To oversimplify the investing world, one could say that there are two types of investments. One in which your values can negatively fluctuate, and another in which they will not. To be clear, this conversation is more about the day-to-day, week-to-week, month-to-month values, etc., and not necessarily about purchasing power over extended periods of time (i.e. inflation).
In my last article, we looked at a couple of highpoints regarding annuities and taxation. This week, as promised, we’ll consider the major types of annuities. Those types include variable annuities, immediate annuities, fixed annuities, and fixed-indexed annuities. This will be a 30,000-foot view of these investment vehicles, so it is important to point out that not every annuity offered to consumers will directly correlate point-for-point.
As a reminder from the previous annuity post, all annuities are tax-deferred, regardless of their tax classification.
Variable Annuities | Those that have some wiggle
To kick things off, let’s begin with annuities whose values can have some positive and negative movement. I like to call that type of movement “wiggle” (technical, I know). I call it wiggle because, if you look at the value of an account over time, the graph you see in most cases is nonlinear. The account value might increase one day, and decrease the next. Think of the movement of the stock market. There can be a little growth day-to-day or a little loss. There can be big growth or big loss. The values are subject to the will of the market and the various asset classes represented.
In a variable annuity, unless invested in a fixed-rate, you’ll be invested in the insurance industry’s equivalent of a mutual fund. These are called sub-accounts. They look, feel, and act like general mutual funds that you may have in your 401(k) or a brokerage account.
Additionally, variable annuities often come with several types of fees (morality and expense, administrative, investment expense ratios, and various rider fees). It is not uncommon for these fees to quickly add up to between 2.5% and 5% in annual fees. If that sounds high, that’s because it is. What that could mean for you is that your account would need to return 2.5% to 5% just to have a flat year!
So, why do people flock to these types of investments? One answer is that some financial professionals offer them to investors because they are compensated well to do so. However, that is a story for another day. Some good reasons that people might consider utilizing a variable annuity have to do with the tax deferral of non-qualified (non-IRA-type accounts) and potential lifetime income benefits. We’ll look at lifetime income benefits in the next annuity blog post.
Immediate Annuities | Bye-bye ownership
We all have heard horror stories about someone’s Uncle Bob and the mean ol’ insurance company. The story goes something like this:
Uncle Bob had, let’s say, $200,000. He handed it over to an insurance company in exchange for $500/mo for the rest of his life. Unbeknownst to Uncle Bob, the rest of his life ended up only being two months. After the funeral, the family remembered that Uncle Bob had just put $200,000 with ABC Insurance Company. When they contacted the company, the company told them some bad news: there was no inheritance for them. Uncle Bob had exchanged $200,000 for monthly income that he could never outlive. The insurance company won. Uncle Bob’s relatives lost. Uncle Bob no longer cared.
The major downside to immediate annuities is that an individual gives up ownership of their capital, in exchange for monthly income. Giving up ownership and control of your life savings is generally frowned upon.
Immediate annuities are going to look and feel a lot like a pension. In most cases, this is set monthly income for the rest of your life. In fact, pensions begin with a block of money. Prior to starting a pension, you are given options as to how long you’d like to receive income or take it all out at once as a lump-sum. Generally speaking, if you start income, you no longer have access to the lump-sum amount. If you take the lump sum, you no longer have the option to receive a pension.
Immediate annuities, like anything, can be right for the right person. However, there are ways to accomplish a monthly income goal that you cannot outlive, while maintaining access to the larger value of the account. More on that in the next annuity post.
Fixed Annuities | Principal protection with often linear interest
There is a segment of the population that is totally content with earning some interest and protecting their principal from negative market volatility. The most direct correlation is to think of it similar to a certificate of deposit (CD) that you might get through your local bank or credit union.
With a CD, an individual will invest a certain amount of money for a certain period of time in exchange for a certain interest rate. This is also how a fixed annuity will work. However, there are generally four notable differences.
- Interest earned on a CD is taxable in the year it is earned, whereas interest earned on a fixed annuity is taxable when it is withdrawn from the account. If you’re under 59 ½, don’t forget about the IRS’ 10% early withdrawal tax on non-qualified annuities. Tax deferral is a major reason most investors choose to utilize a fixed annuity over a certificate of deposit.
- Fixed annuities have historically offered investors a better interest rate. While it is possible to cherry pick a high paying CD and low paying fixed annuity to dispute the previous sentence, the general rule of thumb is that, on average, you’ll likely find a higher interest rate at within the insurance industry as opposed to the banking industry.
- An investor utilizing a fixed annuity will generally have a little better access to their money during the term. Typically a fixed annuity investor can access between 5-10% of their account balance without paying a fee, unlike a typical CD.
- Technically as an insurance product, an investor can add various benefits or features to their account, often for a fee. These are known as “riders.” We will explore these in a future post.
It is important to note that there are a couple of types of fixed annuities. The standard fixed annuity could change the interest rate from year-to-year during the contract term, typically with a minimum guarantee of 1%. Another type of fixed annuity is called a multi-year guaranteed annuity (MYGA). These are typically more desirable, as they offer a set annual rate for the entire contract length. For example, an investor might get 3.5% per year for five years. You know what you have going in, and you know what you’ll have at the end.
Fixed-Indexed Annuities | Principal protection with better interest potential
Essentially, everything that was mentioned above about fixed annuities will hold true to fixed-indexed annuities.
Fixed-indexed annuities have been around for almost 25 years. They were built to offer principal protection while giving the investor an opportunity to earn more interest in a given year than they might in a fixed annuity. This is accomplished by tying an investor’s potential earnings in an account to a certain market index, often up to a point known as a “cap.”
The most standard interest crediting method is an S&P annual point-to-point strategy with a cap. This type of strategy will base the interest that is credited to the account off of the performance of the S&P 500 from the date the account is issued until one year later.
Let’s say you opened an account with a 6% S&P point-to-point cap. On the day you opened your account, you had $100,000 and the value of the S&P was at 2,879.
If one year later, the value of the S&P rose by 4%, you would get 4% added to your account. If it rose by 5.9%, you would get 5.9% added to your account. If it rose by 8%, you would get 6% (your cap) added to your account.
Conversely, if the S&P was down 1% (or 10%, or even 50%), your account would see no change and you would start the next year still at $100,000.
There are quite literally hundreds of interest crediting options including fixed rates, real estate indexes, uncapped strategies, participation in a percentage of the growth of an index, index strategies tied to obscure indexes the average investor has never heard of, etc. From a sanity standpoint, either a fixed rate option or the S&P annual point-to-point strategy with a cap might be the best options.
When we circle back around to annuities on the blog in two weeks, we’ll consider both ends of the annuity see-saw regarding the reason to have one: growth vs income.