Annuities are insurance products that provide guaranteed income for life in exchange for an upfront investment. They are designed to provide retirees with a steady income stream that they cannot outlive. However, research shows that many retirees are reluctant to purchase annuities despite their benefits. In this article, we will explore some of the common reasons people avoid annuities and provide an overview of annuity products to help readers understand them better.
Lack of Understanding
One of the biggest reasons retirees do not buy annuities is simply a lack of understanding about how they work and their key benefits. According to a 2018 survey by the Insured Retirement Institute, less than half of pre-retirees aged 55-64 could correctly identify a definition of an annuity. With such little knowledge about their features, it is not surprising many retirees are hesitant to invest in a product they do not fully grasp.
Annuities come in many complex forms, but their primary purpose is to provide a guaranteed stream of income either immediately or at some point in the future. Unlike investments which can lose principal, once an annuity is annuitized, it will provide set payments for life regardless of what happens in the financial markets. This ensures retirees will not outlive their money – a key retirement planning goal. However, the myriad of annuity options and insurance jargon used to describe them makes them intimidating and difficult to compare for many retirees.
Lack of Trust
In addition to limited understanding, some retirees may simply have a lack of trust in annuity providers to fulfill their long-term income promises. This is understandable given the fiduciary role assumed by insurers when retirees entrust them with a significant portion of their life savings. However, consumers can take steps to find financially strong companies with high ratings from independent agencies such as A.M. Best when purchasing an annuity. Working with a financial advisor who understands annuities can also help provide guidance and an objective third party assessment of a company’s financial stability.
Desire for Flexibility and Control
Once funds are used to purchase an annuity, retirees give up access to that principal and must abide by the contract terms for income distribution. This can be unsettling for retirees who place a high value on maintain flexibility and control over their savings. With an annuity, they are locking into to a set income schedule that cannot be altered. Many worry about their future needs changing or wanting to access a lump sum of cash from their savings for emergencies or large purchases. With an annuity, the tradeoff for secure lifetime income is reduced access and control.
However, it is important to note some annuity contracts do allow for partial withdrawals or other options to access funds if needed. For example, “living benefit riders” can be added to variable annuities to enable policyholders to take withdrawals for a set number of years or up to a certain percentage of their income benefit base each year. Retirees concerned about maintaining access to funds should inquire about these features when shopping for annuities.
Desire to Leave an Estate
Since annuities provide guaranteed income as long as the policyholder is alive, they do not leave any remaining funds to heirs as an inheritance. All payments stop upon the annuitant’s death (or their spouse’s death if a joint-life policy). Therefore, retirees who have a strong desire to leave assets to children or other beneficiaries will be reluctant to tie up a substantial portion of savings in an annuity. Withdrawals or annuitization under an annuity contract are permanent, so funds used to purchase them will no longer be part of one’s future estate.
Some annuity products do allow policyholders to add return of premium riders which return the original investment to heirs if the owner dies prematurely. There are also period certain annuities which provide payments for a guaranteed number of years even if the annuitant dies. However, in general, those who purchase annuities must be comfortable with the tradeoff of lifetime income in exchange for reduced estate planning options.
Concerns About Fees, Commissions, and Surrender Charges
The costs associated with annuities are another source of apprehension for some retirees. While immediate annuities have no explicit fees, other variations such as fixed, fixed indexed, and variable annuities do come with annual mortality, expense, and administrative fees. There are often commissions paid to financial advisors on the sale of annuities as well. Furthermore, annuities levy surrender charges if a policyholder wants to withdraw more than the penalty-free amount in early years of the contract.
These expenses eat into investment returns and the policy’s cash value, leaving some retirees thinking they can find better values. However, it is important to weigh the guaranteed lifetime income and other benefits provided by an annuity versus potential investment returns. For many, the security of never outliving savings far outweighs the annuity costs. But due diligence on fees and a long-term perspective are important for any retiree exploring annuities.
Concerns About Interest Rates
Current interest rates also influence people’s choice of whether to buy an immediate annuity which begins payments right away. Annuity payment amounts are calculated based on interest rates at the time of purchase. If rates are low, payment amounts will be lower. This deters some retirees from locking into payments they perceive to be unfairly low. They may choose to wait in hopes rates eventually rise.
However, predicting future rate movements is difficult if not impossible. There is a risk rates move lower instead of higher. Retirees must also consider the security of having a set income versus investment risks while waiting for higher rates. Working with a financial planner to run an annuity breakeven analysis can help determine ideal timing based on life expectancy, income needs, and risk tolerance. Diversifying annuity purchases over time can also smooth out the impact of interest rate swings.
