Annuities

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Let’s talk for a minute about annuities. An annuity is really probably most easily thought of as some sort of an insurance or pension product available from an insurance company. That’s the best way to think about an annuity. A lot of times they get confused with retirement accounts. A lot of times they get confused with investments. But in reality, it’s a separate kind of product that has some similar characteristics to both retirement accounts as well as investments.

So the simplest type of annuity to think of as an example of what an annuity can be is what’s called a single premium immediate annuity, or SPIA. What this is, is somebody who goes and takes a lump sum of money, gives it to an insurance company in exchange for a promise, a contract, that the insurance company will pay them a certain amount every month for the rest of their life, as long as they live. Whether that’s two years or whether that’s 50 years, they’re going to pay them that amount every month. And so that is classically what an annuity is, but its legal structure can be used to form all kinds of other things.

And so the problem is, because it can be changed to all kinds of other things, it gets changed to all kinds of other things, and they’re made complex and they’re made expensive, and they’re made difficult to analyze, and they’re made easy to sell. And so there’s a whole slew and a whole industry of annuity agents out there who want to sell you annuities with all kinds of bells and whistles, and want to swap you into new annuities where they’ll get another commission over and over and over again. So you’ve got to be a little bit careful about the annuity industry and probably get advice. If you’re thinking about an annuity or considering an annuity, you need to get advice from somebody who is not getting paid to sell you an annuity.

Annuities can make lots of sense in certain situations and certainly have some useful features, but they’re oversold, like lots of insurance products like whole life insurance. It’s oversold. It’s used way more often than it ought to be used. Annuities can be the same way.
Okay, so annuities are taxable, but they’re taxed in a different way, and lots of other things are taxed differently from life insurance. They’re taxed differently from retirement accounts, they’re taxed differently from investments. They’re taxed in all kinds of interesting ways. Basically, if you put money into an annuity outside of a retirement account, because you can also buy annuities with retirement account money, but if you put money into an annuity outside of a retirement account, you don’t get an upfront tax break like you would with a 401(k) or traditional IRA. You don’t get that upfront tax break.

But as the money grows inside the annuity, it grows in a tax protected way, just like it would inside a Roth IRA, just like it would inside a 401(k). It grows in a tax protected way. And when you take money out of the annuity down the road, the earnings are taxable. It’s interesting, though, how they’re taxed, and it depends on if you have annuitized the annuity or not.

What I mean by annuitized is you turn the lump sum into an income stream. You’ve said, okay, I don’t want my $100,000 back. I want $600 a month back. That’s what I want. And so if you’ve annuitized it, it comes out partially taxable. Each one of those payments, part of it is your basis or the principal you put in there, and part of it is the earnings. That’s called an exclusion ratio. So some of the money that’s paid to you is excluded from taxes.

If you have not yet annuitized the annuity, it actually gets LIFO treatment, last in, first out. So the earnings come out first. So if you just pull some of the money out of your annuity, the first dollars pulled out are all earnings, and they’re taxable at ordinary income tax rates, not long-term capital gains rates, not qualified dividend rates, and certainly not tax-free like a Roth IRA might be.

So that’s the way annuities are taxed. If you buy an annuity inside your retirement account, it’s taxed just like the retirement account would be. If it’s a tax-deferred account and you use some of the money to buy an annuity, when it pays out, it’s all 100% taxable at ordinary income tax rates. If you buy the annuity inside a Roth IRA, when it comes out, it comes out 100% tax-free.

So a lot of people ask, are annuities a good investment? Well, they’re not really an investment at all. They’re a wrapper with some insurance features. So it’s probably best not to think of them as an investment at all. Instead, it’s good to ask yourself, what do you need, and does an annuity not only do what you need to have done, does it do it better than anything else?

And I can really think of four possible situations where an annuity can do the job better than something else. The first one I mentioned earlier, a single premium immediate annuity. This is for somebody who wants to buy a pension from an insurance company. Maybe they have Social Security. Maybe they have a small pension from a job. They want more of that kind of guaranteed income to put a floor under their spending in retirement. So they’re willing to give an insurance company a lump sum of money in exchange for contracted, guaranteed payouts the rest of their life.

