Protecting the money you’ve worked so hard to save is one of the most important priorities, particularly if you are nearing, or have already begun, your retirement.
Considering the myriad of available investment options, it’s easy to become confused and overwhelmed.
Two of the most common choices for maximizing retirement savings are dividend stocks and annuities.
That being said, having at least a basic understanding of how annuities work, the pros and cons of annuities, and how they compare to dividend stocks, will reduce potential confusion and help with better planning.
What are Annuities?
The most basic feature of all annuities is their ability to convert the balance of the account into a steady, predictable, guaranteed stream of income for a set period of time or even for life. That process is called annuitization, and it’s one of the defining features that every annuity has in common.
Additionally, all annuities provide tax-deferred growth. Since they are structured as retirement investments, growth within annuities will not incur income tax liability. Plus, all annuities contain a life insurance component, and most offer optional benefits that can result in amounts passed to heirs that are higher than the actual account balance at the time of the owner’s death.
Types of Annuities
Nearly every major life insurance company can offer annuity products, and considering the sheer number of these companies it’s easy to get lost in the plethora of products.
However, all annuities fall into one of three categories, and separating them makes the task of evaluating your options much easier and less daunting.
Fixed annuities are the most common type and are offered by almost every life insurance company. They are also the easiest to understand.
Money deposited into a fixed annuity earns a predetermined interest rate. That rate is declared by the issuing insurance company at the time of purchase.
Most fixed annuity contracts offer a rate-lock period ranging from three to 10 years, during which the annual return on your deposit will remain unchanged.
At the expiry of that rate-lock period, your account balance will be credited with the then-current fixed annuity rate, which is declared annually by the insurance company.
Contracts of this type also declare a minimum guaranteed rate of return, which means that — regardless of the insurance company’s own investment success or failure — your account will be credited with no less than the stated interest.
However, if the company experiences greater returns on its own investments, fixed annuity rates will be higher than the minimum.
Variable annuities are most commonly compared to mutual funds, as the investment component of these products works in much the same way. Within a variable annuity is a selection of sub-accounts — which are typically just clones of popular mutual funds and are actually often run by the same mutual fund money managers.
Money deposited into variable annuities must be allocated between these sub-accounts. There are no requirements or restrictions on this allocation, meaning you can spread your money out in any way you’d like, choosing as few or as many sub-accounts as you see fit.
Unlike fixed annuities, however, there are no guarantees that the balance of your account will increase. Just like mutual funds and individual stocks, the performance of variable annuity sub-accounts is directly tied to the stock market and depends on the portfolio of stocks and bonds within that account.
That being said, variable annuity sub-account offerings include a wide range of options to suit any type of risk tolerance, from the most aggressive to ultra-conservative.
Simply put, if the sub-accounts within your annuity perform well, then the overall balance of your account will increase proportionately based on your personal allocation.
Equity indexed annuities are the least common type, but have grown in popularity over the past decade due to their unique features. Without delving too deeply into the product’s engineering, indexed annuities offer investors the ability to enjoy the benefits of both fixed and variable annuities at the same time.
Technically, indexed annuities are fixed products, so money deposited into these accounts is never at risk — this is the fixed annuity-like component. However, the value of your account is tied to the performance of the stock market, typically an index such as the S&P 500 — this is the variable annuity-like component.
Simply put, when the stock market goes up so does your account value, but when the market goes down your account balance remains the same. This allows investors to participate in market gains, while shielding them from market losses. This prospect is extremely appealing to a number of investors, particularly those who have experienced losses within other types of accounts.
Indexed annuities can provide these types of guarantees because of the creative ways your money is actually used by the insurance companies. Deposits are used to purchase, among other things, specialized puts and calls on various securities, as well as guaranteed fixed instruments such as Treasury bonds and CDs. The bonds and CDs are used to protect the principal, and the interest earned off of those purchases contributes to the specialized options.
Over-simplifying again, the insurance company can guarantee your money because it’s invested in fixed instruments, but offer significantly greater potential thanks to the puts and calls purchased with the interest.
Benefits of Annuities
A guaranteed death benefit is the No. 1 feature offered by annuities that can’t be added to an ordinary portfolio of dividend stocks. This is only possible because annuities are offered by life insurance companies, and those companies have integrated that core benefit into their retirement product offerings.
