Annuities Part 1: The different types of annuities

It seems that the public’s perception of pensions is changing towards a more positive attitude. In all honesty, as a financial advisor, my own view of pensions has shifted to a more affordable but more cautious view. This is the first in a series of articles on pensions. The point of this is not that someone should be pro-pensions or anti-pensions, but smart about pensions. Part of the confusion is that, like any investment, there are many options. Some annuities are suitable for a select minority of investors. With other types of annuities, I don’t know why more people have and use them. It’s more about proper usage and knowing what each one is. Just to express my bias, after being personally anti-retirement for a number of years, I started looking into them and grappling with them. Once I did that, I could see what types of people and what types of situations they are appropriate for. I hope that this sporadic series of articles will give you an idea of ​​my train of thought.

Let’s start with some history. Pensions are anything but new. They date from the 17th century and even earlier from the Middle Ages. I remember coming across them while reading Victor Hugo, long and sweet That unfortunate which was mainly written in the 1850s. When they were first created, this was obviously before pensions and social security. People would spend their whole lives trying to save money and retire. The concern was, “What if I live longer than I plan and run out of income from my savings when I’m as old and frail as I ever will be?” So initially, they were a guarantee (usually from a bank or insurance company) that if you give them a lump sum they would give you payments for the rest of your life no matter how long you live, but that when you die the institution would keep the money. They would hope that you would give up early (so that they could rake in more of your lump sum) and you would hope that you would live as long as possible (for obvious reasons, but also so that you get paid more than you gave them).

Pensions changed over time as people wanted to guarantee them for the life of their spouse as well. Or when people were willing to accept a lesser payment if it meant the institution failed to uphold the principle in the event of death. Or some may want to deposit the money now and let the money grow at a set rate until they are ready to make payments. Or others only wanted to commit themselves for a short time and wished that the funds would be liquid after a few years. It just kept going and the different products and solutions were developed to meet the demand.

We can reduce the wide world of annuities to four different types. They are:

1. Immediate Annuities – These are the oldest type. You deposit the money and receive an instant stream of income. They may have different terms that change how much you get per month. For example, you could say, “Give me five years’ payments,” in which case you would receive a relatively large payment. Or you could say give me lifetime payments and if there is any money left then it goes to my heirs – this way will understandably give you a lower payment. They work well when people are, say, much closer to life expectancy and need to convert a lump sum into the strongest possible stream of income that they won’t survive.

2. Fixed Annuities – These are fixed rate annuities that people use most often to make money. They’re issued with a set interest rate and a minimum interest guarantee, and the funds grow tax-exempt until you take them out (meaning you don’t have to pay tax on the interest until you take it out). They can be issued with a fixed interest rate that remains the same over the entire term and then also with a minimum interest rate guarantee that does not fall below a certain point. I have a lot of clients that we put some money into pensions with before the financial crisis and they had a high lifetime minimum interest rate guarantee and now that interest rates are very low their rate can’t go below a certain point. Needless to say, fixed annuity rates are now lower, along with everything else.

3. Index Annuities – In my opinion, indexed annuities are probably the most responsible for giving annuities a bad name. They work much like a fixed annuity, except the rate changes up to a cap depending on market performance. Let’s say the cap is 4%, if the market goes up 3%, you get 3%. If it goes up 10%, you get 4% (because you’re “capped” at 4%). Conversely, if the market falls, you get 0%, so your interest rate is not negative. That sounds good, but I’ve learned from observation and experience that rate calculation isn’t as easy as it sounds. Additionally, investors need to be careful as these can sometimes be spent extremely long time commitments. I’ve seen them with 14, 16 and even 20 year commitment periods! I don’t know why anyone would lock up their money for so long, and if you really have that much time to work with, there are probably better solutions out there for you. I’m always open minded, but so far no one has pleaded for them that satisfies me.

4. Variable Annuities – These are hit-and-miss and those that miss are also very much responsible for giving annuities a bad name. A variable annuity is characterized by the fact that the contract value can increase and down according to the performance of its underlying investments (or sub-accounts). These sub-accounts are similar to mutual funds, often managed by the same companies and managers. In addition, the insurance company offers additional “drivers” at some price, which is a percentage of what you have there. The drivers can guarantee the heirs an income deduction or a lump sum. You always hear that annuities have high fees. The way I look at fees is you have to ask yourself what you are getting for what you are paying. Makes sense. I’ve seen variable annuities with high fees that at best give the client a tax deferral (if they’re traditional IRA funds, they don’t even do that). On the other hand, a variable annuity can be used to protect the downside risk that the stock market may have on an income stream. Let’s say an investor has a high IRA and is two years away from retirement and the stock market falls 50%; Certain annuities could have made gains before the market crashed, giving them a lifetime stream of income that can never go down or go away. This can have a side effect as usually when you retire you have 20-30 years left that you need to have income for. Instead of switching everything to bonds and cash for a fee, an insurance company can protect you in a way that allows you to stay in the market (which generally should be someone with such a long time frame).

It’s all about how an investor uses annuities that can make people ecstatic or upset with them. When used correctly, I’ve seen clients be very happy with them and deliver results that are well worth the cost.