What is the primary reason for buying an annuity, and will it be a good investment?
Annuities are indeed insurance products rather than traditional investments, although they can serve as a tool for retirement savings.
Annuities Versus Mutual Funds
Annuities and mutual funds are two entirely different investments, with entirely different purposes, but both can be used to build a solid financial footing throughout retirement.
The only fair comparison between annuities and mutual funds (especially stock mutual funds) is in comparing periodic-payment annuities and standard stock mutual funds.
Periodic payment annuities are those that allow you to invest in chunks. Very much like a standard stock mutual fund that allows you to invest as little as $25 monthly, you can invest whatever sum you’d like into a periodic-payment deferred annuity to build up capital until you decide to receive monthly payments. As you can see, annuities and mutual funds are very much similar here.
Where the two investment types diverge is in their performance, and how their performance works. For this example, we’ll use an S&P 500 index mutual fund and a deferred annuity based on the S&P 500. You would think that the performance of the mutual fund and the deferred annuity would be similar since they track the same investments, but you’d be dead wrong.
Your annuity cannot lose money. What? Wait! I thought all investments were risky.
Nope, not all investments are created equally. The S&P 500 mutual fund tracks the performance of the S&P 500 index up and down, whereas the annuity based on the S&P 500 index only tracks the index when it moves up.
The deferred variable annuity based on the S&P 500 rises in value with the S&P500 but only to a certain degree. You see, your annuity broker will promise to protect you from stock market drops, but they also limit your upside. For example, if the S&P500 index were to rise 15% in one year, your S&P500 mutual fund would appreciate by 15% whereas your annuity may rise the maximum cap of 7-10%. However, if the S&P500 were to plunge 20%, your annuity would lose nothing and your mutual fund would lose the full 20%. When the stock market is performing well, the mutual fund will outperform the annuity, but in bear markets, your annuity will perform better.
Finding Common Ground
Investing in stock mutual funds at 65 is like betting on horses to secure your retirement. Likewise, investing all your money in an annuity at 20 is equivalent to stocking all your cash under a mattress for extreme safety. Both can be used in conjunction with one another and effectively as well.
Conventional wisdom is to take 100, subtract your age from it, and that is the amount you should have invested in stocks, the other part should be in fixed income. A 30-year-old, for example, should invest his or her money 30% in fixed income (like an annuity) and 70% in stocks. At 40, that same person would invest 10% more in fixed income and 10% less in stocks. Simple, right?
A proper balance of annuities and stock mutual funds will allow for solid capital appreciation as well as safety in turbulent markets. It isn’t about one or the other, it’s all about a proper blend of both at just the right time.
Annuities Versus Stocks
Annuities and stocks are in many ways entirely different animals. Thankfully, they co-operate, and when used together they make an excellent retirement plan.
One cannot honestly compare annuities and stocks because they are simply far too different, and serve two entirely different purposes. Stocks are ownership in a company, purchased as a means to generate capital gains and minor income disbursements in the form of dividends. Annuities are the polar opposite, fixed income investments that do not allow for capital gains (except variable annuities) and are geared toward providing an income.
One major difference between an annuity and a stock is the tax schedule. Annuities are taxed just like regular income. So, if you were to purchase a $40,000 annuity that pays out a total of $50,000 in monthly payments, you would owe full income taxes on the $10,000 “profit.” The personal income tax rates go as high as 35% depending on your tax bracket. A $40,000 purchase of stock that rises to $50,000 would create the same taxed income–$10,000–but would not create the same tax burden. The long-term capital gains tax is just 15%.
However, annuity taxation should not be the entire basis of your investment decisions, though they should play a part. You should also consider the amount of risk you’re willing to accept with your investment portfolio.
Fixed annuities will provide a guaranteed, absolute yearly return as well as consistent monthly income checks. Annuities are even backed against failure by your own state government!
Stocks will provide an income if they pay dividends (usually a fraction of what you would earn with the same investment in an annuity) but they rise and fall daily, and do not have nearly the same protection as an annuity.
One final difference is the returns you’d expect to receive from an annuity and a stock portfolio. The US stock markets have historically gained a healthy 10.5% per year whereas annuities perform just over the current triple-AAA-rated bond yields. So the difference between the two in returns can be very, very important to overall portfolio performance.
$10,000 invested in a stock portfolio that returns 10% per year would grow to more than $67,000 in 20 years. $10,000 invested in an annuity with a performance of say, 6% per year would come out to $32,000.
As you can see, a 4% difference in yields creates a scenario in which stocks rise more than twice as fast as annuities.
The Bottomline:
If you have plenty of time before retiring (more than 15 years) you’d be smart to invest in stocks, as they’ll allow for quicker, albeit riskier, growth. If you’re nearing retirement and need consistency more than you need returns, then annuities are the way to go.
The bottom line is that too much of one or the other will hurt you just as much as too little of each. So be sure to never overweight fixed-income investments (annuities or bonds) when you’ve got time to take risks and never overweight stocks when you’re running out of time. If you follow that simple rule, you’ll never mess it up!
