Annuities. The topic may sound boring to most, but it can incite rows in the financial planning community. Some advisors, particularly those who sell annuities, are ardent advocates while most in the fee-only community tend to dislike them. It turns out that not all annuities are created equal. We’ll go through the major categories to see which ones might be appropriate for your situation.
Immediate annuities. These are annuities in their purest form that work similar to a pension. With an immediate annuity, you’re buying your own pension. In return for an upfront lump sum payment to an insurance company, you will receive a fixed payment every month for the rest of your life.
As an example, with current prices a 65 year old couple could purchase an immediate annuity for $100,000 that pays $461 each month as long as at least one of them is alive. Single people would receive a slightly higher amount. Quick math gives you a 5.5 percent payout ratio, which sounds fantastic as a guaranteed return. But don’t be fooled as the reason they pay more than bonds are so-called mortality credits. They don’t return your principal and are often worthless upon your passing.
There are also the oxymoronically named deferred immediate annuities. With these you pay now for a stream of payments that begin in the future. Using the example above, a 60 year old couple with $100,000 could receive $537 a month starting five years from now.
Immediate annuities can be a reasonable way to take a portion of your portfolio and move it to guaranteed income. It is an irrevocable decision in most cases, so measure twice before paying the premium. Plus, it’s particularly important that you verify the insurance company has sound finances. It’s possible you could lose some of the promised payments if the company goes belly up depending on the state guaranty fund. Another downside is that the payout ratios are less than in previous years, as they are based in part on prevailing low interest rates.
Qualified longevity annuity contracts. Known as QLACs, with these annuities you purchase a stream of income that begins when you are well into retirement age, as late as age 85. The payout percentage is much higher than with immediate annuities – about 5 times as high if you wait until age 85 — as they start much later in life. After all, you may not even be alive when the QLAC would start and your life expectancy will be lower. In order to break even on a QLAC, you generally need to live until your late 80s. You don’t purchase a QLAC to make a profit, but rather to cover the financial risk of outliving your money. Some consumers use them as a form of long-term care insurance.
Annuities as an investment. Known as deferred annuities, they are a product that combines insurance and investments. The main issues are that they often have high annual fees and significant surrender charges. While you may purchase a deferred annuity in part due to the tax advantages (which are often oversold), there are significant tax downsides as well.
The first question to ask with these annuities is about the “change your mind” fees known as surrender charges. They could be above 10 percent of your initial premium in the first few years after purchase. Also try to understand the total annual fees of the annuity, including investment costs, mortality and expense fees, and riders. These can often total over 3 percent annually.
While there are low cost deferred annuity options such as from Vanguard and TIAA, the large majority of them have much higher costs. While every person has different needs, in general immediate annuities and QLACs would be recommended for more situations than deferred annuities, which tend to overcomplicate your investment strategy.