By Adam K. Wright, CFA®, CFP®
As interest rates rise, annuities are gaining increased appeal among those planning for retirement, so much so that annuity sales are surpassing the records set during the Great Recession in 2008. Annuities, which offer a potential source of guaranteed retirement income, can be a great alternative for people whose employers do not offer pensions.
Following record-high sales in 2022, the total first quarter annuity sales were $92.9 billion, a 47% increase from the prior year. This represents the highest quarterly sales ever recorded, according to preliminary results from LIMRA’s U.S. Individual Annuity Sales Survey. LIMRA is predicting FIA sales to continue to grow as much as 10% in 2023, as investors continue to seek out solutions with a balance of protection and growth.
Today’s annuities are more intricate than they seem and may not be suitable for everyone. Before considering an annuity as part of your retirement income plan, it’s important to understand some fundamental aspects, such as what annuities are, the various options they offer, and the level of security they provide for your money.
What Is an Annuity?
An annuity is an insurance product that pays out a stream of income either for a set period of time or for life. Similar to other insurance policies, you sign a contract with an insurance company where you agree to pay a premium amount (either lump-sum or monthly payments). These funds are then invested by the insurance company and paid out to you at some point in the future.
An annuity essentially functions as insurance against the risk of outliving your retirement funds. Annuity income is guaranteed based on the terms of the contract and will be paid out even if the underlying investments do not perform well or the account is depleted early.
There are three main types of annuities:
- Fixed: Guarantees a minimum interest rate and a fixed number of payments for a set period of time.
- Variable: Allows the purchaser to choose different investment options which yield higher or lower returns based on performance.
- Indexed: Pays a capped interest rate based on a stock market index like the S&P 500.
Why Are They So Popular?
Annuity sales have skyrocketed over the past year and a half, in part due to the uncertainty in the stock market. Rising interest rates and volatile stock performances have investors flocking to safer investments like certificates of deposit, money market accounts, U.S. Treasuries, and annuity products.
Here are some of the benefits an annuity can provide:
1. Guaranteed Income
The guaranteed income element is one of the biggest advantages of an annuity. If you’re worried about outliving your money in retirement, an annuity ensures you have supplemental income for the rest of your life, or for whatever time period is stipulated in the contract. There are many different types of annuities on the market, so the exact amount and number of payments you’ll receive may vary. Before you buy an annuity, it is crucial that you understand the terms and conditions.
2. Protection From Downside Risk
Annuities insure against downside risk and can provide a buffer against stock market volatility. If you purchase an annuity that has a fixed interest rate of, say, 7% you are guaranteed to earn that much regardless of how the stock market actually performs. This can be a huge relief during times of extreme market volatility as we’ve seen over the last year. The downside? If there’s a cap on your interest or you have a fixed rate, you won’t be able to take advantage of the upswing if the stock market returns more than 7%.
3. Tax-Deferred Contributions
When you contribute money to an annuity, it grows tax-deferred. You won’t pay taxes on the investment growth until you start receiving payments. Depending on your contract’s interest rate, your account value could grow substantially from the time you invest funds to the time you withdraw.
You may even be able to invest pre-tax funds into an annuity by purchasing the product through your 401(k) or another employer-sponsored plan. This is a relatively new option that many employers are embracing, and since retirement plan providers are required to thoroughly vet insurers, this may be a better way to purchase an annuity than combing through all the options on the open market.
Important Considerations
Though the advantages of annuities make them very attractive in the current market environment, they are not for everyone. There are still several important considerations to keep in mind before deciding if an annuity is right for you.
1. Complexity
There are a vast number of annuity products on the market today with a wide range of complexity. As a general investing rule, never purchase a financial product you don’t fully understand. While the payout may seem promising, there could be extra fees and penalties buried in the fine print.
Unlike funds deposited in banks or credit unions, annuities do not have federal protection if the insurer goes bankrupt. States provide some protection, but it varies depending on where you live. What would happen to your annuity if the insurance company goes under? Are you promised returns on optional benefits you purchase with your annuity? How much will your insurer or agent make on this product? These are all questions to consider when purchasing an annuity.
2. High Fees & Penalties
Annuities have a long-standing love-hate relationship with the investing public partly because they’re often sold by agents who receive sales commissions and management fees. In return, many clients need to be highly skeptical about whether or not they’re being pushed to buy a product they don’t need. Annuities also come with many fees, such as:
- Surrender fees: You can cash out your policy—for a price. Surrender charges usually range from 7%-10% of the account balance and can be in effect for the first 10 years of the policy.
- Administration fees: Annuities also come with an annual fee, typically 0.3%, for managing and maintaining the account.
- Early withdrawal fees: Withdrawing funds before age 59.5 generally results in another 10% penalty.
3. Taxed As Ordinary Income
When you withdraw money from an annuity, or begin receiving income payments, any pre-tax funds and earnings will be taxed at your ordinary income tax rate similar to a traditional IRA. When you withdraw funds from a taxable investment account, it’s usually taxed at the long-term capital gains rate if the investment was held for at least a year. For most people, their ordinary tax bracket is higher than their capital gains tax bracket. This means you may pay more in taxes when you withdraw from an annuity than you would if your money was invested in a taxable investment account.
There are seven ordinary income tax brackets ranging from 10% to 37% depending on income and filing status. There are only three long-term capital gains tax brackets:
Simply put: If your income tax bracket is too high, taxes could eat away your annuity earnings.
Does an Annuity Have a Place in Your Plan?
When it comes to purchasing an annuity, it’s important to approach the decision with careful consideration. Understanding the terms and conditions of the product and evaluating your overall financial situation are crucial steps that should not be overlooked.
At Wright Associates, we are here to guide you in making the choice that best meets your needs. If you have any questions about your current finances or would like to explore how annuities can align with your retirement plan, our experienced team is eager to assist you. Schedule a complimentary phone call to get started and let’s start the conversation!
About Adam
Adam Wright is a CERTIFIED FINANCIAL PLANNER™ professional at Wright Associates, helping clients plan and prepare their investments to retire on their terms. If you’re serious about planning for your retirement and investing for your future, his annual process will help you make the right money choices today. Therefore, Adam and his team will proactively manage your accounts while communicating the progress of your financial plans. He believes the retirement advice you receive should be intentional and actionable.
Adam has a Bachelor of Science in Supply Chain and Information Systems from The Pennsylvania State University and a Master of Business Administration from University of Pittsburgh, Katz Graduate School of Business. He lives in Upper St. Clair with his wife and two children. When he’s not working, Adam enjoys the outdoors (fly fishing), reading, and taking long runs while listening to a favorite podcast. He’s also currently encouraging himself to take up golf. To learn more about Adam, connect with him on LinkedIn.
