Money expert Clark Howard is passionate about many financial topics. But it’s hard to find something that gets him more riled than annuities; he considers “annuity” to be a curse word.
Table of Contents
- What You Need To Know About Annuities
- What Is an Annuity?
- How Do Annuities Work?
- What Types of Annuities Exist?
- Advantages of Annuities
- Disadvantages of Annuities
- Why Clark Despises Most Annuities
- Exception No. 1: Immediate Payout Annuities
- Exception No. 2: Longevity Annuities
What You Need To Know About Annuities
Clark expresses disdain for most annuity products.
It only intensifies when he talks about bank and insurance salespeople proactively touting high-commission annuities to people who shouldn’t be buying them. (Clark classifies those commissions and associated fees as “massive,” “humongous” and “unconscionable.”)
As you might expect, salespeople rarely promote the types of annuities that Clark thinks are OK, because those are lower-commission products unlikely to pay for the salesperson’s Hawaiian vacation.
Clark considers most people who sign annuity contracts to be “prisoners” and points out that the insurance companies can change the terms of the “stinking, rotten, awful, terrible annuities at any time.”
“When somebody starts talking about an investment they have for you, and they’re not telling you what it is, just ask the question: ‘Is it an annuity?'” Clark says.
“If they start hemming and hawing or don’t want to tell you or finally say, ‘Yes, it’s an annuity,’ say ‘Have a nice day’ and walk out the door.”
I’ll get into more detail on the mechanics of annuities shortly. But know upfront that Clark says they can be financially troubling.
What Is an Annuity?
An annuity is a contract between you and an insurance company designed to guarantee you income for the rest of your life.
You make one lump-sum payment (or multiple payments). In return, you get a consistent stream of income during retirement, possibly for the rest of your life.
Annuities are complex financial instruments. There are many different types of annuities, and each comes with its own set of choices and potential customizations.
However, most types of annuities — the ones that salespeople at insurance companies promote — are filled with expensive fees and rules that benefit them but can really hurt you as an investor.
How Do Annuities Work?
Annuities often are sold on fear: specifically, the fear that someone will run out of money before they die.
If the stock market crashes, for example, salespeople seize on society’s heightened fear to lock people into annuities contracts. Sometimes they host seminars for senior citizens with free meals as an incentive to attend.
Most annuities are loaded with fees and negative tax implications in addition to what are known as “surrender penalties.” That’s what you have to pay if you break your contract with your insurance company to take out your funds early. I’ll discuss those shortly when I dive into the three types of annuities.
If you shop annuities, you face some common choices:
- Do you want to make a one-time lump sum payment to the insurance company, or would you rather make multiple payments over time?
- Do you want the company to start sending you checks immediately, or do you want to be paid later?
- Will you decide to receive payments for the rest of your life or only for a fixed time period?
The way your annuity works depends on your answers to those choices — assuming you get a choice at all.
What Types of Annuities Exist?
There are three main categories of annuities.
The payments you receive are “fixed,” meaning the insurance company guarantees you a certain interest rate on the money you’ve contributed.
Fixed annuities are similar to certificates of deposit (CDs) at a bank. Your rate of return won’t be very attractive, but you’ll know what it is upfront.
You can choose an immediate payout that begins within 12 months of your paying a lump sum to the insurance company, or you can choose a deferred payout that begins at a later date.
Clark refers to these as “a contract that masquerades as an investment that’s wrapped in insurance.” But what does that mean, exactly?
With a variable annuity, you invest by choosing from a menu of sub-accounts, which are essentially mutual funds. The size of the payments you receive depends on the performance of those investments.
Much like a traditional 401(k) or IRA, those investments grow tax-deferred (no taxes until you withdraw). However, they do come with a bunch of fees attached. So this product is generally valuable only to someone who has already maxed out other tax-advantaged investment options such as 401(k), IRA and HSA accounts.
The most common type of variable annuity is called a “deferred” annuity. The customer makes one or multiple initial payments and starts to receive payouts at a specific time in the future.
One of the big sales points is what’s known as “downside protection.” For example, many variable annuities have a death benefit, which means that your beneficiary would receive, at minimum, the amount that you’ve contributed. However, the costs of this feature, or “rider,” are usually prohibitively expensive and almost never make financial sense.
Deferred annuities are marketed as a way to guarantee a regular income stream during retirement. But giant fees and commissions come out of your funds. And many deferred annuities have clauses that won’t let you take your money out for up to 15 years without paying a surrender penalty.
