Annuities can be confusing and especially when you hear people telling you, “they are bad” or “You should hate annuities” as Ken Fisher advises with his advertising.
The important point you have to understand is what annuity should you hate and why. The logic they are proposing is one annuity is bad so all annuities are bad. So let’s get to the bottom of this and take a deeper dive into annuities.
What is important to realize is there are four types of annuities that are commonly used today. Let’s take a look at each and go over the pro’s and con’s to determine if they are a good fit in retirement planning.
Immediate Annuities
An immediate annuity is where a lump sum has been turned into an income stream. The lump sum is no longer available, but instead a guaranteed income is being received that can payout over a person’s life expectancy. Overall the returns credited to an immediate annuity are very low, but the income guarantee is the real benefit.
The immediate annuity has its place in income planning, such as providing a window of guaranteed income maybe before a pension or social security starts, or it can also serve as a guaranteed lifetime income as well. It pays to shop before choosing an immediate annuity, as some companies will offer higher payouts than others.
Fixed Annuities
A fixed annuity is the simplest annuity for consumers to understand. You simply receive a rate of return determined ahead of time. Many present the fixed annuity as a CD alternative. It is in the guaranteed principle category of investments, and is one of the safest investments for consumers available today.
With bank rates so low today a fixed annuity is a good alternative with higher rates, and it also builds tax deferred until funds are withdrawn. Depending upon one’s tax bracket, this can be very beneficial to the client, unlike a CD that is taxable each year even if the interest isn’t withdrawn.
Fixed Index Annuities
A fixed index annuity is really just a variation of a fixed annuity, so it has all of the same safety features. What the insurance company is doing is instead of offering a fixed rate, they use those funds to purchase call options on various stock indexes, with the S&P 500 being the most common.
Each anniversary date the annuity will either capture a gain if the index it is tracking is positive, or a zero return if the index is negative. If any gains are captured they are “locked in” and added to the account value.
The returns within an index annuity will vary dramatically depending upon the design, and it is very important to make sure it is a competitive product that has solid growth potential. Working with a skilled advisor that understands index annuities is extremely important.
The FIA is a safe investment that helps to bring balance to an overall portfolio. It has been one of the best performing safe investments over the past decade and has proven itself as a solid choice for the right investor.
Variable Annuities
The variable annuity is really just an option to use mutual fund type of investments within an annuity. Depending upon the choices used within the annuity, the account value can be very risky, if stock mutual funds are used or fairly conservative if bonds funds are used.
There is no doubt variable annuities (VA’s) can have high fees and this has raised a lot of red flags throughout the financial services industry today. When you hear annuities have high fees this is the annuity they are referring to. Normally all VA’s have an annuity fee that ranges from 1 to 1.5% per year, with around 1.25% being the average.
Also the majority of VA’s will also add riders of some type, either death benefit or income riders, which can add an additional .75% to 1.5% per year as well. Add the typical mutual fund fee of 1% or more, and you can see that a VA fee can very quickly run 3 to 4% per year. This can really diminish the growth potential of a Variable Annuity.
The VA really doesn’t have a lot to offer for the investor. If they want maximum growth, mutual funds will save the investor a significant amount with much lower fees.