CHAPTER 4: Annuities

CHAPTER 4 Annuities

Before we go any further, let’s put our big girl and boy pants on. As a result of The 403(b) “Clown Car”, you may have preconceived notions about these two 403(b) funding choices, especially annuities. Annuities have gotten a bad rap in previous decades and a lot of that criticism is deserved, but some of it is misplaced. You have to consider where the information you’ve received has come from and how it plays into the narrative. A lot of online information bashing annuities was written by people who sell competitive products. I personally believe some annuities are a great addition to a retirement portfolio. And, there are others, in my opinion, that were poorly designed and offer little benefit to the consumer. I’m going to urge you to put everything you already know or think you know about annuities on a back burner so you can make decisions for yourself.

So…what the heck is an annuity?

Excellent question, here’s a very brief history.

Annuities have been around since Roman times, around 224AD, when the first mortality tables were created. Yeah, people have been buying annuities since before Mt. Vesuvius covered Pompeii in dust. “Annu” is Latin for year. In their most basic form, a Roman would deposit a lump sum of money and in return receive a contractual set of payments from it annually for

life. This process of receiving contractual payments for life is called annuitization.

What’s important to know about annuitization or turning the lump sum inside your annuity into contractual payments, is that it’s a one-time event and it can’t be undone. You can either have access to the lump sum or to the payments, but not both.

Many annuity contract owners no longer turn their contracts into annual payments, through annuitization. I’d like to say that most people buy annuities for growth with a degree of protection, but my honest opinion is that most people buy annuities today because that’s what they are being sold, and many don’t really understand them. So, let’s try to understand them a little better.

First, all guarantees offered in an annuity are based on the financial strength of the issuing company.

When you have an annuity, you own a contract between you and an insurance company. Most contracts have surrender charge periods that range between five and 15 years. This period of time that you commit to leaving your money with the insurance company and withdrawals before this time might involve penalties.

A Surrender Period is the length of time before you can cancel your annuity without incurring surrender fees, unless a waiver provided by the issuing company is met.

Now, I can’t speak for every adviser or insurance agent out there, but it has been my experience that some people who buy 403(b)s that are funded with annuities haven’t been told, or don’t understand, that they are making a commitment and if they break the commitment before the end of the surrender period of the contract they will pay a surrender penalty.

Surrender penalty- a penalty you would pay for withdrawing your funds from the contract before your surrender period is up. A percentage of your entire account value as outlined in your contract.

So, if you are going to make a commitment to a company or to a product, for any length of time, don’t you want to make sure it’s the best option available to you?

This is a great question to ask yourself.

Anytime we make a commitment to anything; a new job, a relationship, a workout routine, we generally ask ourselves, “What’s in this for me?”

If you have an annuity, I want you to ask yourself:

What am I getting in exchange for my commitment to this product and company?

The first benefit that all annuities share is that they are taxdeferred, but that is kind of irrelevant when we are having a conversation about 403(b)s because 403(b)s, and in fact all Qualified Retirement Plans, (pensions, 403(b)s, 401(k)s, IRAs, etc.) are already tax deferred. All annuity withdrawals from qualified plans (except Roth plans) are subject to ordinary income taxes, and if taken before age 59-1/2, will incur an additional 10% federal penalty. (Please note there are some exceptions to this rule in 2020 and 2021).

There are only 3 types of annuities that are found inside 403(b)s.

• Fixed • Variable

• Fixed-Indexed

Let’s look over your choices.

Fixed Annuities

Fixed annuities were created in the 1930s when the depression era investor was looking for a guaranteed way to grow his or her money. Insurance companies gave them that comfort. With a fixed annuity, you get a fixed interest rate every year during your surrender period and that rate usually doesn’t change after your surrender period is over (depending on the product). If you have

owned a contract since 2009 or earlier, it is likely that the fixed rate on your annuity is a little higher (maybe 3%) than if you purchased your annuity after that time. I’m not telling you that your pre-2009 fixed annuity is “the cat’s pajamas”; I’m just giving you the facts.

Pros of Owning a Fixed Annuity: Your principal is protected, and your contract will grow at a guaranteed fixed interest rate every year. When interest rates are high, Fixed Annuities will typically pay higher interest.

Cons of Owning a Fixed Annuity: Since interest rates have declined in recent years, fixed rates have declined as well. I can’t imagine anyone being really jazzed about buying an annuity with a 12-year surrender period with a company promising to give them 1.5% interest per year.

