From time to time, if you’ve read the other posts on this site, you’ll have seen me discuss annuities, with most of the coverage falling into the category of lament.  I don’t mean to put them down entirely, so in this post I’ll give annuities their fair shake by addressing what they are, why I criticize them, and why they may nevertheless still be a potentially viable option for the FIRE investor.

Let me start by saying that the topic of annuities falls less into the category of things to do when saving and investing for early retirement than options to secure income once you’re in retirement.  However, if this is something you might consider, it’s important to think about while you’re saving because it might affect your approach and it will definitely affect projections of income you can expect in retirement.

First, the basics.  When you purchase an annuity, you purchase the right to a payout of a certain sum for a certain duration.  The simplest example of this would be, at age 50, purchasing an annuity for $100,000 that promises to pay you $2,000 per month for the next 5 years.  Basically what you’re doing is paying now to secure a guaranteed stream of income for years into the future.  For retirees, the most popular types of annuities are those that guarantee payment of a certain amount per month until you die.  This way, you won’t run out of money because you’ll always have that revenue stream.

These are the simplest forms of annuities and nowadays there are varieties galore – and I’m sure in the future you’ll see varieties galore and then some.  I won’t get into all the varieties, but here’s a list of some of the most common:

  • Annuities that pay a fixed amount for a specified term of years;
  • Annuities that pay a fixed amount until death;
  • Annuities that pay a fixed amount until death with a residual value depending on when the holder dies;
  • Annuities that are variable and pay a variable return depending on the market for a fixed term of years or until death; and
  • Indexed annuities that can fluctuate depending on how the market moves, but generally within a pre-specified range (i.e, won’t go up or down beyond the range).

Annuities work somewhat similar to the way employer pensions (used to) work.  You’d contribute from your salary during your career, and when you retire, you become entitled to lifetime payments in an amount that depends on how long you worked for the employer, your salary, etc.  With an annuity, you’re setting up this arrangement on your own with a private company.

In theory, annuities are a worry-free way to ensure you don’t run out of money, assuming you purchase one with a lifetime term.  And that’s the way they’re sold.  In exchange for a payment, you transfer the risk of liquidity and market fluctuations to the annuity company and they’ll make sure you never go hungry.  

Of course, there’s a major snag to this, and it’s that the price of this peace of mind is EXPENSIVE. 

Get ready to burn some cash

Annuities are expensive for two reasons: one, because they tend to give you returns that are (far) less than the market, meaning you forego earning potential; and second, they come with administrative fees.  This is why, if you do a google search for annuities, the first series of results you’ll find are advertisements.  Scare tactics are easy sells for annuities and the pitch lines don’t take much creativity: “Never run out of money,” “live your retirement dream,” and so on and so on.  Annuities are big-time money makers for issuers who can capture the difference between market returns on your money and what they pay to the holder, on top of the fees they collect.

Annuity firms, for the most part, will not just publish rates on their websites.  Annuities are sold to you in person (maybe over the phone), and often through the sort of financial advisor whose primary goal is to sell you what earns the highest commission.  And let’s be clear: financial advisors who sell annuities make a hefty commission, up to thousands of dollars depending on how much principal they get you to pay and the complexity of the annuity. 

It’s for this reason that annuities are frequently targeted at those approaching retirement or new retirees.  Scare them with the proposition of running out of money due to the uncertainty of how long they’ll live and a volatile stock market and they’ll buy the annuity to secure themselves.  The ones who make out in this circumstance are the “advisor” who gets the commission and the annuity issuers acquiring your capital.

That out of the way, let’s talk about what annuities are, how they’re structured, and things to consider if thinking about an annuity in your future – despite the characterization they suffered above.

Tax Treatment

Before getting into how annuities are structured, let’s talk about taxes, because we love to talk about taxes.  Annuities are pretty simple.  If you buy with post-tax dollars, the annuity can grow without incurring interim taxes (like interim capital gains from mutual funds, etc.) and then you’ll be taxed when you withdraw funds or receive payments.  

The focus of this photo is the coffee

If you purchase an annuity with after-tax dollars, only a portion of each payment to you is considered growth subject to taxes, while the remainder is treated as a return of principal and is not taxed.  The exception to this is if you purchase an annuity that pays until you die.  If you live longer than your life expectancy, any payments thereafter are fully taxable, on the theory that the return of principal was complete as of the date you were supposed to die.

There are also annuities that can be purchased with pre-tax dollars, including by paycheck deferral or by using funds from a 401(k) or IRA to purchase the annuity.  This is called a qualified immunity and the annuity payments you later receive are subject to tax as ordinary income (not capital gains).  Relatively simple.

Annuity Basics

Now on to the analysis.  From my word choice here and in other posts, you might be able to tell that I’m generally opposed to annuities.  And you’d almost be right.  Let’s explore in more detail.

i. The Traditional Annuity and the Annuity Lottery

First, let’s talk about the classic form of annuity: where you pay a lump-sum in exchange for guaranteed payments for the remainder of your life but without there being a residual value payable when you die. 

Purchasing an annuity like this amounts to playing an “annuity lottery,” because how much you get back is dependent on how long you live.  Traditional annuities like this are priced the same way as life insurance contracts: by evaluating a number of data points about you, the issuer tries to figure out how long you’ll live and price the annuity accordingly.  

If you live longer than the model predicts, you win the annuity lottery by getting more than you paid for.  If you purchase the annuity at 65, and the issuer predicts you’ll live to 75, but you live until you’re 90, you’ve basically gotten 15 years worth of extra payments for which you did not pay.

But if you walk out of the office after signing the annuity contract and fall into a volcano, you’ve just lost all the money you paid and your family won’t even bother to fish out your ashes or ask that the city put up a warning sign in your honor – because you’ve squandered their inheritance.

