Some of you may have been on the receiving end of a sales pitch to buy an annuity. The proposition that annuities defer taxes and guarantees growth on your investment is indeed enticing. What is not to like? Although these complex financial instruments may have a place in the financial planning tool kit of special needs families, it is important to carefully “look under the hood” before you buy. This article discusses what issues should be considered before buying an annuity.
What are annuities?
An annuity is a contract between an applicant and an insurance company whereby the applicant exchanges a lump sum or series of payments upfront for a series of fixed payments either immediately or at some point in the future. These complex financial instruments help the applicant shift the risk of their investment to a third party and/or defer taxes on the growth of earnings on that investment. The annuitant is the person who receives the income payments from the insurance company. The annuitant is in most cases the applicant but can be a spouse, child, or any one named by the applicant.
Types of annuities
Immediate versus deferred: An immediate annuity is established when a lump sum investment is irrevocably converted to an income stream immediately, whereas deferred annuities begin payouts at some point in the future.
Fixed versus variable: Fixed annuities offer a guaranteed rate of return, whereas variable annuities offer potentially higher returns based on stock market performance.
Annuity payout period: The payout period is the period over which payments are made to the annuitant, which can be the owner of the annuity or someone else (e.g., special needs child). The payout period can be over a fixed number of years or the lifetime of the annuitant. The longer the period of time over which payments are spread out, the lower the regular payments will be.
The advantage of annuities
There are two primary reasons people buy annuities: 1) To create a guaranteed income stream, particularly for those people who are long on life expectancy but short on assets; 2) To defer taxes. For people concerned about whether their assets will outlive them, annuities provide peace of mind that at least some fixed portion of their income needs will be met throughout their lifetime. For fixed income annuities, the insurance company guarantees the payouts and therefore assumes the risk that the initial investment, including that the market returns will be sufficient to meet the future payments to the annuitant.
People also invest in annuities as a means of deferring taxes. Taxes are only paid on the growth in the earnings of the premium or lump sum paid to the insurance company when the annuitant begins taking withdrawals.
The disadvantage of annuities
Annuities also have distinct disadvantages. For life certain annuities, which are contracts that pay an income stream over the annuitant’s life, payments stop after the annuitant dies. As an example, let’s say you bought an annuity for $100,000 to pay $500 per month over your lifetime and you die the second month into the contract. You handed over $100,000 and you received $1,000- a “loss” of $99,000! Although you were guaranteed income for life, a life that ends prematurely favors the insurance company (of course, the opposite can happen if the annuitant lives for 100+ years!) One can purchase exception or “riders” to these contracts to ensure some payments are made in the event of premature death but these exceptions all come at a cost.
Perhaps the biggest disadvantage of an annuity is the potential high costs in owning them. These costs are often hidden and opaque to the purchaser but could range up to 3% per year of the assets managed on the contract. Such a drag on earnings can substantially offset the benefits just discussed.
Another disadvantage is that the annuitant no longer has access to the asset that was exchanged as a part of the receiving fixed payments. For many this guaranteed income is a benefit, but for others, not being able to tap into the entire asset can present problems, particularly if one’s cash reserves are low.
Considerations special needs families have in buying an annuity
Annuities can make sense as a financial planning tool, particularly for special needs families who are looking to augment income for their loved one at their death. However, before signing a contract, it is important to clearly define what the goals are before making a purchase. If the goal is to create risk-free monthly income, then clearly understand what the income gap is that the annuity payment will fill. For special needs families, it is important to know what the Social Security payment will be upon the death of the parent. For most families, the child with a disability will qualify for Social Security Disability, which provides payments of 75% of the primary earner’s Social Security payments upon death. Since this enhanced Social Security payment is already providing a fixed income stream, there may not be as much need to provide an additional layer of fixed income through the annuity. If future Social Security income is insufficient for meeting the regular needs of your adult child, consider “annuitizing” (creating an income stream of the asset) just a portion of the portfolio and leaving the remainder in a Special Needs Trust. The lump sum available in the Special Needs Trust could then be available for any emergency or bigger purchase needed for your loved one.
Understand clearly the cost hidden in any annuity contract you are signing. Many annuity contracts contain “riders” or additional benefits and protections alongside your annuity that you may not need. Each of these benefits come at a cost. Evaluate if you really need each of these added protections. For fixed income annuities, the cost of the contract is the implicit lower rate of return you are accepting in exchange for receiving a fixed guaranteed series of payments. Evaluate if the value of “risk free” income that is being guaranteed is worth the lower rate of return implicit in the contract.
For special needs families, annuities may have place in meeting the needs of a loved one; however, due to their complexity, they need to be carefully evaluated before locking into a contract. Because exiting a contract can be costly, extra due diligence is needed in making this evaluation. Discussing the pros and cons of the annuity you consider purchasing with a financial professional who is unrelated to the sale of the contract can help you determine if the annuity purchase is an appropriate fit in meeting the financial planning goals of your family.