An indexed annuity is a hybrid that combines elements of fixed and variable annuities.
Indexed annuity investments and payments are tied to stock market indexes such as the S&P 500.
This type of annuity sometimes guarantees you won’t lose money; at the least, you’ll usually get as much money back as you paid in.
The pitch goes something like this: Get a return during good stock market years and avoid losses in bad stock market years.
However, an indexed annuity usually comes with one of two restrictions in exchange for the safety net of not losing money: a participation rate or a rate cap.
Participation Rate: Let’s imagine that the S&P 500 increases 8% in 2021. If your participation rate is 50%, you’ll realize gains of just 4%.
Rate Cap: Let’s again imagine that the S&P 500 increases 8% in 2021. If your rate cap is 4%, you’ll get only 4% of the gains.
Margin or Administrative Fee: Also known as a “spread” or “asset” fee, it subtracts a set percentage from any investment gain that the index produces. Let’s say the margin is 2%, the index is the S&P 500 and the S&P 500 goes up 7%. The annuity will take 2% in fees, leaving you 5% in gains.
As Clark talked about earlier in this article, the insurance company can also change the participation rate or rate cap in your contract.
The U.S. Securities and Exchange Commission (SEC) does regulate some annuities: those that qualify as securities. But for the most part, the issuer can change the terms of your annuity based on what’s stated (or not specifically prohibited) in your contract. Fine-toothed comb alert here.
Fees & Surrender Charges
Unless you opt for a fixed, immediate payout annuity, your money will be illiquid (locked up unless you pay steep penalties), sometimes for 10+ years.
You’ll pay a surrender charge if you need to take money out of your annuity before that contractual time period ends.
Depending on how many years you have left in the lock-up period, penalties can be in the 10% range. In that scenario, if you withdraw $50,000, you’ll have to pay the insurance company $5,000 in penalties. Plus, if you take out money before you’re 59½ years old, you’ll owe an additional 10% early withdrawal penalty to the IRS. That’s in addition to federal income tax (and potentially state tax) on the interest you’ve earned.
Other annuity fees include:
- Commissions to salespeople
- Insurance charges (sometimes called mortality and expense fees)
- Fees for the investments within your annuity
- Extra charges for riders and options you add to your annuity
Advantages of Annuities
Here are some of the benefits of agreeing to an annuities contract. Note that not every advantage is available with every kind of annuity:
- Guaranteed rate of return. Fixed annuities offer you a set amount of interest. You probably can get a greater return on your money through other types of investments — perhaps a much greater return. But in some people’s opinions, a fixed income is an appropriate part of mitigating financial risk during retirement.
- Protection against long life. A longevity annuity is a Clark-approved hedge if you’re concerned about outliving your money. It’s one of the annuity types that Clark thinks is acceptable.
- Regular payments. Depending on the type of annuity you choose, you may or may not know the amount of your annuity payouts. But you will be able to count on getting a check at the same time each month (or whatever your contract dictates).
- Money for beneficiaries. Many annuities offer guarantees that when you die, your annuity will go to your heirs. The amount depends on the death benefit specified in the annuity contract.
- Protects against losses. By definition, it’s theoretically possible to lose every dollar that you invest. Some annuities are more like insurance products than investments, because they guarantee that you will at least recoup your initial investment. However, that safety comes at a hefty price in terms of fees as well as opportunity costs if the stock market goes up over time.
- Tax-deferred growth. This is a misleading benefit for most people. Clark wants you to max out your 401(k), IRA and HSA contributions before thinking about using an annuity as a tax-deferred investment choice. It takes a significant amount of capital in order to do that.
Disadvantages of Annuities
Here are some of the downsides of agreeing to an annuities contract:
- Expensive. Between fees, commissions, customizations and penalties, annuities tend to do one thing well: extract money from you.
- Likelihood of low return on investment. Vanguard’s total stock market index fund charges an annual expense ratio of 0.04%. That’s how much you’d pay Vanguard to manage the fund. The cost of investing in the same product through an annuity is magnitudes higher than that. Even if you make money, there’s a near certainty that your ROI will be worse through an annuity than it will be elsewhere.
- Extremely illiquid. The lock-up period depends on the terms of your specific annuity contract. But in many cases, you won’t be able to withdraw funds from your annuity for years without paying massive penalties.
