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Is an Annuity Right for Your Client?

Evaluating how well an annuity would deliver on common financial goals, from income production to tax efficiency.

If there is one investment that sparks both deep confusion and heated debate, it’s annuities.

It starts with the fact that these are insurance products, even when they are combined with mutual funds. They range from low-cost, simple annuities that can deliver on a promise for a guaranteed stream of income and strengthen a retirement plan, to expensive, highly complicated packages offering uncertain results that critics often rightly deride as not much more than a way for an advisor (or insurance salesperson) to earn a commission.

A combination of potential benefits from some features, significant pitfalls from others, wide variations in complexity, opacity of fees, and high commissions and advisor incentives can make it incredibly difficult for advisors to figure out if an annuity is right for a client in the first place, let alone conduct due diligence on various products.

Moreover, advisors often self-segregate as either “investment people” or “insurance people” and varying incentive structures tend to cement that divide. Financial advisors who are compensated based on the amount of assets they manage might be reticent to recommend an annuity to a client because the purchase will decrease assets under management. Meanwhile, advisors who are compensated based on product sales might be overly aggressive in recommending high-commission annuities, even if they’re not necessarily the best fit for a given client.

The net effect is that some clients who could benefit from an annuity miss out, while others end up locking themselves into products that can do real damage to their financial plans. So, with this article, we’re launching a series of columns designed to help advisors get more familiar with annuities, where they can make senses for clients and where they don’t.

We’re going to start by helping you answer the basic question of “Does my client need an annuity?” From here, subsequent columns will discuss how to evaluate the different types of annuities--from the most simple fixed annuities to complex equity index annuities--assess strategies for fitting annuities into a portfolio, understand and compare costs, and evaluate issuers, among other topics.

The first step, of course, is understanding whether an annuity makes sense for your client.

Does the client need guaranteed lifetime income? The ability to earn guaranteed lifetime income is the biggest attraction to an annuity. In contrast with portfolios, which are a finite resource, most annuities, once annuitized, will pay the client income for the rest of his or her life, much like Social Security. It won't necessarily be a high level of income, but "risk pooling" means that the client "pools" risk with other buyers. Some people in the annuity pool will live longer, some will live shorter, with the shorter-lived people effectively plumping the lifetime payments for those who live longer.

That feature means the payout on basic income annuities will tend to be better than is available on pure investment products. For example, a 70-year-old who put $100,000 into a single-premium immediate annuity with no survivor benefits would receive just over $500/month for the rest of his life, or a roughly 6% “return.” (I used USAA’s calculator to play around with some options.) That’s not directly analogous to a return the client might earn on an investment, in that part of the “return” is the client’s own capital being sent back as a stream of income. By contrast, if the client were to put those same funds into an investment that in turn earns a yield, they’d usually receive at least some of the money back when they sell. (With safe investments like high-quality bonds or bond funds, they’d typically receive all of their principal, though yields are, of course, meager today.)

Nonetheless, the combination of lifetime income plus a higher payout means that basic income annuities can be a sensible addition to retired clients’ tool kits. That’s particularly true today, given low yields on safe investments, the ebbing away of pensions, and longer life expectancies, especially for wealthier individuals. For married couples, there’s a 1 in 4 chance that one partner will live to age 95, and for higher-income clients, the odds are even higher that one of the partners will live to age 95. Other annuities, such as equity indexed annuities and variable annuities with guaranteed lifetime withdrawal benefit riders, discussed below, also can deliver income, albeit with additional costs and complexity.

But even as providing a baseline of guaranteed income may be the most compelling reason to consider an annuity for a client, even retirement experts who are bullish on annuities believe that would-be annuity purchasers should explore delayed Social Security filing first. After all, Social Security provides a lifetime income stream, just like an annuity does, and the longer the client delays the larger the eventual benefit will be. Moreover, Social Security benefits are adjusted to keep pace with inflation; annuity payments won’t be, unless an annuity includes an inflation rider.

Is the client seeking guarantees against losses? Protection against a client outliving his or her assets--or the ability to receive an income stream for life--is arguably the most compelling selling point for annuities. That's the key reason that so many retirement researchers believe that annuities, especially immediate income annuities or deferred income annuities, are underutilized in retiree portfolios.

Yet annuities are often sold because of other guarantees--namely, protection against big stock market losses. Indeed, a common type of annuity--an equity indexed annuity (sometimes called a fixed index annuity)--has that as its main selling point. These products use options to provide returns that are based on the performance of an equity index but also put a floor underneath losses.

From that standpoint, equity-indexed annuities might seem like the best of all worlds, but there are meaningful trade-offs. For one thing, the contracts curtail how much equity-market performance investors actually enjoy, owing to "caps" and "participation rates" that protect the insurer's profits but cut into the client's upside. That means that returns on equity indexed annuities tend to fall between stocks and high-quality bonds. (Economist Roger Ibbotson has argued that because of that risk/reward profile, the products are best considered an alternative to bonds than to stocks.) The products can also be incredibly complicated.

