Written By Anthony Striker, MBA – Senior Wealth Manager
Today I want to put in writing some thoughts that I have about what I jokingly tell our clients is the “most googled term in our industry”, annuities. Like any other product, annuities can be used as a tool in a retirement plan, but it is imperative to understand the ins and outs of these investments so that expectations can be set properly and most importantly, goals within the portfolio are achieved.
Let’s start with an “easy” question. What is an annuity? The term “annuity” refers to an insurance contract issued and distributed by a financial institution with the intention of paying out invested funds in a fixed income stream in the future. This is what an annuity is at its core, it gives an investor the opportunity to deposit funds and receive an income stream from these funds at some point in the future. However, as you may already know, not all annuities MUST be used strictly for income stream purposes. Some can be used for safety in a portfolio or to grow assets conservatively. Nevertheless, it is imperative to understand both the pros and cons associated with these potentially long-term commitments (some annuities can have surrender periods of up to 20+ years!).
Below are some examples of types of annuities and what they can be best suited for:
Fixed Annuity: Pays a stated rate of interest and keeps money in the contract principally protected. Sometimes we call Fixed Annuities “CDs from the insurance world” as they are the most predictable type of annuity one can have. The stated rate of interest can either be credited to the annuity account value or come in the form of monthly or yearly payments.
Fixed Indexed Annuity: This is an insurance contract whose account value follows an index (such as the S&P 500, Dow Jones, or even proprietary indices created specifically for the annuity) to determine how much interest will be credited to the account each year. There are different crediting strategies that are used to determine how much interest will be credited. The two most common are “Cap Rates” and “Participation Rates”. A Cap rate will “cap” your earnings on an index’s growth, while a participation rate will let you “participate” in a certain amount of the growth. As an example, if an index went up 10% and I had a 7% cap rate, my annuity contract would only earn 7% due to the cap. If the same happened and I had a 50% participation rate, my contract would earn 5% (50% of the 10% growth of the index). Finally, fixed indexed annuities are often fully principally protected.
Variable Annuities: In a variable annuity, the value of your account can move up and down based on the performance of an underlying portfolio or “sub accounts”. These sub-accounts are usually invested into one or more mutual funds that follow stocks, bonds, and other investments. Variable annuities may have higher growth potential but come with much more risk than the other two types of annuities discussed above. Generally, variable annuities are not used for protecting assets from market downturns. For this reason, Wheelhouse does not offer variable annuities, as our focus is often to take our market risk directly through investments in the stock market, without going through an insurance company to do so.
Many annuities start as a “base” product and have features that can be added on, often for a fee, known as “riders”. Some common riders are:
- Guaranteed lifetime withdrawal rider — ensures that you can receive guaranteed income for the remainder of your life.
- Terminal illness rider — waives any surrender charges you might pay if you have a terminal illness and a drastically shortened life expectancy.
- Cost of living/inflation rider — allows your annuity payments to keep pace with inflation. This type of rider allows the value of your annuity to increase along with inflation, up to a preset cap.
It is important to weigh the pros and cons of any investment product and know what is right for your specific situation. While there may be benefits listed above, investors should also be aware of the possible costs associated with an annuity, such as potential fees as well as not having their funds fully liquid while holding an annuity. Any reference to protection of benefits or lifetime income refer only to fixed insurance products, not securities or investment products. Insurance and annuity products are backed by the financial strength and claims-paying ability of the issuing insurance company.
No matter the base product, the extra riders, or the fees attached, we believe that every part of a retirement plan should be evaluated at least on a yearly basis to ensure that it still benefits or makes sense for your overall plan. If you have questions about an annuity that you currently own or you are just looking for more information on this topic, please don’t hesitate to give our team a call.
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