Variable Annuities

Variable Annuities came around in 1952 and were originally introduced by Teachers Insurance and Annuities Association–College Retirement Equity Fund (TIAA–CREF), which is still a MAJOR player in the 403(b) industry. They were created to give customers the potential for market growth inside an annuity, which had become increasingly more necessary due to a general fear of inflation at the time.

When you put money inside a variable annuity you are given two options. The first is a fixed interest option, just like a Fixed Annuity. Any money you put in the fixed interest option of your annuity grows at a fixed rate. You are also not charged any

additional fees on this portion of your account. Just like a fixed annuity, this fixed rate is determined by what interest rates are in the economy, but they do tend to adjust, meaning the fixed rate might have been 2% when you bought the annuity, but it is currently set at around 1-1.5%.

Your other option is the variable portion of your account, from which you (or your advisor) has a variety of funds to choose from. Yes, the Mutual Funds that we just talked about. In this type of annuity your money (minus the fixed portion) is pooled with the premiums of other annuity holders in investment options called subaccounts, which in turn invest in mutual funds, so the value of your annuity can fluctuate up and down based on the performance of the funds you are in. If your funds perform well, your account value will grow. If your funds perform poorly you can lose money.

All of that being said, Variable Annuities are one of the main reasons why many people cringe at the word “annuity”. Why?

Some of it has to do with fees. While both fixed and variable annuities have many of the same costs to operate—admin, taxes, death benefit, etc. Variable Annuities are an investment and an insurance product. It’s up to you, the client, to decide if the added costs associated with Variable Annuities is worth the potential for higher returns.

Pros of Owning a Variable Annuity: Because your money is invested in mutual and bond funds, your growth potential might be higher than Fixed or Fixed-Indexed Annuities. In a great year, your annuity should outperform other types of annuities. Also,

your original investment amount or contributions are protected from loss in the event that you pass away.

Cons of Owning a Variable Annuity: There are typically higher fees due to the investment component of the product as well as fees for mortality (your death benefit protection) and at times there are additional riders that have a cost to them (See Income and Other Riders in the next section). Also, they involve risk and you can lose money.

Fixed-Indexed Annuities

Around 1994, insurance companies realized there was a market for annuities that protected principal but also had the possibility for greater growth potential than Fixed Annuities, and so FixedIndexed annuities were born. They are also commonly referred to as just Indexed Annuities.

Because they are still in the Fixed Annuity family, Fixed Indexed Annuity owners still have the option of allocating their money to a fixed interest strategy, but today they offer many other strategies as well, all of which use external market indices to benchmark growth.

Okay, what the heck does that mean?

An external market index could be any number of indices: the S&P 500, the DJIA, the NASDAQ, or many others.

Let’s say you purchase an Indexed Annuity with Insurance Company A, which has an allocation that is benchmarked by the S&P 500.

You choose to allocate your funds 100% to the S&P allocation. You have a strategy term (in this case it’s one year).

At the end of the year the insurance company is going to look at the growth of the S&P 500, where it started the day you bought the contract, and where it is on your anniversary date. If the S&P 500 had a positive return, a portion of the growth will be credited to your account as interest, subject to the limits set by the company, called a cap, spread, or participation rate. If the S&P 500 had a negative return you will get 0% credited to your account.

The 0 is important with Fixed Indexed Annuities. A 0% floor, as they call it, means your account will never experience a negative return due to market loss.

To help you visualize, imagine you are on the bottom of a set of stairs. Every time interest is credited to your account you go up another stair. The stairs will all be different sizes, because sometimes you will have a larger gain and sometimes a smaller gain, or none at all, depending on how the external indices perform and what the interest rates of your contract are.

However; once you go up a stair, that new level becomes your floor. Your interest earned is locked in, your stairs only go up and never down. If there is a negative return in the external index you stay on the same stair. You will never get a statement that is less than your previous statement, unless you are paying for an additional rider (see Income and other Riders in the next section) or unless you are taking money out of your own account.

Lots of options: In recent years a lot of Indexed Annuities have included index options from which to choose when allocating your money. Your plan might have an option that looks at the S&P 500, another that looks at the NASDAQ, one that looks at a Barclays index, and three more. You can generally make changes or reallocate to different strategies every year (or number of years, depending on the strategy you’ve chosen).

