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Why You Should Never Buy an Annuity

Over the years since the 2008 Recession I have watched as Annuities have gained in prominence.  The rise seems to correspond with the increase of individual district of banks and the stock market.  Frankly, Annuities are one of the worst type of investments you can buy.  Today I’m going to tell you why you should never purchase an annuity.

Rise of the Annuities

Annuities are essentially contracts between you and an insurance company or investment company.  You provide them a lump sum in exchange for them providing you payments or a lump sum sometime in the future.  These payments can also be either a fixed amount or a variable amount.  This means they either pay out the same amount regardless of situation or they pay out a different amount in that period based on some metric.

From what I can tell the big rise in annuity usage comes from those who want the fixed variety. People looking for a “Guaranteed” payout tend to purchase annuities rather then an investment in the market or bonds.  They are viewed as set it and forget it investments with little risk.  But is that true?

Why You Should Never Buy an Annuity

The first thing to realize about Annuities is as stated in my second paragraph they are a contract.  By investing in an annuity you are incurring a counter party risk, which we talked about at length in the past.  You are betting that the Annuity Company will be here to pay you when it is time to payout.  Sometimes these also have some sort of secondary company backing their payments, which gives a second level of protection.  However, at it’s root you are taking a bet and a risk that the company you purchase the annuity from will be here to pay out.  Lest we forget many Mortgage Backed Securities had a second level company providing insurance over their payout.  Those companies went bankrupt in 2009 and the owners were left holding the bag.

Annuities tend not to be liquid.  If you invest in an annuity that returns 2% and the market starts returning 3% you can not just pull out and reinvest.  If you need the money for some period you also cannot just up and sell and deploy the money. If there is a provision at all to get your money out it’s like with a hefty surcharge.  I’ve seen rates well into the double digits for withdrawal.

Annuities tend to charge hellacious fees.  Typically annuities are sold by insurance companies, not investment companies. They are doing so to make a profit.  Furthermore their salesmen are likely making a giant commission cut.  This is why he is pushing this pile of dung on you in the first place.  Think about it, the only way the insurance company makes out on an annuity is if they make enough in fees to cover their payout, their profit, and their commission.  They have to do so by investing in the same vehicles as you, the market and bonds.  So in practice your Annuity is always going to have a return minus expenses situation well less then the market return over time.  If not the annuity company would go out of business which brings us back to my paragraph on payout risk.

These instruments are also incredibly complicated.  You should never invest in something you do not understand.  These investments tend to be opaque with respect to costs, penalties, and even underlying performance measures.

Finally consider that payouts of Annuities often times cease upon death.  Which means you are counting on living long enough to recoup even your original lump sum.  There are no guarantees this will occur.  Even inheritable annuities are not necessarily a great move, as unlike stocks you see no step up in tax basis on inheritance of an annuity.

Do you need a low risk portfolio allocation?

We’ve talked before that your asset allocation should feature lower returning but lower risk investments in correlation to your risk tolerance.  The more risk intolerant you are the more return you would be willing to trade for lower volatility.  If those funds keep you from selling at an inopportune time and allow you to sleep during the depths of a depression then they are well worth it.  Obviously, taking too little risk will be suboptimal to your return, requiring you to work much longer. However there is some marginal utility to return where it holds less value then stability. This is the personal aspect of personal finance which is up to you to decide. However there are other ways to do that with higher guaranteed returns, lower fees, and less risk then an annuity. These might include savings bonds or a cd ladder for example.

These items are not sold by your insurance guy and have an out clause if you change your mind. After all as we discussed before Risk Tolerance and investment needs change throughout your lifetime. You need flexibility where possible, which is not going to happen with annuities. As such if your truly of the type that needs an extreme level of comfort with the risk of your investments then your better off with one of those other investments. There is no scenario I can foresee where I would choose an annuity. And hence my mantra is you should never purchase an annuity.
How do you feel about annuities? Do you hold any?

14 Comments

  1. Leo T. Ly
    Leo T. Ly June 2, 2017

    I like to invest my money in vehicles that I do have direct control or access to my money. Hence, I don’t have annuities nor any voluntary investment in company or government pensions.

    If I don’t have control of the investment, then I don’t have control of the fees or the performance of my investments. So I only invest my money with my self directed brokerage account.