Unfortunately, you can’t get these anymore that are inflation indexed for the most part. Sometimes there’ll be an inflation adjustment, but it’s not truly indexed to inflation like Social Security is. So it turns out, if you’re interested in buying these sorts of annuities, the best annuity you can get is just delaying Social Security to age 70, because it’s priced better than the annuities you can buy from insurance companies and is indexed to inflation. So it seems silly to buy a SPIA at all if you’re not deferring your Social Security to age 70, but some people add a SPIA on top of that, and that’s a reasonable use.

Another reasonable use of an annuity is a DIA, a deferred income annuity. Think of this as longevity insurance. You give the insurance company a lump sum of money in exchange for them paying you a lot of money starting in 10, 20, 30 years, if you’re still alive. And what this does is protects you from your own longevity. And the benefit of not getting any payments immediately, like you would with an immediate annuity, is you get much bigger payments down the road.

So after 10 or 20 or 30 years, instead of getting five or six or seven percent of what you put in the annuity back out, you might be getting 35% of what you put in that annuity 20 years ago each year, because it had time to grow and the insurance company didn’t have to make those payments along the way. So buying longevity insurance is a reasonable use for an annuity.

The third reasonable use is what is called a MYGA, a multi-year guaranteed annuity. Think of this as the insurance industry’s answer to certificates of deposit or CDs available at the bank. So basically, you lock up your money for a certain period of time, they give you a guaranteed interest rate on it. The interest is all taxable at ordinary income tax rates, but it’s not taxable until you’re done with the annuity. And in fact, even if your annuity runs its term, if you exchange it into another annuity, you still don’t have to pay the taxes on it. So until you actually take the money out, ready to spend it, that’s when you pay the taxes on the earnings for those MYGAs.

So some people, especially at certain times when rates are higher than what you can get in a CD or you can get in a treasury bond or something like that, they actually find these attractive and buy MYGAs.

Finally, sometimes people find a use for a low-cost variable annuity. Now, a variable annuity just has the annuity wrapper around it, then basically puts an investment inside that wrapper. Often it’s an investment that looks a lot like a stock mutual fund. This can be beneficial for certain types of highly tax inefficient investments, like maybe a real estate investment trust mutual fund. This is fairly tax inefficient and might make sense to put that inside an annuity wrapper.

It might be that the tax-protected growth over the years makes up for the fact that when you pull the money out down the road, you’ve got to pay ordinary income tax rates on it. So for a very tax inefficient asset class, it can make sense to have it in a very low-cost variable annuity. Sometimes people also exchange the cash value from a whole life or other permanent life insurance policy where they’re underwater into a variable annuity when they surrender it, and that allows them to grow back to their basis, back to the total amount they paid for the premiums on that whole life insurance essentially tax-free. Then they surrender the annuity, but in essence, they save themselves a little bit of taxes and are able to make a little bit of lemonade out of lemons that came from a bad decision to buy a life insurance policy they shouldn’t have bought in the first place.

But there are also some unreasonable uses for annuities. Most variable annuities should be avoided like the plague. I’m not a big fan of fixed index annuities either, especially because those who sell them seem to masquerade them as being something like index funds, which are very different from fixed index annuities. And so I’m not a big fan of those or the way they’re sold.

In reality, your return, your payout on those is a lot more like what you would expect from a fixed annuity than what you would expect from an index fund. And the more complex the annuity, the less I like it. I want a straightforward annuity that not only you can understand, but you can compare and shop around from various companies. If one company is the only one that offers these features, it’s hard to know if they’re being fairly priced without that competitive aspect in the marketplace. So the more complex it is, the less I like it and the less you probably want to use it.

So the bottom line is there are some reasonable uses for annuities, primarily as a method of providing guaranteed income in retirement and to protect against longevity. But just like with whole life insurance, this is a product that is easily sold inappropriately to unsuspecting investors.
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