Annuities: What They Solve, What They Cost, and What a Fee-Only Advisor Says

Few products produce as much heat as annuities. Some advisors call them all bad. Some sell nothing else. Both camps are talking from the seller's side of the table. From the planning side, "annuity" describes several very different contracts. One or two of them are useful tools for specific problems. The rest are mostly ways to pay for a guarantee you didn't need. This is how we sort them.

The problem an annuity solves

A retirement portfolio can produce income, but it can't promise it. Markets fall, people live longer than they expected, and the combination is the sequence of returns risk that retirement planning is largely about. An insurer can promise income because it pools thousands of lives: the people who die early subsidize the people who live long. That pooling is the one thing an annuity does that a portfolio cannot.

So the question for any household is how much guaranteed income they need beyond Social Security and any pension, and what it costs to buy. For many of our clients, Social Security alone covers essential spending and the answer is none. For others, particularly single retirees with modest portfolios and long-lived families, some additional floor is worth paying for.

The simple ones

Single premium immediate annuity (SPIA). You hand the insurer a lump sum; it pays you a fixed monthly amount for life (or for two lives), starting now. The contract is a page long, the price is a competitive quote, and comparing it to alternatives is straightforward. A 70-year-old might receive 7% to 8% of the premium each year for life in the current rate environment; part of each payment is return of principal and part is taxable. The money is gone. That's both the point and the drawback.

Deferred income annuity (DIA). Same contract, but payments start later, at 80 or 85. Because many buyers won't live to collect, the payout per premium dollar is much higher, and a small premium can guarantee a large late-life income. A qualified longevity annuity contract (QLAC) is a DIA bought inside an IRA, up to an indexed limit of roughly $210,000, with the premium excluded from RMD calculations until payments begin.

Multi-year guaranteed annuity (MYGA). A fixed rate for a fixed term, like a bank CD issued by an insurer, with tax deferral on the interest. Occasionally useful for someone who wants a fixed return, doesn't need the money for several years, and is in a high bracket now.

These three are transparent enough to price. They're the ones we sometimes recommend, and when we do, it's for the guarantee, with the client buying through a low-cost channel that pays us nothing.

The complicated ones

Variable annuities wrap mutual funds in an insurance contract. Costs commonly run 2% to 3% a year all in: mortality and expense charges, fund expenses, and riders for guaranteed income or death benefits. The "guaranteed income" rider usually guarantees a withdrawal percentage from a benefit base that isn't real money and can't be taken as a lump sum. Gains are taxed as ordinary income rather than capital gains on withdrawal, and the surrender schedule locks the money up for seven to ten years. For the great majority of buyers, a diversified portfolio and, if a floor is needed, a SPIA deliver the same outcome at a fraction of the cost.

Fixed indexed annuities credit interest based on a stock index, subject to caps, participation rates, and spreads the insurer can change. They're sold as "market upside with no downside," and the upside is typically capped at a level that trails a balanced portfolio over any long period. Commissions of 5% to 8% of the premium are common, which is why they get sold so energetically. The guarantee they actually provide (no loss of principal if held to the end of the surrender period) is one a Treasury ladder provides more cheaply.

Registered index-linked annuities (RILAs) are a newer variation with a buffer or floor against losses in exchange for capped gains. They're simpler than indexed annuities and sometimes cheaper. Still rarely better than owning the index and holding some bonds.

The questions we ask

When a client brings us an annuity proposal, or already owns one, the evaluation doesn't change.

• What guarantee does this actually provide, in dollars, starting when, for how long?
• What's the total annual cost, including riders and fund expenses?
• What's the surrender schedule and what does it cost to leave?
• Who gets paid for selling it, and how much?
• Can the same guarantee be bought for less with a SPIA or DIA, or replaced by delaying Social Security, which is the cheapest annuity available to almost everyone?

That last one deserves a pause. Delaying Social Security from 67 to 70 raises the benefit 24%, inflation-adjusted, with a survivor benefit, backed by the government. No insurer sells anything close to that price. So the claiming decision is the first annuity decision, whether or not anyone calls it that.

Existing contracts

Clients arrive with annuities they were sold years ago, and surrendering isn't always the answer. A contract past its surrender period with a rider that has become valuable (because the benefit base ran ahead of the account value in a bad market) may be worth keeping and drawing on. One with high costs and no useful guarantee can be exchanged tax-free under Section 1035 into a low-cost contract, or annuitized. The analysis is specific to the contract, and we do it as part of the insurance review.

Why we sell none of them

We're fee-only. We don't sell insurance and we receive no commission from any product. When we recommend an annuity, which we do for some clients, it's purchased through a channel that pays us nothing, and the recommendation exists because the plan needs the guarantee. We think that's the only arrangement in which advice about annuities can be trusted. The products that pay the most to sell are, reliably, the ones that serve buyers least.

Frequently asked questions

Joseph G. Valerio, CFP®, EAFounder and Lead Advisor at Valerio Wealth Management, a fee-only, fiduciary virtual family office in Miami, Florida. One advisor, credentialed in both financial planning and federal tax. About Joseph

This article is general education, not individualized advice, and it is not tax, legal, or accounting advice. Figures reflect federal law for the year stated and can change. Valerio Wealth Management does not prepare or file tax returns. Speak with a qualified professional about your own situation before acting.