Understanding the Risks of Annuities
Updated: Jan 17, 2020
With the return of stock market volatility, we are receiving more and more questions about annuities and whether they can be an effective product in providing downside protection in your overall portfolio. Annuities are complicated, so I thought it would be helpful to touch on some basic information about these products.
The Basics – What is an Annuity?
An annuity is a contract, usually sold by an insurance company that promises to make periodic payments for some period, such as over your lifetime. It is also a way to accumulate tax-deferred assets for retirement. The two main types of annuities are fixed and variable. As the name suggests, fixed annuities grow with a fixed rate of return or provide regular payments at a fixed amount. A variable annuity has underlying investments in the stock and bond markets (similar to mutual funds), allowing you to choose from a selection of investments, and then pays you a varying level of income in retirement that is determined by the performance of the underlying investments. In recent years, the insurance industry has designed numerous hybrids of these two types of contracts, including those that have long-term care features, and they are not easy to understand. Annuities can appear attractive as they grow on a tax-deferred basis and are only taxed once distributions are made. Unlike other tax-deferred retirement plans, there is no annual contribution limit.
Many annuities offer additional protection benefits that may come as options with the contract at an additional expense, the most common being a living benefit rider. To put it simply, these riders are generally designed to provide some type of guarantee, either a stream of income for a specified duration, often the account owner’s lifetime, or a guarantee that the annuity will not fall below the principal investment amount – in either case, these are purchased as a protection in case the investment returns don’t perform as expected. With a variable and hybrid annuity, the contract holder does assume market risk from the underlying investments, and living benefit riders are intended to capture market upside while limiting downside losses.
Understanding the Risks of Annuities
All investments have advantages and disadvantages, and annuities are no exception. Annuities may look attractive to investors, but the following are some of the disadvantages over a traditional investment portfolio that are important to understand:
The allure of capturing market upside, while protecting downside risk comes with a significant cost. The fees within annuities can total 3% and higher, especially when the investments decline in value. Fees are typically broken into three categories: mortality and expense charges (M&E), rider fees, and fund expenses. These fees are frequently not transparent in the contract and deducted from the fund values on a daily basis. It can be complicated to understand the exact amount being charged, and these high fees can have a dramatic impact on the value of the portfolio over time, thus, limiting the actual upside potential of the contract. Frequently, investors do not fully understand the expenses involved.
Surrender Charges & Schedules
High contract fees are not the only cost of guaranteeing potential future income. Insurance companies often employ surrender charges on the contract, lasting for a certain number of years after the start of the contract. This means the principal can be locked up and unavailable for several years unless a penalty is incurred. Some annuities allow for small withdrawals annually with no fees or penalty, but either way, your funds are generally not entirely accessible for a certain period of time.
High commissions in these products can often lead to ambitious selling practices and conflicts of interest in annuity product recommendations.
Limited Investment Selections
These contracts limit the investment selections to their customers. The securities offered are referred to as subaccounts and act very similar to mutual funds. Instead of having an open investment architecture, the selections can be limited to as few as eight choices. While not impossible to create a diversified portfolio from such a limited selection, it can be a drawback.
The Bottom Line
For some investors, annuities can be a useful part of a financial plan and it is important to review your personal financial situation to make that determination. It is important to fully understand the risks, liquidity, and fees associated with annuities to determine if the benefits are worth the expenses. Whether using annuities in your financial plan or not, it is important to develop an appropriately diversified portfolio that is designed to address your specific risk tolerance and needs. While promises of guarantees and lifetime benefits are appealing, it is imperative that both investors and advisers recommending these products fully understand their limitations and fees. We’ve all heard the saying, “If something sounds too good to be true, it probably is.” The bottom line is to always know what you are buying before making such an important financial decision.
Please do not hesitate to reach out with any questions or if you would like to schedule a review meeting.