Here’s the low down on annuities – what kinds there are, their pros and cons, and how to make an informed choice, whether or not you hire True Link as your financial advisor.
What is an annuity?
There are many different types of annuities, but what they all have in common is that in return for some amount of money upfront, an insurance company promises to pay you a certain amount of income in the future.
Annuities are often referred to as “guaranteed* income.” You’ll notice we always put an asterisk next to word guarantee* as a reminder that the guarantee is only as good as the insurance company and any government protections available at the state level.
How do the types of annuities differ?
Annuities can be very complex, but there are three things you should know about any annuity you’re considering:
1. When payments start: They can be “immediate,” which means you start getting money right away, or “deferred,” which means you set a period in the future for when payments will begin.
2. How long payments last: They can be “period certain,” e.g., pay out for five or ten years; “single life,” which means they pay out as long as you’re alive; or “joint life,” which means they pay out as long as either you or your spouse is alive. There are certain individuals who are less comfortable putting money into an annuity with the risk of losing it all if they were to die tomorrow. That’s why some companies offer “life with guaranteed term,” which means they pay out for your whole life, and will continue to pay out if you die before your set term – ten years, for example – has ended, or “life with guaranteed minimum” which means that your heirs will receive a set amount assuming it has not been paid already. If the guaranteed minimum is equal to the full payment amount, it’s sometimes called “life with cash refund.”
3. How much payments are: Annuity payments can be “variable” or “fixed.” Variable annuities are partially linked to the stock market – the payment might go up and down, but certain types could have a guaranteed minimum. Fixed annuities, on the other hand, offer the same payout no matter what. Certain fixed annuities have a cost of living adjustment and some others do not. It’s worth noting that the insurance company might be backed by state guaranty associations, but you or your financial advisor should always verify the financial health of the insurance company and confirm that the specific product is subject to government protection before you purchase an annuity.
Why do annuities work well in certain situations?
In some cases, annuities are the cheapest way to make sure you will never run out of money, no matter how long you live.*
Suppose you’re a 65-year-old female. According to the US government, your estimated longevity is 20 years – until you’re 85. But if you’re in good health the odds of living another fifteen years, to 100 years old, might be 15-20%, or more. In this case, the responsible choice may be to set aside something like a third of your assets for years 85-100, so you don’t run out even if you live to 100 years old.
Now imagine there’s a pool of one hundred people. Only fifteen percent will live to be 100 years old, which means that if they worked together, they could all set aside 15% of their assets instead of 30%, and then whoever lived beyond the age of 85 would have access to the money they need. This is essentially what insurance companies do across the board – whether it’s car insurance, health insurance, or homeowner’s insurance, they take a group of people who might have an unexpected expense, pool the money, share the risk, and pay it out to just those who need it. In this case, the “unexpected expense” is living a very long time.
So, what does this mean? If someone participates in the insurance company pool (i.e., if they buy an annuity) that means they could, for example, set aside a certain percentage of their money for years 85+ and secure a known level of income. If they plan to live off of their own savings, on the other hand, they might have to set aside a larger portion of their own assets and assume all of the risk.
Why do annuities sometimes get a bad rap?
First, for certain cost-conscious individuals, the level of fees can be a concern. Second, assets held in an annuity are inaccessible, forcing one to borrow against it, at considerable cost, in the event liquidity is needed to meet an unanticipated expense. Third, there can be expensive and confusing features of annuities that could, in hind sight, yield less that what could have been earned if those same funds were invested in an index fund.Every financial product from stocks to CDs has its pros and cons. At True Link, we believe investors are best served through an ethical financial advisor who explains choices in plain English and helps make an objective decision that’s in our clients' best interest.
*Guarantees are subject to the claims-paying ability of the issuing company.