The reassurance of ‘guaranteed lifetime income’ comes at an often high and hidden cost. All annuity products impose fees by various mechanisms. Whether an annuity product is appropriate for you is highly dependent upon your individual investment return objective and risk tolerance.
The Business Model of Selling Annuities
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A ‘fee’ by any other name
You purchase an annuity which promises to provide ‘lifetime income’. The insurance company takes your money, invests it, keeps a portion of the investment profits for itself– an "interest rate spread", and transmits the net to you in the form of a series of payments. The "interest rate spread" is the difference between the yield the insurance company generates on their investment- using your money- and what is transmitted to you.
Though annuity merchants may claim otherwise, all annuity products impose a fee. As respected financial planning journalist Michael Kitces eruditely surmises
Variable annuities have an explicitly disclosed expense ratio that is subtracted from the account balance on an ongoing basis. In the case of fixed or equity-indexed annuities… the costs are subtracted from the annuity company’s gross returns in the form of an interest rate spread before paying the net remaining return to the investor.
Or in the case of the indexed annuity, the interest rate spread is subtracted before the remaining yield is invested into options to provide the investor’s participation rate in the index being tracked.[i]
Exit Penalties aka ‘Surrender Charges’
Life inevitably yields unexpected changes to the best formed plans. If you should decide at some point within the first ten years of purchasing an annuity that you would like your money back, you will likely incur a ‘surrender charge’ of up to potentially 10% depending on how many years have elapsed since purchase[ii].
The purpose of the surrender charge is to ensure that the issuer of the annuity can recover any remaining commissions that were already paid to the agent but haven’t been recovered via interest rate spread. Why do surrender charge periods extend for up to ten years or more? Simply put, because it may take the insurance company that long to recoup the agent’s commission.
The Risk of ‘Guaranteed Lifetime Income’
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Inflation
In June 2016, a recent retiree decided to purchase a $1 million fixed annuity offering ‘guaranteed lifetime income’ with a term guaranteed yield of 2%. The insurance agent indicated that yields were sliding, and it seemed prudent to lock in the 2% yield. After all, that was the Federal Reserve’s official inflation target. The investment appeared to work as anticipated- inflation averaged at around 2% year-over-year…until 2021 when inflation surged to over 9% year-over-year.
By the end of June 2024- the date of the planned annuitization- living expenses had risen by 31% from when the annuity was first purchased. The annuity-which was guaranteed to grow at Fed’s official inflation target had only increased in value by 17%. The guaranteed lifetime income came at the price of a significant loss of purchasing power.
The Verdict
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It All Boils Down to Real Internal Rate of Return
Annuity products vary considerably in their expenses and internal rates of return. Fixed and indexed annuity fees tend to generate a compensatory fee amount of roughly 1% per year for the issuer [iii]. Variable annuity products are estimated to generate fees on average of between 2-5%[iv][v].
Due to the wide variation in expenses and internal rates of return, before purchasing an annuity, it is paramount to ascertain accurate understanding of the anticipated internal rate of return net of fees and expenses. Whether a specific annuity product is ‘good’ or ‘bad’, or more to the point – ‘good for you’- cannot be determined without a baseline from which to compare the annuity with its alternatives.
Fees and expenses create an insidious drag on investment returns due to the effects of compounding. These costs are justifiable in instances where the value delivered to the investor exceeds that of its alternatives. Annuities are an investment offering which, like any other, must compete in a crowded landscape. Their core value proposition is the guarantee of lifetime income. The real value of this proposition is one which must be carefully examined within the context of your individual needs and contrasted against any and all alternatives which may be more appropriate for your specific situation.
[i]https://www.kitces.com/blog/the-myth-of-free-no-expense-fixed-or-equity-indexed-annuities-interest-rate-spread-is-still-a-cost/
[ii]https://www.investopedia.com/terms/s/surrendercharge.asp#:~:text=What%20are%20Some%20Typical%20Examples,in%20year%2010%20or%20longer.
[iii]https://www.kitces.com/blog/the-myth-of-free-no-expense-fixed-or-equity-indexed-annuities-interest-rate-spread-is-still-a-cost/
[iv]https://www.nationwide.com/lc/resources/investing-and-retirement/articles/annuity-prices
[v]https://www.raymondjames.com/hendrywealth/articles/mutual-fund-annuity-costs