    Lastly, flexibility and liquidity in your investment cannot be underestimated. I don’t want to sacrifice that just to receive a perceived guarantee return in the future. I don’t believe in guarantees.

    • fulltimefinance@fulltimefinance.com
      [email protected] June 2, 2017

      There are no true guarenteed in life, there are always sometype of risk or tradeoff. Nobody rides for free.

  2. I have looked at annuities as a potential way to invest part of my “stash” when I retire.

    The key points I can think of here are that you need to keep the annuity simple, so you can compare across companys. The more “riders” you put into this contract, the easier it is to not get a true “apples to apples” comparison.

    Riders like “guaranteed 10 years even if you die”, etc. can serve to confuse it

    If I was to get an annuity for part of my stash, I would go with a survivor 100% clause (i.e. the spouse would continue to get 100% of annuity even if I died) and an inflation kicker (i.e. it goes up each year with inflation). That would be it. I could then do a comparison between high quality companies and see who has the best.

    Another option I’m exploring is the Vanguard Managed Payout Fund (VPGDX) that pays you 4% annually from the fund (which is invested in a variety of other Vanguard funds). This is a way to follow the 4% rule without too much hassle.

    Again, good topic

    • fulltimefinance@fulltimefinance.com
      [email protected] June 2, 2017

      I could see something like a stable value fund or the payout fund you mentioned potentially being an alternative if you must be that conservative with your choices. That being said it is important to remember Conservatism costs return.

  3. Matt Kuhn
    Matt Kuhn June 2, 2017

    Thanks for the post, I’ve been seeing annuities mentioned around the Internet but never really took the time to learn what they were or advantages vs. disadvantages.

    It’s all about low risk, high return investments, and annuities don’t seem to fit this category very well. I need liquidity or at least the high guarantee that I’ll see my money back like with a CD ladder.

    I agree with you, I don’t see a reason to buy an annuity over a CD or a bond index fund (which seem to average decent 3-4% returns over several years).

  4. Lily @ The Frugal Gene
    Lily @ The Frugal Gene June 2, 2017

    I’m getting those “free steak dinners” advertisements in the mail where they want you to come to dinner so they can sell you annuities. Something told me then that if you need to give free steak dinners to people in order for them to buy your product….that’s probably not a great product.

    • fulltimefinance@fulltimefinance.com
      [email protected] June 2, 2017

      Great point. If they have to bribe you to listen there’s probably something your missing.

  5. Mr. Freaky Frugal
    Mr. Freaky Frugal June 3, 2017

    I don’t own an annuity even though I’ve already FIREd.

    I agree with much of what you say, but I view an annuity as a form of longevity insurance because it continues to pay out no matter how old you get.

    Like you, I’m concerned about counter party risk, but I could by multiple annuities from multiple companies to mitigate some of that risk.

    My other big concern is inflation protection. I can buy an inflation-adjusted annuity but it’s really expensive. My plan is to maximize social security which is inflation-adjusted and then figure out whether a purchased annuity makes sense. I may eventually buy one.

    • fulltimefinance@fulltimefinance.com
      [email protected] June 3, 2017

      I personally view the longevity insurance as largely overrated. The insurance company has taken a bet. That law ensures they will invest in the same things you do in the lower end of the risk pool. Their return on these things plus their fees will provide them with a positive return over your expected lifetime. The only way you would be ahead is if you only invested in the same low risk assets and your lifetime significantly exceeds your expected lifetime. The odds are not in your favor.

  6. Never say never. True, annuities get a bad rap for a lot of reasons, including ones that you’ve mentioned- inflexibility, high costs, low returns, counter-party risk, etc. A few points however:

    First, every investment has it’s own problems. Bonds have lower returns. Stocks are volatile. Cash and cash equivalents don’t even keep up with inflation. And all of the above are more subject to longevity risk (outliving your savings) than annuities. So true, annuities have issues, but they also solve a major problem for people in the last stage of life. Does that mean that you should put your entire savings in annuities? Probably not. But buying enough annuities to guarantee income as long as you live could be incredibly wise depending on the amount you’ve saved for retirement.

