A Simple Guide to annuities

Written by
Peter Dunn


What do you think about annuities? I’ve heard they’re expensive and aren’t great for investors. My advisor wants me to buy one with my retirement money. But I’m not sure I want to lock-up my money. Should I buy one?


This is a great, but tough, question to answer. It's hard to answer this question without a lot of personal information about your financial situation, which I don't blame you for not including in your question. So I can't tell you if an annuity is right for you or not, but I can clear up what an annuity is and isn't.

"To begin, annuities are neither good nor bad. Annuities are very complicated. And annuities are actually insurance products, not investments. Well, they are investments, but they are insurance too. See? This where it starts to get complicated. An annuity is a type of investment, typically issued by a life insurance company, that tries to mitigate your risk exposure to the financial markets. For instance, if you don’t want to expose your retirement funds to market risks, an annuity may offer you the ability to participate in the upside of the market, while protecting your money from the downside of the market. Sometimes. Kinda." (courtesy of Indy Star)

Confused? Yeah, that's why people struggle to understand annuities, like I said, they are complex. So let's break it down to the three different types of annuities: fixed, indexed, and variable.

Fixed annuities are similar to a CD but are more restrictive. The money in the annuity isn't accessible from a tax standpoint until 59 1/2, additionally there may be other surrender periods which lock up the money for longer. You'd think that a fixed annuity means it has a fixed interest rate and sometimes it does mean that, but not always. But despite those few issues, fixed annuities are the least risky and expensive option when it comes to annuities.

"Next up, we’ve got indexed annuities. They were designed to allow a person to partially participate in the upside of the stock market, while limiting exposure to the downside. To say that indexed annuities are nuanced, would be the understatement of the millennium. Indexed annuities are incredibly complicated, expensive in a subversive way, and in my opinion, overprescribed. What’s expensive in a subversive way, you ask? In 2013, the S&P 500 was up nearly 30%. If you had an indexed annuity which allowed you to participate in the upside, but limit the downside, you would have received about a 10% return, not 30%. I look at that as a 20% fee. People flock to indexed annuities because of the insulation from loss, but there are ways to insulated yourself from loss without suffering a 20%ish 'fee'." (courtesy of Indy Star)

Lastly, we have variable annuities. This type of annuities is so complex it comes with a 200 page prospectus, which leads me to believe that not even those who sell them fully believe them. That's not a totally fair statement, but you have to at least see where I'm coming from. By fully exposing the portfolio to market risk this type of annuity has the potentially to earn more, and this risk is even mitigated by some guarantees. But beware, the fees can reach up to 4%.

Like on most topics, there are people who are super black and white when it comes to annuities, either pro or con. I'm neutral. Especially when I'm not looking at all the details of an investor's financial life. An annuity is just a product someone sells, and you can take it or leave it.

Hal, I answered your question even more in-depth in my Indy Star column this week, you can check it out here.

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