18.3: Annuities

Video - Audio - YouTube (Material for this section begins on slide 22.)

An annuity is a life insurance product designed to provide a guaranteed income to an annuitant. The annuitant is the person who will receive the stream of income. Annuity options include income for a set number of years, or for as long as the annuitant lives, the so-called life income option, usually just referred to as the life option. The life income option can be modified so that it also will pay the annuitant for as long the annuitant lives or pay a spouse or other dependent as long as they live if they outlive the annuitant. The periodic payments depend upon the annuitant’s age, which of the above options were chosen, how much was contributed, and how well the annuity’s underlying investments, if applicable, have performed over time in the case of a variable annuity discussed below.

There are numerous options and variations of annuities but they generally fall into two categories, fixed annuities and variable annuities. With a fixed annuity, the annuitant knows exactly how much they will receive over time. The life insurance company typically invests the annuity contribution in bonds, fixed investments. With variable annuities, the annuitant chooses various underlying investments, most typically stock or bond mutual funds, and the periodic payments will, of course, vary depending upon the results of the underlying investments.

Once the insurance companies began to offer mutual funds as options for annuities, the Securities and Exchange Commission claimed regulatory jurisdiction. For this reason, life insurance agents who sell variable annuities must also be licensed with the SEC. The agents can choose to take the Series 7 Registered Representative (aka Stockbroker) exam but often they take a much watered-down version, the Series 6 exam. This exam goes by the unwieldy name, the Series 6 Investment Company/Variable Contracts Products Limited Representative exam. You will rarely hear anyone refer to it other than as the Series 6 exam. It was designed solely for insurance agents who only wanted to be able to sell variable annuities and had no desire to be registered representatives, commonly referred to as stockbrokers.

An advantage of annuities is that contributing to them is very flexible. Unlike retirement accounts and other tax-qualified accounts, annuities can be funded with pre-tax dollars or after-tax dollars and there is no limit on contributions. Interest earned is then tax deferred and similar to retirement account, you pay taxes on any pre-tax annuity contributions and all tax-deferred earnings as you withdraw them in retirement. As with other retirement plans, when you retire you will likely be in a lower income tax bracket.

The Siren Call of Annuities

The life income option is typically the major selling point of annuities. “You will never outline your income!” Given that outliving their investments is always a concern to investors no matter how many resources an individual or couple have accumulated, this provision appears very attractive indeed to potential annuitants. What could be the downside to a lifetime of income?

The Reality of Annuities

It turns out that the downsides are severe. You are paying dearly for that guarantee of lifetime income. Annuities have supersized fees. Recall that fixed annuities typically invest in bonds and variable annuities typically invest in mutual funds that invest in stock or bonds or both. The fixed annuities will typically shave 1% to 2% off the interest income from the bonds they invest in. With variable annuities, they pocket typically 2% to 3% and can take as high as 4% of the yearly investment results. Where is the difference going? You guessed it! The spread is going straight into the coffers of the insurance agencies.

The spin doctors at the insurance companies will invariably craft propaganda along these lines: “Don’t gamble with your money! You may receive mediocre returns by investing in mutual funds, stocks, and bonds. Instead, choose our life income and we will guarantee a stream of income for the rest of your life.”

If the spin doctors were somehow given a truth elixir, the spiel would go something along these lines: “Don’t gamble with your money! You may receive mediocre returns by investing in mutual funds, stocks, and bonds. Instead, choose our life income and we will guarantee that you receive mediocre returns and receive a paltry stream of income for the rest of your life.” On the website is an illustration comparing the income streams from two different retirement alternatives, a fixed income annuity and a balanced mutual fund. There is a very stark difference between the two. (Remember that we are assuming that the investor does not panic when markets fall! The case where an individual is incapable of keeping their emotions in check is the only situation where Your Humble Author might recommend an annuity. However, a better option would be to consult a lawyer about a trust fund. What is a trust fund? Talk to the lawyers!)

Once annuitants realize their annuity is not all that their life insurance agent made it out to be, it is often too late. They are locked into the agreement for the rest of their lives. In some instances before the life income option is initiated, there may still be time for the unfortunate individual to break free of the agreement. However, the cost will be steep. Do you remember the Contingent Deferred Sales Charges of the Class B mutual fund shares that declined from 5% to 0% over the course of 5 years, for example? Annuities typically have what they call a “surrender schedule” that works similarly. Unlike the Class B mutual fund shares, the surrender schedule starts at 20% or 25% and can take as long as 20 years. Life insurance companies do not relinquish their ill-gotten gains easily.

Of course, if you are a life insurance agent, you are in love with selling annuities. The commissions are very generous indeed. Your insurance company will even send you an all-expense paid Caribbean cruise! (Ah, we are talking about the life insurance agent going on the cruise, not the annuity client.) It is important to note here, Dear Readers, that Your Humble Author is also a licensed life insurance agent in the State of California. Personally, I have never found an annuity whose results have come close to what a prudent, long-term oriented investor could produce with the education from a course such as this and the maturity to not panic when markets fall or the help of a trusted financial advisor. I could sell these abominations but I won’t. If someone wanted to buy one, I would do my best to show them alternatives that ‒ assuming the world does not end ‒ should do much better over the long term.

You may also have heard that you can actually invest in life insurance itself. Whole life, cash value, straight life, ordinary life, universal life, variable life, variable universal life, and permanent life policies are all examples of what the insurance industry loves to call investments. They are even worse than annuities. Why so many names? Every few years they change the names when people get savvy to the awful deal they are getting. For a more detailed discussion, please refer to chapter 10 of our BUS-121, Principles of Money Management, class, that covers Life Insurance.

Oh, by the way, if any individuals from the world of insurance are reading this and are tempted to sue me for defamation or libel, by all means, we welcome the suit. During the initial discovery process, we will bring life insurance illustrations and mutual fund illustrations to the court with us. Many years ago, on a few occasions, when challenged about my aversion to annuities and whole life policies, I offered to enter into an agreement with the life insurance representatives. Let’s compare comparable investments. If yours are better than mine, I will buy yours personally from you. If mine are better yours, you will buy mine personally from me. No one ever accepted the offer. One individual exclaimed, “But that is not a fair comparison!” My sentiments exactly. Never trust an insurance company with your investments, Dear Readers!