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Annuity 101
A lot of my clients ask me if they should put some of their money into annuities or if they are better off with simple bond investments… so I thought I’d make this a topic on my show today. The gist of my commentary is from an article on of FinancialPlanning.com titled Annuities vs. Bonds: Do the Math, by Elliot Kass.
As Americans are living longer due to better healthcare, diet and nutrition… many are worried that they will outlive their retirement savings… and see annuities as an attractive option for guaranteed lifetime income… and as insurance if they outlive their retirement assets.
Returns on annuities, after annual fees, are often less than 3%… so, in essence, your annuity payment does not even keep pace with inflation.
And annuity underwriters are well aware of this fear and structure annuities so they pay relatively unattractive interest but provide the peace of mind of a guaranteed annual payout. Returns on annuities, after annual fees, are often less than 3%… so, in essence, your annuity payment does not even keep pace with inflation.
Here’s how an annuity works… when you buy an annuity, the underwriter subtracts certain fees and expenses and does some math to come up with a fixed amount he can pay you each year… say that works out to $5,000… now $5,000 is what you will receive each year for the rest of your life, without any adjustments for inflation.
Annuity Drawbacks
But over the course of 20 years, with inflation at about 3%, the purchasing power of $5,000 drops significantly… to the equivalent of about $2,000 – so that’s one catch with annuities – your income stream does not keep pace with inflation and loses purchasing power significantly over time – so factor that into your annuity purchase decision.
Here’s something else to be aware of: With annuities, investors generally get their principal back in about 15 years… so if you opened an annuity at age 65… you’ll earn back your principal and recoup your invested capital by the time you’re 80… then… if you’re still alive past 80, you’ll start seeing a paltry return on your investment – doesn’t sound too appealing!
Most annuities also charge fairly high fees – from 3.5% to 5% each year… so if your annuity earns about 5% to 7% a year… after fees, you only end up with a net yield of 1.5% to 3.5% each year. A lot of these fees pay for generous broker commissions… which is why annuity salespersons sell you pretty hard, often locking-you into unrealistic expectations.
Should you choose to break an annuity, you’ll end up paying hefty penalties.
So, if you’re considering annuities, research your options well – look into fees, commissions, payouts, inflation adjustments… and compare them to yields on simple or inflation-protected U.S. Treasurys or high-quality corporate bonds that yield a bit more, don’t charge exorbitant fees and do not lock-in your money or have you pay hefty penalties on early termination.