Annuities Versus Life Insurance
Have you ever wondered why so frequently life insurance companies are also in the business of selling annuities? Well, the answer is quite simple. Life insurance companies take a huge risk in betting that you’ll live a very long time to pay your monthly premiums to ultimately collect a payout smaller than the sum of its parts. To counteract that risk, they also take bets that you’ll live a very short time via annuities, where you may only live a few years to receive payouts much smaller than the face value of your annuity.
For them, it’s just business. For you, well, it’s just business too. You have to decide which is a better investment, and how to allocate your money for each. The thing is, you only have a limited amount of money.
First, you need to decide how much life insurance you should have. I should mention that many people are either grossly uninsured or grossly overinsured. That is, having far too much or far too little insurance for their needs.
If you’re young, have a family, and a spouse that absolutely cannot live without your income then you need to have a lot of life insurance. Imagine, one day you just don’t wake up, you’re dead as a doorknob just a few years after buying a house—a purchase made on the premise of having two incomes. While for the first few days, it will be an emotional strain as loved ones grieve, the next few decades will be even more difficult as your spouse struggles to pay for the expenses of a family without you.
In this case, you need to have enough life insurance to cover expenses for your children and living costs for your spouse. In many instances, couples get away with planning to have enough money to pay off the mortgage, cars and other debts, as well as college expenses for children and funeral costs. The good news is that because you’re young, buying enough insurance to cover it all will be insanely cheap.
However, if you’re older, or just in your twenties, buying too much life insurance is a huge problem. When you’re 65, you’re kids are out of the house and your home is paid off, there is little reason to have any more life insurance to pay for funeral costs. You might not even want to have that insurance at all!
At 20, single, and searching to start your career, you probably want just enough to cover funeral expenses. Though be sure to ask Mom and Dad, you might already be covered by a policy they owned since your childhood.
Annuities
Annuities are something that you should start thinking about as you near retirement age. Whereas life insurance was a really good deal for a 30-year-old with a wife and kids, it isn’t anymore. Now your best investment is in yourself, and your standard of living, until the day you die.
At this point, life insurance will be expensive. So, if you haven’t yet covered the cost of an expected funeral, or haven’t preplanned, then you may want to seek out an insured annuity. With an insured annuity, you’ll get the remainder of your annuity’s balance at the end of your death. This is most often used to cover funeral and burial costs.
Your best bet is to reduce your life insurance while kicking up contributions made into a retirement plan or annuity. As you age and advance through the milestones of life, you should be reducing your total insurance needs and increasing your retirement planning. An annuity is an excellent replacement for monthly life insurance premiums and by the time you retire, you’ll be more than happy you saved a few extra dollars.
Annuities Versus IRAs
So you wanted a comparison, huh? Well, we’re not going to give you one. No, that would be silly! Annuities and IRAs should be used side-by-side. However, some of their benefits are the same for both annuities and IRAs.
An IRA is an individual retirement account in which you can put financial instruments like stocks, bonds, CDs, and annuities to save tax-free toward your end retirement goals. One popular choice is the Roth IRA, wherein you deposit after-tax income to allow your investment to grow tax-free, and be withdrawn tax-free forever. This is a very popular choice among investors because you pay your taxes upfront, and even if the tax rates keep going higher (as they have been) you’ll have already paid your share to Uncle Sam. That’s a pretty sweet deal!
A Roth IRA, just like an annuity, will allow you to grow your money tax-free, and even allow you to save post-tax income without paying more in the future.
So, if you’re looking at both an annuity and an IRA, open both. You’ll be happy you did.
One great way to use them in tandem is to buy a periodic-payment deferred annuity within your retirement account, or IRA. Don’t worry, the explanation for how periodic payment annuities work is shorter than the name.
Periodic-payment deferred annuities allow you to build up a retirement income source over some time. With the periodic-payment deferred annuity, you are funding your pension program, adding money every month, quarter, or even paycheck to grow your total monthly payment when you retire.
Some investors like to start saving in an annuity at a young age, putting just a few dollars in each month to start building up a very safe, very secure, investment for the future. Others, who already have an established retirement fund, like to transfer their income into a annuity as they age, protecting more and more of their assets against downside risk. Wait, we didn’t cover that part…
Annuities, unlike other investments, are protected against loss. First, they inherently can’t lose money as part of the contract you sign with the insurance company when you purchase them. Second, most are protected up to as much as $250,000 by your state government. So, should the company writing the policy go bankrupt, your state government will cut you a check for the value of your annuity up to the maximum insured. Pretty cool, huh?
But you’ll also be able to grow your money, not just protect it. In a periodic-payment deferred annuity, your returns will be indexed to the stock market, allowing the amount of money you invest to grow while protecting you from the downside. Often, in years of excellent stock market performance, you’ll get anywhere from 7-10% added to your account. In years that the stock market dips, you won’t have any money subtracted from your account, but you won’t have any added either. All in all, annuities make excellent investments, and it would be wise for those nearing retirement to start considering a move from their mutual fund-based IRA into an annuity.
