Fixed annuities. If we could look at a lineup of financial products this would be the one that we could sing “one of these is not like the others”. Fixed annuities are a very misunderstood and misused product. And they are NOT an investment product. Let me explain.
(1) What Are Fixed Annuities?
Fixed annuities are insurance products. They are not investment products by definition. A fixed annuity gives the buyer a specified return on the money put into the annuity for a specified period of time all the while getting tax deferred growth. (Meaning that the buyer doesn’t pay taxes on any growth until it is taken out.)
The time frame that an annuity (fixed or variable) will pay out can vary. It can be for as short as 5 years and it can also pay out for the entirety of one’s life.
The word fixed is important when understanding what a fixed annuity is. The rate of return on the annuity will be the same (AKA, fixed) for the entire life of the contract.
A overly simple example might be something like this:
Mike puts $100,000 into a fixed annuity. His payout is 2% for 25 years. That means that he will get a check for $2,000 per year (or $166.67 per month) for 25 years. (Without taking into account any fees, charges, etc. to make it simple.)
(2) Problems With Fixed Annuities
Everything I have said so far might sound great to you.
I have a steady income stream that I can count on? Nice!
I have a guaranteed rate of return? Alright!
I get tax deferred growth? Great!
I don’t have to fear losing my money? Woo hoo!
But with all things in life, there is a catch. Yes, with a fixed annuity the buyer gets all of these things.
- Steady income stream
- Guaranteed rate of return
- Tax deferred growth
- No loss of money
But it comes at a cost. Here are the main drawbacks of fixed annuities.
They are not investments.
As stated before, fixed annuities are NOT investments. To be an investment, there has to be a chance of losing money. And there is no chance of losing money with these products.
Your bank account works similarly. Because a bank account will not lose money, it is not an investment.
You might be thinking, “I don’t really care if it is an investment. So long as it doesn’t lose money, I like it!” And that is a reasonable thought.
But the problem is that these products are often sold as if they are investments when they are not.
To sell a fixed annuity, one does not have to have a securities license. The salesperson only has to have an insurance license. This is because they are insurance products.
A true financial advisor (or someone with a securities license) will not put you in a fixed annuity unless you are in a very specific place.
The only time that a person should think about this product is once their retirement account(s) are completely maxed out, IRAs are maxed out, and Roth IRAs are maxed out.
Often, insurance salesmen don’t know this (because they are not investment advisors).
They have high fees.
Fixed annuities have several fees associated with them that other investment products do not (at least for the majority of other investment products).
The fees can consist of:
- Commission: Up to 10% of what you invest can be given to the salesperson.
- Underwriting fees: Because this is an insurance contract, there are underwriting costs.
- Fund Management: Because the funds that you deposit are invested by the insurance company, the fund manager has to get paid.
- Penalties: If you are under 59 ½ and withdraw money you will likely be penalized (much like investment accounts.)
- Beneficiary taxes: If you happen to have an annuity that will pass to your heirs then they will be taxed on all gains (unlike an investment).
The money can be gone when you die.
There are several different ways to structure the contracts for these products. But most of the time they are structured in a way that your heirs will not get any money.
For example, Edna opens a fixed annuity with $300,000 that will pay her $500 per month for the rest of her life. After she has the annuity for 10 years, she dies. The rest of the money that she deposited into this product goes to the insurance company and not to her family. Even though she only received $60,000 back.
Yes, there are ways to structure these contracts to avoid that, but it will come at a cost. And the cost will be an even lower rate of return.
They have low rates of return.
This is arguably the second leading problem with fixed annuities. They have a HORRIBLE rate of return. Currently (February 2022) rates are around 3.25%. Compare that to the S&P 500 rate of return for 2021 of 26% or even a more average rate of return of 8-10%, fixed annuities have a HORRIBLE rate of return.
Why do they have such a low rate of return? Because they are guaranteed.
That is the trade off. The buyer trades any uncertainty in the market and the possibility that the market will decline for a guaranteed rate of return. That is the opportunity cost of a fixed annuity.
In other words, fixed annuities trade an average rate of return of 8-10% but with the possibility of sometimes having a negative rate of return for a guaranteed small rate of return no matter what.
The problem is that the buyer then misses out on the gains that the market has in most years to protect themselves from the occasional market decline.
There is a surrender period.
A surrender period is a time frame at the beginning of the fixed annuity that you CANNOT cancel it. You have to leave it in place for a specified period of time.
This time frame can vary from contract to contract.
I have seen it for as little as 3 years and as long as 15 years.
If you were to cancel your fixed annuity during that time you would be hit with penalties and fees. These typical surrender charges are about 10% and drop periodically the longer that you have the contract.
(2) The Largest Risk: Inflation
This is by far the largest risk that someone takes on with a fixed annuity.
Remember, that the rate of return with these products is guaranteed for the life of the contract.
The problem is that it is not indexed to inflation.
Think about it. Say someone took out a fixed annuity for $500,000 in 1990 that would pay them 4% every year until they died. That means that they would be paid $1,666.67 per month forever.
That wasn’t bad for 1990. But it is bad now.
In 1990 the average rent payment was $447. Which would be about 26% of that annuity.
By 2020, the average rent was $1,104. Which would be about 66% of the annuity.
A loaf of bread in 1990 cost about $0.75. In 2020 it was about $2.20.
A gallon of gas in 1990 cost about $1.15. In 2020 it was about $2.35.
You get the picture.
Inflation will eat away a fixed annuity over time.
Final Thoughts
I know it seems that I have bashed fixed annuities for this entire article. However, there MIGHT be a place for a fixed annuity in someone’s portfolio. However, that should only be considered once that person has maxed out all other savings vehicles and wants a small portion of their dollars to be guaranteed.
The reason that I don’t really care for fixed annuities is because they are sold under the guise of being an investment or retirement insurance. But the problem is that if you rely on fixed annuities, you should be prepared to pay high fees, not give the money to your heirs upon your death, and have the money eaten away from inflation.
If you are looking for a financial advisor or someone you know is trying to get you to put your money in a fixed annuity, stop and read this article first.
As always, I am here to help you.
I will do my best to give you the tools to make sound financial decisions for yourself.
You can do it!
Until next time!
0 Comments