Annuities – A Deeper Dive

By James I. Moore, CFP®

What is an annuity?

An annuity is a financial product sold by an insurance company. You write a check to an insurance company and they promise something in return. What you get is determined by the terms of the contract you sign.

Insurance products like annuities can be appropriate for some people, but for most, there are probably better ways to reach your financial goals. We have found that the majority of annuities are sold, not bought. Insurance companies and annuity salesmen are very good at making their products look good.

Annuity contracts tend to be complex and difficult to understand, even for financial professionals. And unfortunately, there is often a big disconnect between what the contract says and what the person purchasing the annuity thinks it says. Our Fullerton financial planning firm has met with many individuals over the years who own an annuity and wish they had never bought it.

There are some general categories of annuity products, such as indexed annuities or variable annuities, but ultimately each product is unique because its terms are laid out in its specific contract. This makes it challenging to compare annuities with each other, even those within the same category or even those issued by the same insurance company. That said, we have noticed that there are a few common “disconnects” between how these annuity products are advertised and how they actually perform. The following is an example of one of these common misunderstandings.

One example: “Guaranteed 6% annual bonus that keeps your protected balance growing, even when the market is down!”

Most people will probably hear this phrase and assume (quite understandably) that the annuity is offering a guaranteed 6% annual compounding return. For example, let’s say you write an initial check to the insurance company for $100,000. After 1 year, you would expect the annuity to be worth $106,000. After 2 years, you would expect the annuity to be worth $112,360. After 10 years, you would expect the annuity to be worth $179,085. What a great deal, right? Where else can you get a guaranteed return like that nowadays?

Contrary to that sales pitch you received, there is a good chance this “guaranteed 6%” does not mean what was just described. If you look at the fine print, you might notice that this bonus is only in effect for the first 10 years. Additionally, the bonus is 6% of the initial premium. If you initially invested $100,000, in 10 years it would be worth $160,000 = $100,000 + ($6,000 x 10 years). Notice that this is not compound interest! So in reality, the 6% is actually only 4.8%. Right away it appears that the initial guarantee is not what it seems.

Unfortunately, it gets worse!

This 4.8% return is usually applied to the annuitization value or the guaranteed lifetime withdrawal benefit value. These values are not “real” dollar amounts that you can withdraw at any time. They are “paper” amounts that usually only come into play if you decide to annuitize your contract, which very few people end up doing.

So what is the actual benefit of this 6% guarantee (well… actually 4.8%) for the annuity holder? In order to calculate the true investment return, you would also need to know the payout rate and estimate how long the annuitant will live.

Continuing on with our previous example, let’s assume a 55-year old man purchases this annuity with an initial premium of $100,000. After 10 years, his annuitization value is guaranteed to be $160,000. Remember, this annuitization value is different than the actual cash surrender value of the policy! Let’s assume that this individual decides to annuitize his policy at age 65 in order to ensure he realizes the “benefit” from the policy guarantee.

Annuitization “benefits”

At annuitization, the insurance company uses a payout rate percentage (we will assume 5% for our example) to apply to the annuitization value ($160,000) to determine the annual withdrawal amount. In this case, the annuitant will receive $8,000 per year for the rest of his life (5% of $160,000). These $8,000 payments will continue every year while the annuitant is alive, but the payments will not increase with inflation.

For the first 12.5 years, the annuitant is essentially receiving his own initial premium back ($8,000 x 12.5 years = $100,000. Note that at around age 78, some 23 years after initially purchasing the annuity, the true investment return of the annuity is actually 0%.

At age 65, the Social Security Administration says that the average additional life expectancy is 18 additional years. Assuming our hypothetical annuitant lives to age 83, the true investment rate of return would be 1.9% annualized. If they lived ten additional years to age 93, the true investment rate of return would be 3.5% annualized.

As you can see, these true investment rates of return are very different than the “advertised” rate of 6%. In fact, for an extreme example, let’s assume that our hypothetical individual lives to the age of 130. Even in this scenario, the true investment return would only be 4.8%.

Remember that the annual $8,000 per year does not increase with inflation. Each year it will buy less. Over ten or more years, this starts to make a significant difference, even if there is only low to moderate inflation.

What if you own an annuity like this?

We recognize that sometimes annuities may be an appropriate option for some people. However, we hope that this example demonstrates the importance of fully understanding an annuity product before purchasing it.

If you already own an annuity, don’t beat yourself up! Some annuities may be far from ideal, but there are some that could be appropriate for your situation. There are usually ways to get out of an existing annuity and move to more efficient investments. The details of your contract will lay out the options you have, and our firm has helped numerous clients evaluate their options.

If you have specific questions about your own unique situation, our Fullerton financial advisory firm is happy to help. Please feel free visit our website at www.eclecticassociates.com to schedule a complimentary phone call or meeting with one of our fee–only financial advisors