Clearing the Smog Surrounding Annuities

I’m convinced that annuities are the most misunderstood financial and insurance product in the financial services universe today.

I think there are several reasons for that, which I will get into in a minute. In this article I will try to provide an “Annuities 101” course covering what they are, what they aren’t, and a brief overview of the basic types of annuities.

How Many Thousands?

But first, why do annuities so often get misunderstood and branded with a negative image? I don’t doubt there are many subpar annuities being sold around the country.

But let’s be clear: There are only about 3,700 publicly traded companies on the major stock exchanges today, yet there are thousands and thousands more mutual funds and ETFs offering different plays on the market and different baskets of stocks or bonds. Forbes recently pegged the number at 16,700. But the majority of these thousands of mutual funds and ETFs are garbage.

So why don’t you also hear investors and financial advisors disparaging mutual funds and ETFs at the same level as annuities? The reason is that virtually every investor is involved with and every advisor peddles in mutual funds or ETFs, but the financial universe of individuals who are also involved in annuities is much smaller.

For example, if an advisor only has one tool (i.e., funds) to apply to every investing situation, do you think he or she is going to speak favorably of annuities if a client inquires about them?

And unfortunately, many advisors who are also licensed agents of annuities don’t understand them very well, but still sell them to their clients. This leads to bad communication, misunderstandings about what the annuity is or isn’t supposed to do, and a bad reputation for both the agent and the annuity.

The Regulatory Scheme Is Messy

In addition, annuities are regulated in a messy manner. For starters, they are separated into fixed annuities and variable annuities. Fixed annuities are classified as insurance products, and state insurance departments regulate them. Variable annuities can lose value and are treated as securities (similar to stocks, bonds, mutual funds, and ETFs). Both the Securities and Exchange Commission (SEC) and state insurance departments regulate variable annuities.

Having multiple regulatory bodies at both the state and federal levels involved at the same time never simplifies an outcome or a product.

Many Different Types of Annuities Lead to Confusion

And finally, there are many types of annuities and variations on them, having completely different characteristics, which I will describe below. So if all you tell me is that you have an annuity, or you’re selling an annuity, that means absolutely nothing to me.

For example, some annuities are guaranteed not to lose principal value. Others have the risk of going to zero. That’s a big difference.

Putting aside their complexities and misconceptions, annuities can play an important role in financial planning. For one, they can provide a guaranteed stream of income during your retirement all the way to your death.

I have met several investors who thought they were stock market experts who were going to trade their own way through retirement, only to lose a huge chunk of their portfolio. Having an annuity as a portion of your retirement plan can help protect you from yourself. (There are also several studies that show investors routinely underperform the very investments they hold because of ill-timed purchases and sales in and out of the market.)

Basic Structure of an Annuity

In any discussion about annuities, you must first understand the type of annuity that’s being discussed, so let’s go over their basic structure.

There are two phases to an annuity: the accumulation phase and the annuitization phase. The accumulation phase is the period of time when the annuity grows in value. The annuitization phase is the period of time when the annuity pays out its benefits to you (i.e., pays you the money).

Not all annuities have both phases, however. For example, an annuity can have just an accumulation phase, or just an annuitization phase — I will explain with illustrations in a minute.

Suppose I paid $100,000 for an annuity. Suppose further it is contractually guaranteed to grow at a 3% rate for 10 years to approximately $134,000, at which time it begins paying me $8,000 per year for the rest of my life. The 10-year growth period from $100,000 to $134,000 is the accumulation phase. The phase where the annuity pays me $8,000 per year for the remainder of my life is the annuitization phase.

Because the annuitization, or payment phase, occurs at a later time after I purchased the annuity, this annuity is considered a “deferred” annuity. In this particular illustration, the annuity is also considered a “fixed” annuity, since the growth amount is contractually guaranteed to be 3%. Furthermore, since I created this annuity with a single up-front payment (as opposed to funding it with multiple periodic payments) it would also be considered a single premium annuity. Therefore, in the annuity industry this annuity would be referred to as a single premium fixed deferred annuity.

As I mentioned, an annuity does not always have an accumulation phase. For example, suppose I change my example above to instead pay $100,000 for the annuity to have it immediately begin paying me benefits of $5,000 per year for the remainder of my life. In this example, there is no accumulation phase. It is still considered a fixed annuity because of the guaranteed benefits of $5,000 per year. This annuity would therefore be referred to as a single premium fixed immediate annuity.

Fixed vs. Variable Annuities

Probably the most important distinction to understand about any annuity is whether it is a fixed or variable annuity. In a fixed annuity, the insurance company guarantees the annuity will have a certain minimum level of accumulation or payout. A variable annuity does not.

A variable annuity is subject to market losses just as an investment in the stock or bond market is subject to losses. In fact, the reason a variable annuity is subject to losses is precisely because your money inside the variable annuity is invested in an underlying investment account consisting of stock and/or bond funds. That is why the SEC gets involved in regulating variable annuities and they are not strictly an insurance product.


