When the markets take a stomach-tightening dive, many investors head for the perceived safety of annuities.
These insurance products offer the promise of guaranteed income, an attractive proposition for many retirees in a volatile market. Variable annuity sales rose 16% in the first quarter over the same period last year. Within that category, sales of registered indexed annuities grew by 44% over the first quarter of 2019.
“Whenever there is a significant drop in the market, annuity sales rise," says Ben Lies, a financial planner in Vancouver, Wash. "People are scared. They want something that feels safe.”
Today's record-low interest rates complicated that retreat to safety for one kind of annuity, however. Sales of fixed income annuities, which lock in lifetime returns based on today’s interest rates, were 22% lower in the first quarter of 2020 than in the first quarter of 2019.
What’s an annuity?
In simple terms, an annuity is a contract between a customer and an insurance company. The customer makes a lump-sum payment (or sometimes a series of payments). In return, the insurance company sends the customer a regular monthly payout that's guaranteed and typically continues for the rest of the customer’s life (as long as the insurance company remains in business; it's important to buy from a highly rated carrier). The trade-off is the loss of liquidity for a portion of your portfolio. And if you liquidate those other investments now to buy the annuity, you lock in losses by selling when stocks are down.
Annuities come in three types: fixed, indexed, and variable. The differences lie in the details of how your insurance company invests your money and determines your monthly payout. The most basic type, a fixed income annuity, pays a specified, guaranteed interest rate on your lump-sum payment. An indexed annuity pays an interest rate that’s based on the performance of a market index, such as the S&P 500. Variable annuities pay out sums that vary based on the performance of an underlying mutual fund portfolio.
Immediate annuities pay income right away; deferred annuities begin paying at some future date. You owe taxes on disbursements, but can defer taxes on account accumulation that you haven’t yet withdrawn.
To someone whose investment portfolio has been buffeted by a market downturn, the idea of worry-free monthly income for the rest of your life might sound pretty good. "A basic annuity is a way to buy yourself a very vanilla pension,” says Andy Panko, a financial planner in Iselin, N.J. “When it gets complicated, it gets expensive. And when it tries to be all things to all people, it doesn’t do anything very well.”
An expensive security blanket
Every kind of annuity can come with extra features, each with its own additional fee that takes the form of a lower monthly payout. Some incorporate long-term care insurance, pay a death benefit to your heirs, increase your payments to keep up with inflation, or offer a guaranteed minimum income or account value accumulation.
Consider the example of a hypothetical 60-year-old man who spent $100,000 on a basic fixed annuity at the end of April. According to numbers supplied by New York Life, that annuity will pay about 5.25 % annually if it begins immediately, and about 6.6 % annually if it begins paying in 2025. It will pay a monthly sum for the rest of the man’s life and stop at his death. This particular example will not grow with inflation, offer a death benefit, provide long-term care insurance, or improve its payout according to market performance.
How do these payouts stack up to the stock market? Between its 1926 beginning and 2018, the S&P 500 returned an annual average between 10% and 11%. Our annuity customer would forfeit about 5% a year in lost return for a smooth, guaranteed annuity income. That's in an average year, of course. In a down year or a volatile market, that tradeoff might help him sleep better at night.
That average 5% loss to the consumer compensates the insurance company for the risk it’s taking, gives it a profit, and often helps pay annuity salespeople commissions that can range from 4% to 7% of an annuity’s purchase price. Companies make money on the spread between what they earn and what they pay annuity holders.
A good choice for some
Even with those costs and limitations, a simple annuity can be a good tool for people near or in retirement, with investment portfolios that might not return enough to continue paying their essential monthly expenses.
An annuity is preferable to taking uncomfortable risks with a portfolio that isn’t quite big enough, says Joshua Knauss, a financial planner in Lewisburg, Pa. “It can be a good tool if you don’t have quite as much saved as you’d like or you don’t want to reach for both growth and income,” he says.
Some financial advisors recommend tallying your essential expenses, calculating your known income sources (such as Social Security and a pension, if you have one) and then buying a fixed income annuity to cover the gap between them. That way, you know you have your basics covered, no matter what the stock market is doing.
Kaleb Paddock, a financial planner in Parker, Colo., says he likes to treat annuities as a source of fixed income. “If you use an annuity as the bond portion of your investment portfolio, you can create a framework where your basic living expenses are covered largely through that annuity and Social Security benefits,” he says. “From there, you can invest the liquid investment portfolio more aggressively to fund other goals, like travel, inheritance bequests, college funding for grandchildren, and so forth.”
Annuities can also be a decent choice as longevity insurance for those who fear outliving their money, or as an option for people who can't stay calm through market volatility. Some consumers are willing to pay for peace of mind. “Temperament is a big consideration,” Paddock says. “Overall you will probably come out with a bigger portfolio if you do without an annuity—but it might be a wild ride.”
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