Is growth the client's main objective? Another common selling point of annuities is growth. But how much growth the client can expect depends completely on the annuity type. For income annuities--either immediate or deferred--guaranteed income is the main objective, so growth will be modest. To be able to pay out to annuitants what they've been promised, the insurer must invest the assets used to purchase the annuity very conservatively. That suggests that investors buying an income annuity who also want growth would do well to augment it with exposure to the equity market; they're not going to get it from this type of annuity.

Other annuity types offer more growth potential. In the case of variable annuities, for example, the account owner controls the investments (subaccounts). The funds can be invested in safe investments as well as higher-growth, higher-risk ones such as equity funds and even emerging markets. Equity indexed annuities also offer equity-market participation, as discussed above.

At the same time, other features of these annuities can dilute their growth potential. High costs--which can total nearly 2.5%--can erode the growth of variable annuities. With equity indexed annuities, the guarantees against losses also typically mean that the buyer must accept a cap on gains. Thus, investors seeking growth who don’t also have a need for the additional benefits the annuity confers may be better off investing outside of the confines of the annuity, either in an IRA or brokerage account.

Does the client need additional sources of tax deferral? Another of the main selling points for annuities is the potential tax benefit. Annuities are tax-deferred, similar to funds in a traditional IRA or 401(k). That means that as long as the client's assets stay inside the annuity wrapper, they're not subject to taxation. Because contributions to annuities aren't subject to the same income or contribution limits as IRAs and 401(k)s, the products are often sold as an additional source of tax-deferred funds for retirement.

That's true, but it’s also important to understand the tax treatment of the funds on the way out. If the annuity consists of assets that have never been taxed--for example, the client purchased the annuity with rollover IRA assets (the assets consist of pretax dollars plus investment gains have never been taxed)--it’s considered qualified, and any payments the client receives from it are fully taxable at their ordinary income tax rate. If, on the other hand, the client steered aftertax funds into the annuity, the tax due upon any payments from it are subject to what’s called the exclusion ratio. That means that any funds the client has already paid taxes on aren’t subject to taxes, but amounts over and above that level are subject to ordinary income tax. If the client/annuitant outlives his or her life expectancy, any payments past that point are taxable.

That opportunity for tax deferral means that annuities have some tax benefits relative to saving in a plain-vanilla brokerage account, but they’re not necessarily better. While a brokerage account doesn't supply tax deferral in the same way as an annuity does, the appreciation on assets in a taxable account is taxed at capital gains rates. That's lower than the ordinary income tax rate that applies to annuity payments (apart from amounts that have already been taxed). And if the client buys an annuity with qualified funds, they’re effectively doubling up on the tax advantages.

Does the client need access to their funds? Finally, your client's need for liquidity should be a key consideration before they venture too far down the path of an annuities purchase. Annuities are contracts with insurance companies, and while different annuities have different rules about withdrawals, they typically carry charges if the buyer needs access to their funds within the first several years of purchase. (Some annuities do provide the option to withdraw a portion of funds each year.) Taxes also come into play. Similar to the tax treatment of funds in an IRA, the client will owe ordinary income tax on any investment gains (above and beyond the amount they put into the contract), plus an additional 10% penalty if they're not yet 59-1/2. If the client put qualified funds into the IRA--for example, they rolled over an IRA consisting exclusively of money that has never been taxed--the withdrawal will be fully taxable.

Thus, if your client’s financial situation is uncertain or if there’s a possibility they’ll need to take a chunk out of the annuity with the first seven to eight years of purchase, an annuity probably isn’t the right vehicle for them in the first place. (Guaranteed lifetime withdrawal benefit riders, discussed above, allow for more flexibility on the withdrawal front, albeit with extra costs.) And liquidity helps explain why people who do decide that an annuity is best for them should hold also nonannuity investments alongside that annuity to further diversify and to meet liquidity needs as they arise.

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About the Author

Christine Benz

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Christine Benz is director of personal finance and retirement planning for Morningstar, Inc. In that role, she focuses on retirement and portfolio planning for individual investors. She also co-hosts a podcast for Morningstar, The Long View, which features in-depth interviews with thought leaders in investing and personal finance.

Benz joined Morningstar in 1993. Before assuming her current role she served as a mutual fund analyst and headed up Morningstar’s team of fund researchers in the U.S. She also served as editor of Morningstar Mutual Funds and Morningstar FundInvestor.

She is a frequent public speaker and is widely quoted in the media, including The New York Times, The Wall Street Journal, Barron’s, CNBC, and PBS. In 2020, Barron’s named her to its inaugural list of the 100 most influential women in finance; she appeared on the 2021 list as well. In 2021, Barron’s named her as one of the 10 most influential women in wealth management.

She holds a bachelor’s degree in political science and Russian language from the University of Illinois at Urbana-Champaign.

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