    As for counter-party risk- first, most states have a government-run central guarantee fund that backs annuities. So you say that this secondary backing might fail. So might FDIC and SIPC which protect your cash and other investments. The point is that everything is subject to counter-party risk. Furthermore, by buying annuities from well established companies, you mitigate your counter-party risk. And by buying from multiple companies, you mitigate counter-party risk even more. No different than diversifying your stocks and bonds. Is there a chance that all your stock holdings will go bankrupt? Yes, but not a high chance. Is there a chance that all your insurance companies will go bankrupt? Yes, but an extremely low chance.

    As far as fees go- annuities’ reputation for high fees is a relic from decades gone by. Yes, there are still annuities that charge high fees. But faced with competition from ETFs and index funds with rock bottom fees as well as more knowledgeable consumers, insurance companies have been forced to bring down annuities’ fees to be competitive with other investment options.

    As far as inflexibility goes- true, annuities are inflexible, but this is one of the trade-offs for the guarantees you are getting.

    The bottom line is that annuities exist for a reason- because they are an important piece in many people’s financial plans. Yes, unfortunately there are less-than-ethical sales people who sell annuities to people who don’t need annuities, as well as sell straight up bad annuities. But there are also annuities that meet needs that no other investment can meet.

    Think and research very carefully before you say ‘never’.

    • fulltimefinance@fulltimefinance.com
      [email protected] June 3, 2017

      While I will admit I chose the title to emphasize the point, I still feel the much vaulted longevity insurance is overrated. The reality is the only way the annuity comes out ahead is if you exceed your expected life and you compare it to low risk investments (like bonds). If you simply invest in stocks or you live to your expected life or shorter it fails. The insurance company would only sell you an annuity if they can come out ahead investing in the low risk investments they are required by law to pursue. Social security and a good stock allocation with a moderate withdrawal rate is a far superior course of action.

      In my honest opinion the only reason to ever buy an annuity is if you believe you are incapable or will become incapable of managing your investments/spending. Liquidity can save you from yourself.

      • Daniel Palmer
        Daniel Palmer June 4, 2017

        Of course, by the very nature of being an insurance product, you only come out ahead if you exceed the odds. Same with home insurance, life insurance, auto insurance, etc. Doesn’t mean you forgo those insurance products.

        You don’t buy annuities to ‘come out ahead’ or beat the stock market. You buy them so you don’t run out of money if you do in fact exceed life expectancy, which there is a decent chance of. Of course, if you have a large enough nest egg to live on until 100, you might decide to forgo an annuity. But if you have a smaller nest egg, sacrificing​ a little potential yield for guaranteed yield can be a smart move. A bird in the hand is worth two in the bush.

        http://penniesanddollars.com/5-reasons-to-consider-annuities/

        • fulltimefinance@fulltimefinance.com
          [email protected] June 4, 2017

          I don’t really see them the same as other insurance products. Life, home insurance, and auto insurance are insurance products. Annuities are investment products. One is paying as you go to insure against an event. The goal is not to make money, it’s to avoid something. The other is an attempt to make money and have it last. I believe its a very bad idea to mix the two.

          There is a major problem with the life expectancy argument. If you have enough for the annuity to cover until your 100 then you should have enough for the investment to last until 100 if done properly. There is no free ride. How about a real world example ( and if you have one that breaks my example I’d love to hear it, but this is the best real world example I have). A friend of mine has a pension worth 550K. Their pension pays 2200 a month if taken as a payment or 550K as a lump sum. 26,400 a year is the yearly payout. Thats about 4.8%. The person is 65. A quick look at firecalc shows the odds that this money will run out if they spend the full 2200 a month over 30 years at just 2%. (note: this assumes you can only spend 2200 a month regardless since the annuity has no inflation rider). I can’t see how you could justify investing in protection against a scenario where you have to exceed average life expectancy by 20 years and be amongst the less then 2% of return sequences that would exhaust your money? Your probabilities are off the charts low. Based on discussion with others, my friend’s numbers are about average. Obvious there is risk in an anecdotal example but I have yet to find an exception.

          Now this does point back to the exception of protecting you from yourself via illiquidity. My friend actually might be a good case study for that exception. Your post did a good job of highlighting that exception.

  7. Mustard Seed Money
    Mustard Seed Money June 4, 2017

    I had a friend try to convince me that annuities were the way to go. I said we’re in our 20s there is no way that I’m going to buy an annuity with so many other options available, especially passive index funds.

    I think he ended up buying it but he’s never talked about it since then. I think he’s a little embarrassed especially since the market has exploded since then.

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