One example of an annuity death benefit feature is commonly referred to as the “high water mark” option. The beneficiaries of annuity owners who choose this option will receive a death benefit payout equal to the highest balance ever recorded in the account, regardless of the actual balance at the time of the owner’s death. For variable annuity owners, this is often a desirable feature as it ensures heirs will receive the maximum benefit possible, even during times of market volatility or depression.
Another example of a common benefit available with annuities that isn’t possible with a portfolio of dividend stocks is the ability to use a portion of your account to automatically pay for assisted living or nursing home care. The insurance company can begin paying for your care directly out of your annuity account, without complicated procedures or decisions regarding the sale of stock shares. With an ordinary stock portfolio, this simply wouldn’t be possible.
The Downside of Annuities
The most common objection to the use of annuities compared to individually purchased stock shares is the internal cost of owning the product.
Aside from typically nominal trading fees and a small annual custodial fee for retirement accounts, there usually aren’t many other costs involved in an ordinary brokerage account. However, annuities of all types have a wide range of possible fees that vary based on a number of factors including the insurance company’s internal cost structure, the type of annuity, and the specific benefits (called riders) added to the product.
All annuities contain mortality and expense fees, commonly referred to as M&E charges. These fees go toward paying for the life insurance component of the annuity contract and usually average between 0.5%-1.5% per year.
Additionally, each rider added to an annuity contract will carry its own annual fee, which typically ranges from 0.5%-1% depending on the specific benefit. So, the more complex you make the annuity, and the more guarantees you add to the contract, the more expensive it will become. It’s not uncommon for annuities with the most popular riders to end up with annual expenses totaling 2.5%-3%.
Two or three percentage points may not sound like much, but for larger account sizes (and over the course of many years) those fees can add up to quite a bit. But, countless investors each year proceed with annuity contracts because, for them, the expenses are worth the guarantees and benefits that wouldn’t be possible in any other type of arrangement.
The biggest potential drawback to annuities, the soapbox upon which almost all anti-annuity arguments begin, involves surrender charges. Almost every annuity contract contains a surrender charge, which is nothing more than a penalty fee that will be imposed by the insurance company if you decide to close your account within a specified number of years. Common surrender charges can range from 6% to as high as 10%. Most annuity agreements reduce the surrender charge by one percentage point each year until it eventually disappears entirely.
While the prospect of being forced to keep your money within an annuity for at least the next several years for fear of being charged a hefty penalty fee can definitely be discouraging, bear in mind that annuities are intended to be long-term retirement investments. If you’re looking for a place to simply park your money for a couple of years, an annuity is most definitely not that place. But, if you don’t intend on using the money for at least a decade, then the idea of a surrender charge is all but irrelevant.
It’s also important to realize that insurance companies spend a rather significant amount of money when you first purchase an annuity, more than the expected administration and paperwork filing costs. For example, even though the life insurance component is not formally underwritten like a regular life insurance policy would be, there are still costs associated with creating the “life insurance” for you. Additionally, annuity contracts require the insurance company to set aside a minimum dollar amount in reserves to ensure sufficient capital is available to pay the life insurance portion. This is particularly relevant for variable annuities with the high water mark rider added.
Further, insurance companies pay impressive commissions to the brokers and agents who sell these contracts. It’s not uncommon for annuity products to pay commissions between 5%-10%. If an annuity is terminated before the insurance company has had time to recoup all of that outlay, the surrender charge serves to make the carrier whole again. This is also why surrender charges decrease over time, as the company can slowly recover the money it spent via interest generated from the conservative investments in its reserve account.
Closing Thoughts on Annuities Versus Dividend Stocks
Determining whether an annuity makes sense for your retirement investment portfolio is not a decision that should be made lightly, nor is it one that should be made without the assistance of a trusted independent financial advisor in most cases. Both annuities and dividend stocks offer potentially significant appreciation, as well as potentially significant risks, to your savings, and there’s no one-size-fits-all solution for everybody.
It’s essential that you compare the costs and benefits of an annuity with those of a dividend stock portfolio. Plus, considering your risk tolerance and time horizon is paramount to determining the most suitable course of action, and a financial professional will have the means to comprehensively evaluate your unique situation and present appropriate solutions.
Annuities aren’t for everybody, especially given some of their fees, but they most definitely offer a suite of unique benefits and guarantees that you won’t find anywhere else.