Beware of strangers bearing gifts: Many companies offer upfront bonuses when you purchase a contract. I have nothing against bonuses. I like free money as much as the next gal. My warning is, never buy an annuity simply because of the bonus. There are some great annuities with bonuses and then there are those that will lure you in with a big, fat, juicy bonus, and your growth potential from that point on could be less, or you may be required to follow specific rules in order to truly receive the bonus. In addition, bonus annuities often involve lower caps, higher spreads or lower participation rates. I repeat, work with an adviser that understands these products, or you could make a mistake.

Pros of Owning a Fixed Indexed Annuity: If the external indices that your Fixed Indexed Annuity use to benchmark the growth of your account perform well, you could have higher interest credits than a fixed annuity would give you. It’s not uncommon for some plans to have multiple double digit returns in a ten-year period. Also, Fixed Indexed Annuities often come with optional riders to create lifetime income, increased death benefit, and increased liquidity, (See my explanation of Income and Other Riders in the following section).

Cons of Owning a Fixed Indexed Annuity: Your growth potential in a Fixed Indexed Annuity is only as good as the rates of the contract. If the rates in your annuity don’t allow for very much growth, then you might be better off in a different product.

Reach out to one of our advisors to help you better understand your annuity and the guarantees/growth potential it provides.

Income and other Riders

First, what’s a Rider? As the name implies it’s something that rides with you on your journey.

In this case it’s something that you pay for (in most cases) that adds an extra benefit to a policy or plan. There are riders on annuities that create guaranteed income, additional income in the case of sickness or need for long-term healthcare, additional death benefit, additional liquidity, additional growth potential,

and many more. But the ones we see most in the 403(b) world are income and sometimes additional income in the case of sickness or need for long-term healthcare.

Income Riders- Since the original purpose of an annuity back in Roman days was to create income, it’s not really surprising that creating guaranteed income is a big function of annuities today. Many companies sell annuities that are offered with income riders. This is something you pay for, that offers you guaranteed growth on your money, for the purpose of turning it into an income stream at a later date. I’m not going to go into a lot of detail here because income riders vary from company to company, but these are the things you should be aware of:

• Income riders can be a great way to turn a lump sum into an income stream that you cannot outlive. • Income riders vary from company to company and annuity to annuity, so be sure that you have one that is appropriate for your needs. For example, if you are planning to take income in three years there would likely be a different/better annuity for you than if you were planning to take income in 15 years. • Income riders have a cost! Usually around 1% of your total account value per year. • I believe many people (and this may include you) have been sold income riders without having them properly explained.

Before I go on, I’m not knocking income riders at all. I believe in them, and if sold appropriately I believe they can make a massive difference to retirement income.

However…

About once a week I speak to someone who has been convinced they are getting “guaranteed 6% on their money”. If you are reading this now and thinking, “She might be talking about me”, then I apologize, I probably am talking about you. When I hear this, I have to explain that the “guaranteed 6%” is the guaranteed growth on your income rider value and not the growth of your actual account value. This means you need to take income from the income feature of your annuity as described in your annuity to actually realize this higher value. If you surrender your annuity for cash, the value you receive will not have realized this 6% increase from year to year. We encounter this misunderstanding all the time, and in my opinion, it’s often because the feature was misunderstood by the client or misrepresented by the agent who sold it.

If you are actually getting guaranteed 6% on your account value, then you most likely bought it in the 1980s and I suggest framing your policy pages and putting them on your wall in a place of honor. If you think you are, you probably are not, unfortunately. Either way, if you give us a call, we can help you figure out what’s going on.

Income riders are available on Fixed Indexed Annuities inside 403(b)s, depending on the company and product you are talking about, and they may (or may not) be available on Variable

Annuities inside 403(b)s. In my years in this role I have only seen a handful of income riders on Variable Annuities that were 403(b)s. However, I very frequently see income riders on Variable Annuities that are not 403(b)s, like IRAs and NonQualified accounts.

Wrapping up Annuities

I apologize if any of that was confusing. Annuities are complicated products and I believe they are often sold to people who have a limited understanding of what they are and how they work. To make things worse, they are sometimes sold by people who have a limited understanding of what they are and how they work. At the same time, a lot of annuities, at least the good ones, can be great products that minimize human error.