What exactly is an annuity? It is a contract between an individual and an insurance company. Some allow investing in stocks and bonds (Variable) while others start paying immediate monthly income (SPIA). All are indirect investments where the insurance company uses your money to invest, pay you back principal plus a portion of any returns, and earn a profit.
Here are some of the problems with annuities and ideas on how to create your own strategies to mimic insurance company's.
Here are some of the problems with annuities and ideas on how to create your own strategies to mimic insurance company's.
Variable Annuity: High fund fees, mortality fees, administrative fees, guaranteed income fees, surrender fees, rider fees. These are common costs associated with variable annuities and they can add up to 4% a year. Don't forget about the big up front commission of around 8% you have to pay. Variables also lack liquidity locking in your money for, say, 10 years. Before that time period is over you are only allowed to take out minimal amounts of principal each year. Amounts above what they deem acceptable will face stiff penalties. This limits your flexibility in case of an emergency and if your financial life changes.
Indexed Annuity: These are marketed as providing market returns without risk. The issue is state regulators have strict rules for how insurance companies can invest money forcing them to be conservative. This lowers the potential returns to them and the customer. Returns are usually tied to an index like the S&P 500 but with caps. For instance, the insurance company can stipulate that the return can be capped at 4% a year. So, if the S&P 500 goes up 9% you still only get 4%. But if it goes down 10% you have a 0% return. For this special privilege you will pay a large upfront commission and a large penalty, say 10%, if you want your money back early.
Income Annuity: A SPIA (Single Premium Immediate Annuity) and deferred life annuity fall in this category. They provide monthly paychecks to the annuitant for their lifetime. The issue here is most of the money coming in those monthly payments is returning your principal or what you put into it. I recently reviewed a fixed term SPIA for a client and it is paying 1.6% interest for 10 years. Take out taxes and inflation and they have negative total returns.
Annuity-like Strategies Without the Costs
First, don't forget everyone has annuity already. It is called Social Security. To maximize the income from that wait until full retirement or delay benefits until age 70. Every year you wait past full retirement to the maximum age of 70 you increase your benefit 8%. In contrast, taking Social Security at age 62 permanently decreases the benefit by about 30%.
Variable Annuity: Build a low-cost conservative portfolio using index funds of stocks, bonds and inflation protected bonds. Forty percent or less in stocks is a good place to start.
Indexed Annuity: With this strategy you go to each end of risk spectrum. On one end you use ultra safe CDs and on the other side you use a stock fund. The majority of the money goes into the CD to protect principal but also earn some income. What is left goes into a total stock index fund that may provide an extra kick to your returns. You will have more control over your money and the potential for better returns than the annuity.
Income Annuity: Delaying Social Security is an easy and cost effective way to replace an income annuity. It will cost you a lot less than the annuity and Social Security annually adjusts for inflation with no additional cost to you. Inflation increases in an annuity takes a separate rider with additional fees. If you believe you need more retirement income look at building a bond ladder using inflation protected bonds.
With the help of a trusted Certified Financial Planner™ you can create your own annuity-like investment using the same principles and strategies as an insurance company but at a much lower cost.