You probably should’ve seen it coming

ii. Annuities with Residual Values

The traditional annuity lottery example has somewhat gone out of style for the exact reason you might think – people are unwilling to risk their savings on the unpredictable variable of exactly how long they’ll live.  As a result, a number of alternatives have sprung up that reduce the risk associated with the traditional annuity. 

Annuities with residual values pay out a certain amount to your estate (or a selected beneficiary) after you die depending on how long you draw down payments, or pay out a residual value at the end of the annuity’s term.  For example, for a lifetime annuity with residual value, if you die one year after purchasing the annuity, a calculated amount will be paid to your estate that accounts for the fact that you only withdrew a small portion of the principal paid. 

With this type of annuity, there’s less risk of squandering everything than with the traditional annuity lottery.  But remember, with these you’ve already taken your pile of cash, given it to someone else, paid a good chunk of fees and a commission, and earned little rate of return, just to have less money returned back later.

iii. Variable Annuities

One of the other issues with traditional annuities is the fixed payments, meaning that if the market is showing strong returns, your upside potential is limited to the fixed amount, leaving the annuity issuer to reap the benefit.  And indeed, this is how annuity issuers make a great deal of money.  

Variable annuities, which make payments to you based on market returns, are an option to capture the upside of a strong market.  With truly variable annuities, however, you’re not really shifting the risk of market fluctuations to the annuity company, which is typically the point of buying an annuity in the first place.  While you may be able to receive higher payments if the market does well, if the market falls, so do your payments.  And, you’ve paid fees to experience that loss.  

If you’re willing to take the risk of market movements, the case for purchasing an annuity is far less compelling.  The annuity issuer is essentially acting as an expensive investment advisor.

iv. Indexed Annuities

Indexed annuities are like variable annuities, except that while an indexed annuity can fluctuate depending on market returns, it will only do so within a certain range.  For example, when the market is showing strong returns, your annuity payments may go up by a certain percentage, while if the market is going down, your payments may also go down, but not beyond a pre-specified amount.  

With these, in contrast to purely variable annuities, you’re sharing risk to an extent by better protecting your principal against market downturns.  The price for this, however, is that your upside is limited.  And that limited upside is often very limited – take a look at the annuity contract and you’ll see that even in the best of times, your payments may only increase by a small percentage.

These four types are a broad brush over the numerous variants that exist.  If you’re truly interested in exploring annuities, you’ll be able to find these, permutations of these, combinations of them, and so on.  If nothing else, the annuity market is constantly evolving to develop products for all sorts of risk tolerances.  Just remember this: the less risky the product, the less you’ll receive in return, while the more risky or variable the annuity, the more upside and downside potential you retain.  It’s kind of like investing generally.

You’ve still got calculations to do

Assessment of Annuities

The basic rundown complete, here’s my conclusion: annuities generally offer limited returns for very high fees and are simply not worth the value.  

To put it bluntly, annuities are for the extremely risk averse.  And while the option of risk averse products may seem worthwhile for a retiree seeking to live without a dependence on wages, there are plenty of ways to limit market risk and exposure without an annuity, including through low volatility ETFs, good old fashioned bonds, and other lower-risk products.  And remember, if you diversify properly, the likelihood of getting wiped out completely is very slim, and the sort of systemic shock that would need to occur to zero you out is likely to affect you regardless of how you hold your money.

What about the guaranteed income stream from an annuity?  Well, to an extent that mitigates the risk that you’ll burn through all your money while you’re still alive.  So this can be a real high point of lifetime annuities.  However, keep in mind that this is only attractive if you really can’t manage your money.  And don’t forget, as time goes on, if you have an annuity that makes fixed payments, the value of those payments is continually chipped away by inflation.  In contrast, so long as you can manage money appropriately and invest wisely, even if with a risk averse outlook, you can keep pace with, and even obtain returns that are higher than, the rate of inflation.

And let’s talk about fees.  High fees.  Notoriously high fees.  If you’re looking at an annuity, just read through the disclosure documents and you might be floored.  The agreement will be long and written in legalese – and that’s not an accident, but you still have to read it and understand it.  Don’t sign something while you’re at someone’s office – take it home, study it, ask someone else to study, and don’t agree to anything until you fully comprehend where and how the fees apply.

Wave goodbye to some of those returns

And do this even though the person trying to sell you the annuity says it’s low-fee or no-fee.  Because while that may technically be true, those administrative costs are recouped in up-front purchase prices and in how the amount of your returns is generated.  So yes, it might not technically have “fees” withdrawn from your payments, but your guaranteed return will be a slice lower.  There are fees whether they’re called fees or not – just like mutual funds.

The point is to be careful if considering an annuity.  However, I will not categorically say that you should avoid them at all costs, but if you must, make it part of your retirement strategy and not the whole thing.  If you just can’t figure out how to reduce your risk when investing on your own, by all means, an annuity is one (expensive) way of paying someone to do it for you.  Or, if you’re so risk-averse that you can’t sleep at night with the thought that your money is at risk in the market and that you could spend all your money before you die, then by all means, use some of your money for an annuity that guarantees future payments.  

Then sleep tight – except know that you can lose money if your annuity company goes out of business.  Because most annuity providers are insurance companies, some annuities are protected up to certain limits by state (not federal) insurance guarantee funds.  That’s right – state insurance guarantees.  But not all annuities are protected and those that are may be subject to total limits.  So your “safe” investment for which you paid a premium may not protect you after all.  

In sum, do your due diligence, don’t believe everything a salesman is telling you, and decide for yourself whether it’s really a good value.