All Annuities Are Not Equal: Do Your Homework Before You Bash Or Buy

When you say the word “annuity,” it seems the typical reaction is a wince. There might even be a slight gasp through gritted teeth or an involuntary shaking of the head.

Although they’ve been around for years and years and can play a critical role in many retirement plans, annuities have gotten a bad reputation over the past decade or so. And that’s too bad, because they can be a useful tool if you know what you’re buying and what it’s meant to do.

But, of course, most people don’t. Some in the media and, sadly, many of the people who sell financial products tend to lump the different types of annuities together as though they were all the same. Many take a complex topic and broad-brush it — leaving out the positives or the negatives of each product in whatever way best serves their purpose.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

But all annuities are not created equal, and it’s a disservice to consumers to treat them that way.

So, what is an annuity? At their core, annuities are contracts sold by insurance companies – with the contract provisions guaranteed by that company’s financial strength and claims- paying ability. The purchaser provides money (sometimes as a lump sum, sometimes as a series of payments) and the insurance company promises to pay that money back over time as a lump sum or series of payments, plus interest gains.

Immediate vs. deferred annuities

The most common types are immediate annuities and deferred annuities. There are also fixed annuities, indexed annuities and variable annuities. Each fills a different niche.

With an immediate annuity, you give a company a lump sum of money, and they spit out payments to you for a predetermined amount of time. It could be 10 years or a lifetime, depending on the contract. Immediate annuities can provide a fixed or variable stream of income, depending on the type you purchase.

With a deferred annuity, you purchase the contract from an insurance company and let it grow tax-deferred until the date stated in your contract. The advantage is that your money keeps growing until that date with an internal rate of return. And again, you can have either a fixed or variable (i.e., cost-of-living-adjusted) payment.

Not all annuities work under a straightforward “give the company a lump sum of money and they’ll issue a paycheck” format. They become a little bit more multifaceted in what they do.

The fixed annuity

One of those is the fixed annuity, which provides a fixed payout on a regular basis. Individuals will always know exactly what they will be receiving from their annuity. There are varying levels of restrictions — but the bottom line is that you’re trading access for a higher interest rate, so there can be heavy surrender charges. Fixed annuities pay guaranteed rates of interest, and that interest is tax-deferred – a big plus. But you also should take inflation into account when considering this type of annuity. With rising interest rates potentially causing bond prices to fall, these can add another layer of diversification to the low-risk portion of your investment portfolio.

The fixed index annuity

A newer annuity product that people are talking about is the fixed index annuity, which has attributes of a fixed and a variable annuity. You get the principal protection of a fixed annuity, but, like a variable annuity, you have an opportunity to see higher gains if the stock market rises. The growth is subject to rate floors and caps, which guarantee a minimum rate of return but also limit your investment’s growth if the underlying stock index rises beyond those limits.

It’s probably the most misrepresented of the annuities that are out there right now, and usually that misunderstanding comes from those who don’t normally deal with this type of product. Critics tend to focus on high commissions or the fine print in complicated contracts.

For example, the contract might say that the rate can go as low as 1% of the cap — and that’s true. However, in rare cases insurance companies may lower the cap, and sources often skew the reasoning for that. These are not merely arbitrary caps – they are reflective of the options-purchasing ability of the annuity carrier. The carrier will not directly invest in the index you choose: It will buy options on indexes so that if the index hits its written target price, it can pay the owner of the contract.

At the end of the day, enforcing a contract minimum is incredibly rare, and companies will rarely want to deal with the potential bad press that would arise if they aggressively slashed rates. Commissions also vary wildly on fixed index annuities: from 0.6% per year over the term to well over 1%. Insurance companies build the commissions into the annuity’s original price, so your statement will not show $100,000 becoming $93,000 from a 7% commission.

Fixed index annuities aren’t for everyone. They are geared toward safe growth, so you have to be comfortable with zeroes. You won’t lose anything if the market goes down, but you won’t get as much if it goes up. That’s the tradeoff. It’s the difference of playing small ball and hitting for average rather than hitting for power. Find a financial professional you can trust to take you through how it works, how you could combine it with other products in your portfolio, and ask for the downsides before deciding.

The variable annuity

Finally, there are variable annuities, with payouts that are dependent on the proceeds of their investments. They’ve become kind of the poster child for annuity bashing with high costs, and sometimes deservedly so. But even a variable annuity can have desirable features and benefits if it is positioned right in your portfolio and is in line with your specific goals. But that’s the key: having clear goals and objectives for your financial strategy will do wonders for working with a financial professional to determine if an annuity is an appropriate option for your overall strategy, and, if so, what kind.

About riders

Annuity benefits can be layered and have many components to consider. For instance, many annuities offer the option to add contract riders, or extra features, for an added fee. For typically a percent a year, purchasers can buy assurances for their lifetimes and that of their spouse. Or they can add inflation-specific features. In my experience, though, this is another area of concern, since consumers often don’t understand what benefit they are getting, or at what cost. When used correctly, riders can be excellent contract additions. Yet, all too often, the rider isn’t all that it’s cracked up to be, and its fees serve to eat up a contract holder’s interest earnings. Again, do your homework and work with someone who you can trust.

A little healthy skepticism is beneficial when you’re looking at any annuity. Don't let uninformed critics make your decision for you — and, on the flipside, don’t believe it when someone tells you a particular annuity can accomplish all your goals. After all, no single product can do everything. With annuities, a tradeoff for guarantees is that they aren’t very liquid – many of them have penalties for withdrawals before 59 ½ or whatever date your contract specifies. Even then, most of them only allow you to take up to 10% of the original contract value per year. For some people, this is not a problem at all. For others, it’s a reason to think twice.

The qualifications to sell financial products vary. Make sure you’re talking to someone who’s looking out for your best interests and not just going for a sale.

Before you buy, ask yourself why the purchase is appealing. If you’re unclear, do some more research. Be sure that an annuity — whichever type it is — fits into your long-term financial strategy.

Kim Franke-Folstad contributed to this article.

Investment advisory services offered through Brookstone Capital Management LLC (BCM), a Registered Investment Adviser. BCM and Fritts Financial LLC are independent of each other. Insurance products and services are not offered through BCM but are offered and sold through individually licensed and appointed agents.