Another layer of complexity is that annuities can come with many different types of riders. A rider is an addendum or supplement that can be added onto the annuity. The rider may add a completely new or different characteristic to the annuity. As we previously discussed, annuities are regulated as insurance contracts (except for variable annuities), so that’s why the term “rider” is used for addendums or supplements.

So, for example, a variable annuity could have an income rider attached to it that will guarantee you a certain level of lifetime income even if the cash value of your variable annuity goes to zero due to market losses.

Equity-Indexed Annuities

And finally, I would be doing a disservice to you if I did not explain one of the fastest-growing categories of annuities, the equity-indexed annuity.

These are a type of fixed deferred annuity. During the accumulation phase, the equity-indexed annuity is tied to one or more stock market indices, such as the S&P 500, a European index, and/or an Asian market index. If the market index goes down, your account does not go down with it. (Protection against losses is why it is considered a fixed annuity rather than a variable one.) If the market goes up, you get credited with a portion of the market gains.

So, for example, suppose I put my $100,000 into an equity-indexed annuity tied to the S&P 500 in which I receive a 50% participation rate. During the first period of time, the index drops 20% in a bear market. The value of my annuity would stay at $100,000 (less any annual fees or expenses charged by the particular insurance company). During the second period of time, the index goes up 10%. I would get credited with half of that gain, or 5%, and my annuity value would increase to $105,000 (less any fees or expenses).

Many equity-indexed annuities have required minimum accumulation periods, six to 12 years for example, at which time you can withdraw the accumulated value and do something else with it, or annuitize it into a lifetime stream of payments. This is an example where you may just have an accumulation phase and no annuitization phase.

Of course, there are many more details to all of these annuities, but that is beyond the scope of this article. The main goal here is to acquaint you with a basic overview of the lay of the land.

What Are Some Benefits of Annuities?

Fixed annuities offer protection against downside risk. This can be especially useful to someone who is in retirement or nearing retirement to protect a portion of their portfolio from a potential crash in the stock market.

Annuitizing an annuity into a guaranteed stream of payments for the remainder of life also gives many people peace of mind to know they will at least have certain income sources guaranteed to their death.

Annuities can be used to diversify sources of retirement income streams beyond Social Security payments, interest payments, and dividends, the latter of which can fluctuate greatly from year to year if companies hit rough times and cut back their dividends.

Annuities also grow on a tax-deferred basis, which can be helpful if someone has a significant amount of taxable money that they would like to grow on a tax-deferred basis and may not have the ability to contribute any more to an IRA account.

What Are Some Limitations and Drawbacks?

Annuities typically have limited liquidity, especially during the accumulation phase. You should have other sources of immediately available funds in your portfolio to handle unexpected expenses during the accumulation phase.

If the stock market enters a strong period of growth, then a fixed annuity may have significant opportunity cost compared to what your money could have made in other places. You must remember that in a fixed annuity you are giving up some upside in order to have certainty and protection on the downside. However, this is hard for many investors to remember or be OK with if the market hits a period of huge growth. That is also why an annuity should not be more than a portion of an overall portfolio plan.

And, probably the biggest source of misunderstanding and ill will toward annuities for many folks is that annuities are long-term commitments, often six to 12 years, before you can do something else with your money without penalties or surrender charges.

Many people have difficulty staying married for six to 12 years to someone they once loved, let alone staying committed to a financial strategy for six to 12 years — especially in a media environment where our attention span is usually measured in weeks. If you change your mind after just a couple of years and want to put that money somewhere else, then you could face fees of 15%, for example, deducted from the balance of your annuity value.

Even if someone is informed about these penalties and surrender charges at the time of purchasing the annuity, they’re not likely to remember them a couple of years down the road when they desperately want to use the money for something else. (If you don’t believe me, try to recall all the details of just a couple of conversations you had last week.)

There is actually a good reason for at least some of the surrender fees and penalties. Take, for example, an equity-indexed annuity. As I described above, an equity-indexed annuity protects the owner from market losses but allows the owner to participate in a portion of market gains. The insurance company typically implements this strategy by purchasing bonds with the premium money paid and using the interest from the bonds to purchase call options in the futures market.

To implement this strategy for your annuity, the insurance company is required to take multiyear positions in both the bond and options markets. If I call up the insurance company a year later and tell them I immediately want my money back, they aren’t exactly sitting on the cash in a money market account, and the value of those bonds and options could have changed significantly. On top of that, there are also administrative and trading expenses just in unwinding those market positions.

The Bottom Line

Annuities can serve a useful purpose in a financial plan. Unfortunately, their purposes are often misunderstood because of poor communication and education between the agents selling them and the people who could benefit from them.

Tim Van Pelt is a financial planner and registered investment advisor representative of Steele Capital Management Inc. The views expressed in this article are solely his and do not necessarily reflect the views of Steele Capital or its management. You can reach him at or (608) 577-9877. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, investing, tax, legal, or accounting advice. You should consult your own investment, tax, legal, and accounting advisors before engaging in any transaction.

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