What You Need to Know About Annuities

Key Takeaways

• An annuity is a contract with an insurance company.
• With income annuities, you give them a pool of your money, and they send it back to you as a stream of income.
• When it comes to annuities helping with retirement planning, these very basic income annuities can be helpful in terms of addressing a household’s basic living expenses.
• The most familiar type of deferred annuity will be a variable annuity where, if you buy such a product, you’re in control of the investment allocations, for better and for worse. There are also the increasingly popular “fixed index” annuities, where you’re also obtaining some market exposure, but there are caps on your gains.
• Deferred annuities will carry really long contracts with lots of fine print about how they work.

Margaret Giles: Hi, I’m Margaret Giles from Morningstar. Retirement researchers are often enthusiastic about annuities, but many consumers are reasonably skeptical. Joining me to share some basic information about annuities and their pros and cons is Christine Benz. She’s Morningstar’s director of personal finance and retirement planning. Christine, thanks for being here.

Christine Benz: Margaret, great to see you.

What Is an Annuity?

Giles: So you’ve noted that the term “annuity” encompasses so many different product types that it’s almost unhelpful. Can you give us a basic definition of an annuity?

Benz: An annuity is a contract with an insurance company. So in the most basic annuity type, you give the insurance company a pool of your money, and they send it back to you as a stream of income over your lifetime. That is the most simple annuity type, and of course there are lots of different variations on that, but that’s the basic idea in play.

How Do Income Annuities Work?

Giles: Right. So you think it’s helpful to separate annuities into two main categories, income annuities and savings annuities. Let’s start talking about income annuities first. How do they work, and how are they different from investing in something that pays out income like bonds?

Benz: I have to credit our colleague Spencer Look for coming up with this framework for thinking about annuities. With the income annuities, that’s the basic annuity type that I referenced earlier where you sign a contract with an insurance company, you give them a pool of your money, and they send it back to you as a stream of income, and the reason that retirement researchers tend to be so excited about those types of products is that they do give you more income than you could earn on your own by investing in a bond.

They do that because you benefit in the annuity by what’s called “longevity risk pooling,” which means that some people who are buying that same annuity are going to die sooner, and that enlarges the payout for the whole group of you. If you’re the one who lives to be 99, well, you’re the winner in that situation. So that’s one reason that payouts are higher than you’d see for traditional fixed-income instruments. Then the other big reason is that if you buy an annuity, your money is gone, effectively. You get this stream of cash flows from it, but you can’t get your principal back. In contrast, when you buy a bond, you receive some income, but you do receive your principal back at the end. So that’s a major differentiator as well.

How Annuities Can Help With Retirement Planning

Giles: Right. How can these types of annuities help with retirement planning? And what should people know if they’re considering one?

Benz: I think these very basic income annuities can be helpful in terms of addressing a household’s basic living expenses. And you and I have talked about this before, Margaret, where, say, my household basic expenses, my housing, my taxes, my healthcare, say that’s totaling $40,000, which is a pretty low number, but let’s just say that it is, and Social Security is going to give me another $30,000 of that $40,000. Well, I could turn around and buy an annuity that’s going to supply me with $10,000 a year to help meet those basic cash flow needs. I think that that’s an elegant use of an annuity, and it can also help retirees figure out how much they would want to put into such a product. They can look at how much they actually need from that product.

What Are the Different Types of Deferred Annuities?

Giles: Now let’s pivot here and talk about savings annuities, sometimes called “deferred annuities.” They allow investors to obtain market exposure. They’re not just buying income. What are some of those key annuity types that fall under that umbrella?

Benz: The most familiar one I think for many viewers will be a variable annuity where, if you buy such a product, you’re in control of the investment allocations for better and for worse. Then there are also what are increasingly popular called “fixed index” annuities, where you’re also obtaining some market exposure, but there are caps on your gains. There are also caps on your losses in such a product. Those products have become quite popular recently. Then registered index-linked annuities fall between those two product types on the risk spectrum. In fact, Spencer has a paper where he has kind of plotted them from risk and return potential, and the RILAs fall in between the two. So those are some of the most common savings type annuities.

What Investors Should Know Before Investing in Deferred Annuities

Giles: These products are obviously more complicated than income annuities, and they carry more risk and higher costs. How can investors make sure they know what they’re getting into with these products?

Benz: Right. Typically, these products will carry really long contracts with lots of fine print about how they work. That can be very difficult for consumers to wade through. In fact, I can’t tell you how many consumers I’ve encountered who actually show me that what they have is an annuity, but they didn’t know it was an annuity. Obviously the consumers aren’t asking enough questions. A gold standard would be where you hire some objective third party to help you understand what you might be getting into. Consumers often really don’t want to go to the added expense of hiring an advisor to help vet an annuity.

At a minimum, I would say write down all of your questions. There are no stupid questions in this context because transparency isn’t really there for consumers. So write down all of your questions, ask about costs, ask about withdrawals, ask about what you’re getting with this product that you couldn’t get with a very vanilla investment portfolio that would also give you more liquidity, more access to your funds. Until you have exhausted all of those questions, don’t sign on the bottom line. That would be my advice. And you also want to ask about the financial strength of the company, the insurance company backing the annuity, because this is a long-term relationship. You need to make sure that they’re able to make good on whatever promises they’re making to you.

Tax Implications of Annuities

Giles: Absolutely. So can you talk about the tax implications of annuities?

Benz: It gets a little bit complicated depending on the account that you use to fund the annuity. But generally speaking, you will owe taxes. You’ll obtain some tax deferral as long as the funds are inside the annuity, and then you’ll owe taxes on any money that hasn’t been taxed yet. If you put pretax dollars into an annuity and it makes investment gains, well, all of your withdrawals will be taxable and they’ll be taxable at your ordinary income tax rate. If you’ve put in some money that has already been taxed, there’s what’s called an “exclusion ratio,” meaning that you won’t be taxed on those funds again. But it’s important to understand the tax implications of those withdrawals on an annuity as well.

How Investors Can Evaluate Their Annuity Insurer’s Financial Strength

Giles: Right. So you’ve touched on this already a little bit, but this is a long-term contract with an insurance company. How can investors evaluate the insurer’s financial strength?

Benz: There are what are called “financial strength ratings” that are available from ratings agencies that look at the financial wherewithal of the insurance company’s backing. You want to do your homework on this. Don’t just rely on what the insurance company puts on its website. They might have kind of some selective process going on where they’re just showing you the best ratings. Do your homework. Make sure that you understand that these ratings agencies use different spectra to rate companies. So understand that there are different rating systems in play, and make sure that you are looking at more than one ratings agency to gain comfort in the financial strength.

Giles: All right. Well, annuities can be complicated. I appreciate this context and insight into some of those pros and cons.

Benz: Thank you so much, Margaret.

Giles: I’m Margaret Giles with Morningstar. Thanks for watching.

Watch Can Your Investment Portfolio Be Too Diversified? for more from Christine Benz and Margaret Giles.