? Because they make more money for the seller than the product often does. Be afraid of, or skeptical of those who try to convince you with all of the problems you might face twenty years from now.
- Other income is probably already relatively certain. Do you have other reasonably consistent income sources? If you will receive Social Security, you already have a government-provided annuity. If you have a federal, state, or municipal pension, you already have a reasonably certain source of income. If you have a diversified set of bonds or bond ETF investments, it is highly likely that you will continue to see that income. In fact, if you own stocks or equity ETFs, the probability of receiving regular monthly and/or quarterly income is reasonably certain.
- Annuities are complicated so we just trust someone else. Should we? It is far too easy to trust an advisor who knows more than you do. They might be helping you, but they are also helping themselves. You should ask them, “how much will you receive from selling me an annuity?” If your advisor was recommended by another friend or family member you respect, you are probably inclined to be less vigilant and skeptical. Perhaps your friend was sold the annuity product they did not understand based more on fear than on facts and reality. Please understand that I am not calling into question the integrity of your advisor. Nevertheless, ask them a lot of questions. This is not something to decide in an hour.
- Annuities are expensive and underperform the S&P 500. “Well,” you say, “you get what you pay for.” Perhaps you do. But I have found that all of my friends who put their money into an annuity did not understand the costs. They also did not understand the poor growth they would see from their annuity investment. The reason the annuity probably underperforms is that the insurance company gets to keep most of the profits from your investments in a good year.
I reviewed one annuity this month where the annuity has grown in value less than ten percent in some very good stock market years. The S&P index returned 28.7% in 2021, 18.4% in 2020, and 31.5% in 2019. My friend’s annuity grew by an average of 2.6% in those same three years.
You can rightly argue that the annuity protects you during down years. There is a measure of truth in that defense. However, in the last twelve years (2010-2021), only one year saw the S&P 500 go down. For two other years (2011 and 2015) the market was just barely positive.
- How much of an annuity do you really need? If you have a lot of assets, it can be tempting to put a large chunk of money into an annuity. More isn’t necessarily better. If you put far more into the annuity than is necessary to cover your expenses, you are likely to lose opportunities for better income and growth from your investment portfolio. For example, one of my friends has a very nice federal pension plus social security. These already cover all of her living expenses with at least $1,000 per month of excess income. The annuity she purchased sold was a very good idea at the time she decided to purchase it. It became very unnecessary when her husband passed away. Unfortunately, the surrender cost in the early years is very steep. It isn’t surprising that it can cost more than 10% of the value of the annuity to exit and invest elsewhere.
- Are you your own worst enemy? If you buy an annuity, do you then handcuff your advisor so that they cannot be more aggressive with your remaining investments? If you do that, you are certain to realize substandard returns on your other investments. If you have an annuity, avoid bonds and cash. It is a mistake for you to fail to let your advisor approach their other investments in a more aggressive investing approach for future needs.
In the next post I will talk about the advantages of annuities. There are reasons some older adults might want to have an annuity. Then, I hope to talk about the disadvantages. I also plan to share how you can select the best annuity for your needs and provide some web sites that can be helpful in the choice of an annuity.