Concerns About Insurer Solvency
A small number of retirees may also have concerns about the financial strength and solvency of the insurance companies offering annuities. Because these products are not FDIC insured like bank CDs, there is a risk of loss if the issuing company cannot meet its financial obligations.
However, there are stringent reserve requirements imposed on annuity providers by state regulators to minimize this risk. States also guarantee annuity assets through their own insurance guarantee programs up to certain limits per owner. Companies are required to meet minimum capital, surplus, and risk-based capital (RBC) ratios. Overall, defaults on annuity payments are extremely rare but evaluating company financials can offer peace of mind.
Impact of Negative Publicity
Some retirees develop negative perceptions about annuities based on warnings in financial media and publicity about certain sales practices. While all financial products have pros and cons, some analysts more routinely emphasize the drawbacks and risks of annuities while ignoring the benefits. Reports of deceptive sales tactics involving annuities also contribute to distrust among some retirees. However, not all annuity sellers engage in misconduct. Finding an ethical, knowledgeable advisor is key for a good client experience.
Overview of Annuity Types
Now that we have reviewed some of the common concerns about annuities, it may be helpful to provide an overview of the main categories of products available. This can aid in understanding and evaluating their tradeoffs versus other income options in retirement.
Immediate Annuities
An immediate annuity begins disbursing set payments right after purchase. It provides a baseline amount of guaranteed income for life that retirees can rely on regardless of market conditions. Payments are fixed based on the upfront premium amount, current interest rates, and the owner’s life expectancy. Pros of immediate annuities include income security, tax advantages if annuitized, and potential for higher payouts than bonds. Cons are lack of liquidity and flexibility. Once initiated, payments cannot be stopped.
Deferred Annuities
A deferred annuity accumulates savings on a tax-deferred basis during the accumulation years, then converts to an income stream down the road. Fixed and fixed indexed deferred annuities earn interest based on a declared minimum rate. Variable annuities invest in underlying stock and bond subaccounts for potentially higher growth but risk of principal loss. Pros include tax deferral, choice of payout options, and death benefit protection. Cons are surrender charges for early withdrawals.
| Annuity Type | Pros | Cons |
|---|---|---|
| Immediate Annuity | Guaranteed lifetime income | Illiquidity once payments initiated |
| Deferred Annuity | Tax-deferred growth potential | Surrender charges may apply |
Fixed Annuities
Fixed annuities provide a minimum guaranteed interest rate and do not fluctuate based on market performance. The insurance company bears the investment risk. Fixed annuities can provide stable retirement income and principal protection compared to bonds. However, they offer lower growth potential than equities.
Fixed Indexed Annuities
Fixed indexed annuities earn interest based on the performance of a market index such as the S&P 500. However, the principal and previously credited interest are protected from downturns. These annuities offer upside potential with less risk compared to investing directly in stocks. But there are limits on participation in index gains.
Variable Annuities
Variable annuities allow the owner to invest in professionally managed subaccounts containing stocks and bonds. This offers higher growth potential along with risk of loss. Variable annuities can provide lifetime income, tax deferral, and death benefits. But they carry higher expenses than other options due to the active management.
Should You Consider an Annuity?
Despite the various concerns explored earlier, annuities can still play a valuable role in many retirees’ financial plans when utilized prudently. They are the only instrument that can provide guaranteed lifetime income to hedge longevity risk. Below are some guidelines for determining if an annuity may be suitable:
- You want income you cannot outlive or that continues to a spouse
- You are risk-averse and want principal protection
- You want to minimize longevity risk
- You have adequate reserves for emergencies and liquidity needs
- You have maxed out other tax-advantaged options like 401(k)s and IRAs
- You are in average to above-average health
- You are willing to forego access to the lump sum for income security
For those who may benefit from annuities but still have reservations, some suggestions include:
- Consult an annuity literacy program to gain knowledge
- Only invest a portion of assets so some remain liquid
- Compare multiple providers for best benefits and financial strength
- Add liquidity riders or features if desired
- Work with a fee-only advisor who sells annuities part-time to ensure unbiased recommendations
Conclusion
Annuities can provide valuable protection against outliving savings in retirement along with other benefits like tax deferral. However, they are complex instruments that require education and thoughtful evaluation of tradeoffs versus other options. Taking time to analyze needs and consult knowledgeable advisors can help retirees determine if annuities have an appropriate role in their financial plans.
While inherent features like illiquidity and lack of estate planning may continue to dissuade some retirees, those who take the time to fully understand annuities can appreciate their value. With Americans living longer and facing increasing responsibility for financing their own retirements, protected lifetime income solutions like annuities are likely to gain broader appeal going forward.
