Annuities: Buy, Hold, or Surrender?

annuitymapAnnuities are big business: $142 billion sold last year. The hottest ones are deferred income annuities (“DIAs”), an old concept with a tweaked name and sales pitch and lots of new customers. Is an annuity right for you? Sorry, the answer isn’t as simple as the sales pitch.

DIAs were featured in a NYT article on June 6th. Invest now, in a lump sum or periodic payments, in exchange for a guaranteed paycheck for life that starts some years later. Sales man Matthew Grove of New York Life sees it this way, “It’s people realizing that, ‘I can invest in bonds, but I won’t get as much juice. I can buy equities, but I am taking more risk.’ This is kind of right in the middle, where I am driving income, but I am basically doing it with no risk to myself.”

Au contraire, Mr. Grove. Like any investment, annuities come with risk, and often with more risk than a managed investment portfolio.

Here’s an example: a 55 year old man invests $200,000 in a fixed annuity. In 10 years, at age 65, he starts drawing monthly income of $1,750 for life. Actuarial tables tell us he is expected to live to age 85, so an average individual would receive $420,000. The return on his $200,000 would be roughly 3.85% per year. Not a great return, particularly if you are in the 50% of investors who die before age 85. Furthermore, with inflation appearing to be ramping up, how much will $1,750/mo. buy in 30 years? Annuities are illiquid; you can’t tap into the principal. Also, annuity buyers are relying on the financial security of the insurer, for decades into the future.

What about variable annuities (“VAs”) that invest in equities? The concept again is to grow assets tax-free, like an IRA or 401(k), and then withdraw in the future. The problem is the cost. Barron’s annual report on annuities, published Saturday, identified the average contract cost is 1.5% per year. In addition, VAs generally use high-cost, actively managed funds within, adding 1% or more. As a result, there could be a 2.5% annual drag on performance. As our DWM clients know, passive funds and ETFs outperform actively managed funds over time, primarily due to cost. A 1% annual additional cost over decades can take a huge bite out of your investment.

How about a VA with guaranteed benefits? Before the financial crisis of 2008, a number of large insurance companies sold a decent product. It was a VA with a guaranteed annual 7% growth factor. An individual could invest $100,000, for example, with a 10+ year guaranteed annual net return of 7%. Yes, the contract was expensive, 2.5% in fees plus the operating expenses of the funds. But, here is the good part- at the end of 12 years, e.g., an investor could take either the account value (net of the fees) or the guaranteed value of $225,000 and annuitize it (that is, start taking monthly payments). It was a good deal.  In fact, it was so good that insurers aren’t offering them anymore.

Lastly, how about a single premium immediate annuity (“SPIA”)? A 60 year old can invest $200,000 and get a 6% annual return ($1,000 monthly check) for life (roughly 24 years are expected). The return on investment would be 3.24% per year on average. Roughly ½ of each payment is return of principal and ½ is interest.


BUY? In today’s marketplace, we do not think annuities are generally a good investment for clients with investment assets exceeding $500,000. Of course, there are exceptions.

HOLD? If you own annuities, you should review them with an experienced, independent financial adviser such as DWM. You may have a good one (like the 7% program above) or you may not. However, you may be able to exchange them tax-free into a vehicle with lower fees and better investment choices. Jefferson National, for example, has a contract with a low monthly fee and a wide-range of passive investment funds.

SURRENDER? Don’t surrender an annuity before getting advice from an expert. Income taxes are not paid on annuities until distributions begin. So, there may be significant tax consequences and surrender charges. However, if the accumulated earnings are low or the contract is held in an IRA, for example, it may make sense to surrender the contract even if you have to pay a small amount of income tax in order to emancipate your funds.

Contact us to discuss your individual situation.