Every financial professional periodically faces the following question: Is X a good investment? X may be stocks in general or a particular stock; bonds in general or the debt of a particular company or government; a real asset such as gold or real estate or Egyptian ceramics; or a collectible such as baseball cards. No matter what the identity of X, the answer is always the same: It depends.
The problem does not lie in evaluating the qualities of X. The problem is with the question itself. It cannot be answered in the abstract. Practically speaking, there is no such thing as a good investment for everybody at all times, under all circumstances. The suitability of an investment depends on the age, wealth, income, family circumstances and personal preferences of the investor. It also depends on the size of the investment relative to the investor’s portfolio.
Annuities are a financial investment with a long and rich history. They also enjoy a reputation for complexity and expense. In fact, they are no more or less good or bad than any of the foregoing investments. Their features, options and costs needs to be placed in an individual or household context in order to answer the question: Are annuities a good investment?
Are Annuities a Good Investment for the Young?
All types of annuities – immediate and deferred, fixed and variable – levy surrender charges on holders. Annuity withdrawals made by holders younger than age 59 ½ are subject to a 10% tax penalty levied by the IRS. This double whammy is a strong disincentive to annuity purchases by the young. They can achieve tax deferral by investing via an IRA, 401K, SEP or other qualified plan. They can obtain higher average rates of growth than those offered by fixed annuities and incur lower expense ratios than those of variable annuities. They can hold money in money-market funds or bank accounts and collect interest on liquid funds. Consequently, annuities are probably not good investments for the young.
One possible exception might be young professionals or business owners who seek a shield against liability judgments. In many states, life insurance assets are exempt from attachment in lawsuits. Under these circumstances, young professionals might be able to invest in high-growth variable annuities that enjoy liability protection. The annuity expenses are the price of obtaining the protection against liability exposure.
If deferred annuities are seldom suitable for the young, immediate annuities are never suitable. The young need income to handle current expenses and emergencies; otherwise, they need to save the money that they are earning. Immediate annuities utilize money that has already been saved to provide income to people who are no longer earning income. A worse fit could hardly be imagined. Immediate annuities are the square peg in the round hole of youth.
Are Annuities a Good Investment for the Elderly?
Fixed and indexed annuities are roughly equivalent to fixed-income investments on the risk/return spectrum. That is a suitable characteristic for investment by the elderly. The ability to guarantee lifelong income is an attractive feature to anybody concerned with the income dilemma posed by longevity. The surrender charges might take a substantial bite from the principal value of an early withdrawal, however. This makes most annuities a doubtful choice for the truly elderly.
In recent years, variable annuities have added “living benefit” riders designed to guarantee minimum levels of withdrawals, returns and income. Even these products don’t make annuities a slam dunk for the elderly. Their guarantees are only as good as the payout ability of the guarantor, which should be carefully evaluated prior to purchase and continuously monitored thereafter. Since old age may require large medical withdrawals, the wisest course is to maintain a sizable liquid reserve outside of the variable annuity.
Are Annuities a Good Investment for the Middle-aged and Recently Retired?
This is where annuity investment comes into its own. An investment made a decade prior to retirement allows time for surrender charges to expire and IRS penalties to be outlasted. The distribution period for the deferred annuity can be set to begin on the planned retirement date. Conservative investors can select fixed annuities; balanced portfolios can include indexed annuities to goose the rate of return somewhat and aggressive investors can purchase variable annuities to enhance growth prospects. Income is apt to be at its highest lifetime point, making tax deferral a high priority. Variable annuities suffer no contribution limits, unlike qualified plans, and offer an excellent avenue for tax-deferred investment.
Even for people who do not utilize deferred annuities in saving for retirement, immediate annuities can be ideal during retirement. Annuitizing life savings or taking a lump-sum payout at retirement rather than a pension can be a wonderful way to guarantee lifetime income while reducing the risk of loss of principal. (An insurance company is probably a safer payout guarantor than a single company that is responsible for paying a pension.)
Are Annuities a Good Investment for Wealthy, High-Income Investors?
Wealth is the individual’s stock of value at a point in time; income is the flow of value over time. The two are usually positively correlated, but not always. For example, young doctors may have high incomes but little wealth, while retired people may have considerable wealth but relatively low incomes. In the present context, the two affect tax and work status. The higher the income, the greater the value of the tax deferral provided by annuities and the likelier it is that contribution limits of qualified plans have been reached. Moreover, high incomes are associated with middle age, while low incomes are associated with youth and old age. Thus, annuities are often a good investment for high-income investors.
To the extent that high income correlates with wealth, annuities may be good investments for the wealthy as well. However, wealthy investors are often concerned with estate planning – an area where annuities suffer by comparison. Variable annuities are taxable as ordinary income upon withdrawal and do not receive a step-up in valuation upon the holder’s death. This might expose heirs to more capital gains taxation than would alternative investments, such as mutual funds.
Are Annuities a Good Investment for Households?
Although annuities are not a close substitute for life insurance per se, they contain numerous features that reduce risk by incurring cost. These insurance-like features are designed to make annuities more suitable for household consumption. Among these are the ability to specify a beneficiary for a death benefit, the ability to enjoy a guaranteed minimum return and guaranteed minimum interest rate on a fixed annuity, and guaranteed return, income and withdrawal benefits on a variable annuity. As life-insurance products, annuity proceeds can escape probate more easily than alternative investments, such as stocks or mutual funds.
Annuities have both investment and insurance features. Since single individuals have less motivation to acquire insurance, they will be less motivated to purchase annuities. This will also affect the nature of their annuity purchases; singles will opt for fewer death benefits and riskier allocations of annuity assets. They will tend to opt for life annuities – which trade a higher payout during the holder’s lifetime but forfeit uncollected benefits to the insurance company at the holder’s death.
Are Annuities a Good Investment for Different Categories of Investor?
Different types of annuity are particularly suitable for different categories of investor, depending on the investor’s risk/return preferences. Traditional fixed annuities are suitable for the most conservative class of investor, anxious to avoid any loss of principal and willing to accept a rate of return commensurate with that on government bonds or high-grade corporate securities. Indexed annuities offer a slightly higher rate of return but still offer numerous safeguards to principal, in exchange for more volatility of annual returns. Variable annuities offer rates of return comparable to those earned by mutual funds. Expenses are higher since not only fund management but insurance-company administration must be paid for by the investor. Variable annuity returns may be somewhat higher than those of mutual funds, however, because withdrawals are restrained by surrender fees as well as IRS penalties. Even if variable annuities were conclusively proven to be inferior to individual-stock or mutual-fund ownership, the need for liability-shield protection and escape from contribution limits to qualified plans would provide a role for them among growth-oriented investors.
Annuities possess one absolutely unique feature – the ability to guarantee lifelong income that cannot be outlived. This is potentially beneficial to any class of investor once retirement is approached. The popularity of Social Security, in spite of its manifest deficiencies, suggests that the concept of a lifelong pension or annuity has tremendous visceral appeal. Annuities have more advantages than Social Security and fewer disadvantages. Their versatility and flexibility cements their place in the universe of financial products. It is no accident that governments striving to replace or supplement their precarious system of social insurance have utilized private annuities as their primary tool. Chile and the U.K. are prime examples of this phenomenon.
There is no such thing as a good investment in the abstract. Annuities are poor investments for the young and elderly because of their relative illiquidity. They are ideal for middle-aged people and households nearing retirement age, whose age and income suit them for annuity investment. The spectrum of annuity types includes something for every risk/return category – conservative, aggressive or in-between. The unique ability to provide guaranteed lifelong income secures a permanent place for annuities among the pantheon of investments.