Annuities: Worth Exploring, but Handle With Care
Annuities tend to fall into one of two buckets for most people: either “safe and steady” or “confusing and costly.” Unfortunately, those in the “confusing and costly” bucket don’t often inhibit annuity producers from selling them, and trust me, many of those producers don’t have a firm handle on how the particular annuity operates either.
Some folks have an annuity but don’t even know it. I often come across that situation after a client visits their bank in search of a good, fixed interest rate and leaves with “something my banker recommended” which turns out to be an annuity. The money you put in the annuity sold by a banker doesn’t stay at the bank. It leaves there and ends up in the account of an insurance company. That’s not necessarily a bad thing, but many people are surprised to learn that fact.
There are strong opinions, both good and bad, about annuities. Let me try to clear things up:
Annuities aren’t inherently good or bad. If you’ve heard horror stories about an annuity, that is usually a problem with the annuity salesman. Understanding the basics can help you decide whether they belong anywhere in your financial picture.
At their core, annuities are contracts with an insurance company. You give them money and in return, they promise some combination of growth, income, or protection. Think of them as a way to turn a lump sum into a stream of payments, often designed to last for life.
There are three primary types of annuities worth knowing:
- Fixed annuities offer a set rate of return. They’re straightforward and behave a bit like a CD, though typically with longer lock-up periods. Often, these are the annuities people walk out of a bank with.
- Variable annuities allow your money to be invested in market-based subaccounts. This introduces growth potential—but also risk, and complexity, and sometimes unknown (unexplained) fees. The value of these annuities can go up and down with the market.
- Indexed annuities fall somewhere in between, tying returns to a market index (like the S&P 500) but with caps, floors, and participation rates that limit both the upside and downside.
One commonality of all three annuity types is that the growth is tax-deferred until it is withdrawn. Annuities do not provide a step up in basis on the gain at death and all tax on an annuity withdrawal is at ordinary income rates.
One of the main reasons people consider annuities is income certainty. Some annuities can convert your savings into a guaranteed monthly payment you can’t outlive. That can be appealing, especially for those without pensions or who value predictability over flexibility.
That said, annuities come with trade-offs. They often include surrender periods (meaning your money is not easily accessible for several years), fees (particularly with variable annuities), and complexity that can make apples-to-apples comparisons difficult. In many cases, you’re giving up liquidity and simplicity in exchange for guarantees.
So where do they fit? For some, annuities can serve as “personal pension” that covers essential expenses with reliable income. For others, especially those comfortable with market volatility and managing withdrawals, they may be unnecessary.
Bottom line: Annuities are tools. Like any tool, their value depends on whether your needs can be matched with a specific annuity type. I do have one important reminder that applies to all annuities: If you do use an annuity in your financial toolbox, make sure you have beneficiaries listed on file with the insurance company.
Fun Fact: A “millionaire” and a “billionaire” are both well off, but far from similar. In fact, the clearest way I found to get people to understand the difference is in seconds. A million seconds amounts to 11.57 days. A billion seconds amounts to 31.7 years. Quite a difference!
