Why Annuities Suck

Annuities really suck. Wait, that might be a little harsh. Let me rephrase that: Annuities really suck, unless you sell them for a living. There, I said it. Go ahead and argue with me if you want to, but I have yet to see a situation where a government employee would benefit from purchasing an annuity. They seem to exist primarily as a vehicle for moving money from your wallet to that of the insurance company. My opinion is that you need an annuity like you need an asbestos t-shirt. 

I have friends in the financial industry (CFP’s) and from time to time I ask them to give me their sales pitch on annuities (and believe me, there are some serious sales pitches out there!) I try to keep an open mind—not everyone’s situation is the same. In fact, very few financial products, strategies, or approaches are right for all people, all the time, across the board. There are very few financial statements that can be dogmatically applied. 

But, in my experience and the scenarios I have encountered, I cannot find any situation where an annuity would be better than NOT buying an annuity. Perhaps there is one out there and someone will contact me and explain it to me. Believe me, I’m all ears. 

[Before we get too far, it’s very important to clear one thing up regarding the FERS retirement. Our pension checks (you know, the retirement check you get each month based on years of service and high-3 salary?), are referred to as an annuity by OPM, i.e., the FERS annuity check. Likewise, one of the official names of the supplement check is called the RAS-Retiree Annuity Supplement. These function similar to an annuity in that you pay into it until you start to receive payments. But they are not what we are talking about in this paper. We will be looking at the traditional, private annuities that you purchase from an insurance company. So please keep that distinction clear. You don’t have an option to purchase your FERS annuity; it’s automatic. You do have an option to purchase the kind of annuities we’ll be discussing in this paper.] 

What is an annuity? 

An official definition for an annuity is: “a financial product sold by financial institutions that is designed to accept and grow funds from an individual and then pay out a stream of payments to the individual at a later point in time." 

Simply put, an annuity works like this: You give an insurance company your money, and over time, they give some of it back to you. 

Let’s look at the mechanics…. 

Step One: Your Money Goes In 

There are multiple annuities available, and a dizzying array of optional features to add to those annuities. It can become very confusing, very quickly. But, they all start with this step: The buyer gives his money to the insurance company. This can be done through a one-time purchase, (like taking all of your TSP and purchasing the annuity from MetLife), or through a series of purchases. For example, one could spend $1,000 a year from age 50 to 60, making monthly payments. That’s the buy-in phase. Or “accumulation phase”, as it is called in the industry. The person is accumulating value in the annuity. 

Step Two: Your Money Comes Out 

So what do we get for these payments? What exactly are we actually buying? 

In return for giving our money to the insurance company, they will pay us back in the future, generally at a guaranteed rate. (We’ll get to some of the options in a minute, but for now, just understand they pay us back with interest). During our accumulation phase, the money we sent in is growing tax-free. An annuity is almost always related to some sort of deferred tax benefit. In essence, it is like purchasing a private retirement plan, or pension. Just like in FERS, where retirement contributions come out each pay period, and then at retirement, you receive a monthly check for life, that happens in private annuities as well. Which is why our FERS pension is referred to as an annuity by OPM. 

So, you make a one-time purchase, or a series of purchases to the insurance company (the accumulation phase), they take that money and invest it, making themselves money on your money, and then at some point in the future, they start paying you back your money and some of the proceeds of the investment gains. This is called, not surprisingly, the pay-out, or distribution phase. 

One of the big selling points of annuities is this: the option to receive guaranteed payments for life. That’s probably the number one selling point. People see “guaranteed for life” and are drawn to that stability and peace of mind. “They’ll pay me for life?! Wow, that’s a lot of peace of mind.” And insurance companies are counting on that being your reaction. However, we’ll dig into that a little bit more in a minute, and you can see if that is a good deal, or if it comes with too high a price. 

What Happens In Between? AKA, Step 1.5 

Between your money going in (Step 1) and your money coming out (Step 2), the insurance company is using it to make them (and hopefully you) some money. It’s important to understand what your investment is NOT. It is not a mutual fund. I have seen financial literature some of you have sent me that tends to lead the potential investor to that conclusion--unless they read the fine print. Annuities have certain features like early withdrawal penalties, tax-deferred growth, and possible death benefits, that mutual funds don’t have. You may see literature that allows you different investment options in your annuity, but you are buying an annuity, not a mutual fund. They are two different investment products. 

The insurance company may take your money and invest it in something like a mutual fund through their investment or “subaccounts” but you do not own shares in a mutual fund. You may see options in an annuity for growth, value, high-yield bonds, etc., but just be clear that you are not purchasing mutual funds directly from a company—the insurance company is investing your money for you. Of course, this isn’t free. If you’re starting to ask yourself, why would I go through the insurance company instead of just investing the money myself, you are starting to understand the purpose of this paper. 

Insurance companies are required to make it clear that when purchasing an annuity, you are not purchasing a mutual fund, or stocks, or other securities directly. However, looking at some of the literature out there would certainly confuse the average investor. I think I’ve beat that horse enough. 

