There is no doubt that, over the years, annuities have had their critics. “Too expensive;” “Too inflexible;” “Too illiquid;” are among the criticisms that planners and pundits have laid on a financial product that has helped usher millions of people into a safe and secure retirement. While annuities do have expenses, and they do have restrictions regarding access to funds, the only way to truly weigh their potential negative impact is to fully examine the benefits of owning annuities.
Deferred Taxation of Earnings
Next to market risk and inflation risk, taxation risk has the greatest impact on wealth accumulation over the long term. The ability to defer taxes on annuity earnings translates into an automatic doubling of returns for people whose combine state and federal taxes put them in the 50% bracket. For instance, if an annuity and an equivalent taxable vehicle both returned 4%, the taxable vehicle would net out at a 2% return after taxes are paid. The benefits of tax deferral diminish for people in lower tax brackets, however, when state and federal brackets are combined a person in the 25% federal tax bracket could still benefit over the long term. Annuity earnings are eventually taxed as ordinary income when they are withdrawn.
Predictable and Stable Outcomes
Even for people with higher risk tolerances, annuities can add the predictability and stability that all investment portfolios need for proper balance and diversification. While future rates of return on annuities cannot be predicted, all annuity contracts include minimum rate guarantees (most variable contracts include a minimum rate guarantee as an option) on the accumulation account. In the distribution phase, most annuities include a minimum income guarantee (an option for variable contracts). With these guarantees, annuities can form the safety foundation upon which more risk-oriented investments can be built.
In addition to minimum rate guarantees, annuities include principle guarantees that ensure either investors or their heirs will never get back less than what they put in (less any withdrawals made). Most annuities provide principle protection in the form of a death benefit, and many annuities also include provisions or options that protect the gains as well. Such guarantees are only as secure as the assets that back them, and life insurers must follow strict state-imposed requirements to ensure that they have sufficient assets to pay out all annuity claims. Life insurers who meet the highest standards set by independent rating agencies are awarded high ratings that reflect their ability to meet their obligations in the worst of economic conditions.
Competitive Returns -
Whether you are totally risk adverse, risk tolerant, or somewhere in between, the various annuity formats offer the opportunity to earn competitive returns commensurate with the amount of risk you are willing to assume. Fixed annuity rates are comparable to bank CDs for people with no tolerance for risk. Variable annuities offer risk tolerant investors the opportunity to invest in stock and bond portfolios that mirror the returns of mutual funds. And, indexed annuities offer risk adverse investors the opportunity to participate in the gains of stock indexes while protecting their principle against the losses.
Access to Funds
Perhaps the greatest reluctance that older investors have expressed over annuities is their “inflexibility” or “illiquidity”. While it is true that annuities require a long term commitment, all annuity contracts contain withdrawal provisions that provide investors with access to their funds. Generally, annuity investors can withdraw up to 10% of their annuity balance without any charges, and, if older than 59 ½, they needn’t concern themselves with the 10% IRS penalty for early withdrawals.
Annuity investors who want access to their funds due have to contend with surrender fees if their withdrawals exceed 10% and they occur during the surrender period. While the fees do start out fairly high (7 to 12%), they decrease by a percentage point each year of the surrender period until they disappear. For investors over 59 ½ who have held their funds through the surrender period, their annuities become are more liquid that termed bank CDs.
Finally, if an annuity fails to meet investors’ expectations, they have the option of transferring their funds to another annuity without incurring taxes. However, if a transfer occurs during the surrender period, it will be subject to a surrender fee.
Guaranteed Lifetime Income
As the new reality of longer life expectancy and retirement plan shortfalls grows among pre-retirees, the concern over income longevity becomes more paramount. Annuities came into existence as a means to provide individuals with a guaranteed stream of income that they cannot outlive. Today’s annuity products provide enhanced security by guaranteeing a minimum income (minimum income guarantees are an option in variable contracts), and, as an option protecting that income against increases in the cost of living.
Yes, there are expenses associated with annuities. And, there are some restrictions on access to funds. However, each investor needs to weigh those costs against the many benefits of annuities in the context of their individual needs and concerns. As with any investment, they are not for suitable for everybody. But for investors looking for tax advantages and some predictability and stability for all or even a small portion of their investment portfolio, in most cases, the benefits of annuities far outstrip their costs.