Annuities Versus Bonds
Annuities and bonds are very often compared because they generally provide near-equal returns as well as inherent safety. Also, both financial products are largely part of a long-term financial plan and are most likely used at the end of the planning stage, rather than the beginning.
Where the two products diverge isn’t in their returns, nor their prices or options, but in their inner workings. Annuities are simply a bet made with an insurance company, usually a life insurance company, that you will live a very long life…one long enough to collect more in monthly payouts than you paid for the policy. Bonds, on the other hand, are an investment in the debt of a business. When you buy a bond, you’re buying nothing more than a promise from a company to pay you back a certain amount of money plus interest.
One benefit to bonds is that you’ll get your money back even if you die, whereas uninsured annuities stop payment upon death. Another benefit is that you have some safety when buying a basket of bonds either through an exchange-traded fund or a mutual fund. Since most individual bond purchases are made in blue-chip companies, you also have a very good chance of repayment, with little risk of default. However, on the downside, defaults on bond payments do happen, and many times they happen abruptly, with little warning.
Just think for a second. During the roaring 2000 would you have ever expected that General Electric or General Motors would ever be on the brink of bankruptcy? Did you ever think the value of their bonds would ever plummet, or in GM’s case, go to zero? Never. They were both well-financed firms with great management, but eventually, their expansions led to serious financial pitfalls.
When safety matters most, many investors opt to choose annuities. By purchasing an annuity, your payout is guaranteed never to fall and is even insured by your state government up to a certain investment total. That is, for each annuity policy that you may own, the government will insure it up to a set dollar figure by law. So, even if the writer of the policy were to disappear overnight, you’d be guaranteed to get your investment back. And that, of course, is one huge benefit.
On the flip side, you’re likely to pay more in annual expenses on an annuity than you would a corporate bond mutual fund. Also, for uninsured annuities (uninsured annuities are generally a far better investment than insured annuities) your payments will cease when you die. So if you were to buy an annuity on Monday and die on Wednesday, you’d have nothing. If you were to buy a bond on Monday and die on Wednesday, you’d still own the bond, at least, your heirs would.
When it comes down to it, equity-indexed annuities and bond portfolios have virtually the same amount of risk as well as reward, but with annuities, you have just one more layer of protection in default insurance from your state government. We’d recommend you opt for both a blue chip bond fund as well as an annuity.
Stocks and bonds generally trade in opposite directions. Stocks fall when bonds rise, and bonds rise when stocks fall. So, in knowing that, you could practically arbitrage the market by purchasing both an annuity indexed to stock performance and a bond portfolio indexed to, well, the performance of the bond market. When bonds rise, your annuity will stay put, protected from downside risk. When stocks rise, your annuity will rise in value while your bond fund will drop in value. Just some food for thought.
Annuities Versus CDs
Ahh, the infamous question of what kind of fixed-income investment is the best. We’ll try to answer this question, laying out the pros and cons, and how you should evaluate what is best for your situation.
It is obvious from the comparison that you’re looking for a solid, predictable, fixed-income investment, likely for retirement income. You’ll find that both annuities and CDs are very different, but for practical purposes are very much the same.
Annuities, especially prepaid and insured annuities (those that pay until the day you die) allow for greater predictability. Since you know you’ll be receiving a fixed payout for the rest of your life, you won’t have to worry about running out of money as you would with CDs. Also, annuities allow you to draw down on your principal without any concern. You can’t say that for certificates of deposit.
One last benefit of fixed annuities is that you won’t have to deal with the fluctuations in interest rates. CDs that yielded as much as 5-6% during the early 1990s are now yielding less than half a percentage point in 2010. So, ask yourself, is that the kind of volatility you want in your retirement income? What if you had retired at the age of 65 in 1990, making more than 10 times the income then as you do at 85? Prices have surely risen since 1990, especially in health care, food, and energy prices, all of which you’ll consume the same, if not more at 85 than you would at 65.
Oh, and we didn’t even touch taxes! Growth in the accumulation phase of an annuity is tax-free. You only pay as you make withdrawals.
CDs Have Benefits Too
CDs certainly have their benefits over annuities. First, certificates of deposit allow you to keep your principal investment while collecting interest monthly, quarterly, or annually. Another benefit, if you have enough cash to make it through, is that upon your death you’ll be able to pass the principal investment onto children, and grandchildren, who can set it aside for funeral and burial costs or even to start a college fund for the youngsters. It’s hard to put a price on generational wealth.
One major benefit is that if should live less than your life expectancy, you’ll still have cash left over. With annuities, the payouts cease at the time of death, and you’ll have lost everything unless you have insured your plan, or it allows for a cashout at death. Annuities that have the cashout option are generally more expensive, so you’ll have to price that into your planning.
Get the best of both worlds!
We’d recommend that if possible, consider investing in both annuities and certificates of deposit. This way you’ll be able to get consistent cash payments from your annuity, as well as generate passive income from your CD investments.
Diversifying your wealth into both investments is a smart decision. You’ll have the safety of annuities as well as the opportunity to take advantage of high-interest rates with CDs during the good years. Even into retirement, diversification is still very important, and you wouldn’t be wrong to invest in both.