- Easy to misunderstand terms. Annuities are complicated enough on their own. Mix in what could be construed as questionable sales tactics, and you have a recipe for customers ending up with annuities that are not financially smart.
- Potential for emotional decision-making. There’s room for emotion when it comes to setting financial goals. However, choosing the best methods to achieve your financial goals is a practical matter. Annuities are often linked with fear-based investing: If you’re afraid of a stock market crash or of running out of money later in life, perhaps you’ll tend to overlook the horrible fees and rules associated with most annuities.
Why Clark Despises Most Annuities
As I mentioned upfront, Clark dislikes annuities so much that he sometimes refers to “annuity” as a curse word.
Here are some of the many reasons Clark wants you to be wary about agreeing to an annuity contract, especially one that a salesperson is trying to convince you to buy.
- If you can’t explain what it is to a fifth grader, think twice about buying it. Annuities are mind-bogglingly complex. In many cases, signing a contract without reading through every page of fine print isn’t going to burn you (even though it may not be the most advisable thing). In the case of an annuity, not fully understanding what you’re getting into can be extremely painful down the road.
- You’re paying for a salesperson’s vacation. Salespeople earn giant commissions on most annuity products.
- Policy illustrations typically are inflated. Sadly, as is the case with many things in life, annuities can look better on paper than they are in reality. You’ll need to go over any marketing materials with an extremely skeptical eye.
- Your investment gains get capped. If the market does well, the insurance company gets to keep a nice chunk of the profits on your investments. You can’t even get credit for dividends.
- It’s actually possible to lose money during down years in the market. The downside protection offered by some annuities isn’t necessarily guaranteed. Often you must meet specific criteria to avoid losses in annuities tied to the performance of the stock market.
- Most types of annuities are poor choices for most people. If you’re one of the rare individuals who has maxed out your 401(k), IRA and HSA contributions, and you have additional money to invest in tax-deferred accounts, an annuity might make sense. For everyone else, it almost certainly won’t.
Exception No. 1: Immediate Payout Annuities
There are two types of annuities that Clark thinks may be great deals for certain people. The first is called an “immediate payout annuity” or sometimes a “life annuity.”
An immediate payout annuity turns a lump sum of money into a steady stream of income for life.
“The beauty of the immediate payout annuity is it’s like setting up your own pension,” Clark says. “For whatever money you put into it, you’re going to have your own made-to-order pension that gives you a check every month for as long as you live.”
When you retire, you want to avoid getting into a situation where you can’t pay for your monthly needs with your savings. An immediate payout annuity helps guard against that by providing you reliable income.
You typically need a minimum of $100,000 to buy into an immediate payout annuity. You pay a lump sum and then start getting checks, potentially forever depending on how you structure your annuity.
The problem is that if you die one week later, all the money you paid goes “poof.”
If you want to make sure to leave something for your beneficiaries, you can add what’s called a “period certain” guaranteed payout. It’s a provision that will reduce your monthly benefit payment. But if you die within the specified time period, your heirs get a guaranteed payout.
Clark recommends shopping for immediate payout annuities at ImmediateAnnuities.com or USAA if you’ve served in the military. And he says you should look for an A.M. Best rating of A+ or A++ before agreeing to any annuity contract.
Exception No. 2: Longevity Annuities
The other type of annuity that Clark thinks “could be absolutely great” is a longevity annuity.
This is a simple insurance product, and it doesn’t usually provide big commissions for salespeople. So you don’t hear about it as much (because it’s not pushed as aggressively as other types of annuities).
With a longevity annuity, the day you reach a certain age — typically 80 or 85 years old — you get a check every month for life. It’s a hedge against living an unusually long time.
“Let’s look at the big concerns people have,” Clark says. “Let’s say you’ve saved some money over the years, and you’ve reached retirement age. The big unknown is how long are you going to live? The big danger is you outlive your money.”
In theory, with a longevity annuity, you can blow all of your retirement money before your 85th birthday, and you’ll still have this benefit to live on.
“People are living a lot longer, and as they get older, they have ailments. So they can’t really substitute work when they run short of money,” Clark says. “A longevity annuity gives you the ability to know you’re not going to be living in extreme poverty in retirement.”
Bring up annuities to Clark and he’ll almost certainly give you an earful.
The bottom line is that almost all annuities are a raw deal for the individual who buys them. They’re good at lining the pockets of the banks and insurance companies — but not so good as financial investments.