Types of Annuities 

Here’s where it can get confusing. There are a LOT of different types of annuities out there. And more creative ones are coming to market all the time. We’ll just address a few of them. It’s not critical to understand every single option available, because they all work on the same general principle described above. But I will give you a few examples of what you can expect to encounter. 

Fixed Annuity 

This is the standard, traditional, basic annuity like we described above. You buy in (either a lump-sum, or payments over time) and at a certain point in the future, you turn on the payments and your money starts to come back to you. And they are guaranteed for life. Typically this has a guaranteed minimum rate of return. 

Example: 

John retires from the government and decides to take his $500,000 TSP balance and purchase the MetLife annuity. John will give MetLife all of his money and MetLife will pay him back his money at an annual interest rate of 3% (as of July 2018-see TSP.gov). Payments continue as long as he is alive. And they continue at the same amount, i.e. they are fixed. The interest is also fixed (at 3% in this case). John won’t ever make more (or less) than 3% on his money. 

(By the way, our FERS annuity operates similar to a fixed annuity. Although our “return” is based on a percentage of our high-3 salary, rather than some guaranteed investment rate.) 

Indexed Annuity 

This annuity is purchased like the fixed annuity, but the difference is the return can change based on an index, hence the name. An index simply means something that the rate is tied to, generally some market index, like the S&P 500. (See my TSP Timing paper for an in depth explanation of index funds.) This is what I see most often sent to me for review. It is not uncommon to come across financial literature that shows how an indexed annuity makes a high return when the market is doing well, while simultaneously preventing you from losing as much as the market if they market is not doing well. Sounds like a win-win, right? Upside without the downside—what’s not to love? Has the insurance company found some secret to making money while never losing money? Well, kind of. It’s called selling you an annuity. 

Typically, this annuity will pay you up to a certain amount if the market is doing well. And generally, it’s not as high as the market’s actual return if the market does really well. Meaning the insurance company keeps any of the profits over what they pay you. Conversely, they will often tell you that your losses are limited when the market goes down, i.e., they eat it. 

So, how can they do this? It’s based on this premise: over long periods of the time, the market generally goes up. By limiting the amount they pay you in the good years, they make more money. This money more than offsets the losses you would have in the down years. Why? Because the market goes up more than it goes down, over time. No one invests in the market who thinks that 30 years from now it will be lower than it currently is. And so far, it’s always been higher at the end of any given 30-year period. 

By having a cap on what you can earn, they keep the rest. 

Here’s a perfect example: Go to www.annuities.com and the top line reads, “Up to 7% Returns* with NO Market Risk”. (I have no affiliation with this website; I just wanted to demonstrate what is out there). Market returns with no market risk? Better check the fine print! 

Example: 

Meghan purchases an indexed annuity that has a 70% participation rate, up to a 6% cap (standard language for one of these annuities). Let’s say that this annuity is indexed to the S&P 500. And let’s also say that the S&P 500 index goes up 21% (which is what it did in 2017). Meghan’s index annuity should earn 14.7% (21% return x the 70% participation rate). However, because there is a cap at 6%, Meghan will only earn 6% and the insurance company will earn the other 15%. 

The plus side to Meghan’s annuity is that if the market goes down 15%, perhaps Meghan only loses 5% because they insurance company caps the loss as well. 

Sounds good, right? Until you realize, as I’ve already said several times, that the market is more likely to go up over long periods of time, than go down. It’s not terribly different from a casino offering you really good odds for a certain bet, because they know that over time, they will come out ahead. They may even comp your room and food, because regardless of what they give you, they’re making even more. 

Oh, and the 2% or 3% dividends that the S&P 500 would typically pay? Yeah, you don’t get those. 

Variable Annuity 

Any guess how these returns work? Yep, they vary. Nothing is fixed in these types of annuities, (except maybe the commission the salesman gets). Variable annuities use mutual funds in subaccounts as we mentioned earlier. The returns are not guaranteed. The upside could be great, the downside could be not so great. This is most like a traditional mutual fund investment. You aren’t limiting yourself. But again, you are not investing directly into a mutual fund, you are still purchasing a contract with an insurance company. Why do I keep bringing that up? Because that seems to be the way they are marketed, and in some of my discussions with you, I notice that you are evaluating the annuity as if it is simply another investment option like the funds in your TSP, which is most certainly is not. 

The above are the basic types of annuities (fixed, indexed, and variable). But there are many, many options available with each kind. Sort of like if five of you go to buy the same model of car. You may all get a Toyota Camry, but each one of you may choose different option packages, and you may choose different ways to purchase the car (financing, outright purchase, etc.). In the end, you’ll all have the option to do something just a little bit different even though you each now own a Camry. Annuities are similar. There are many different options that you can tack on to them. I’ll address a few, but understand there are a lot. After all, the more options the insurance companies have on the menu, the more likely they can find a product that is just perfect for your situation. 

Annuity Options 

Life Only or Straight Life. The annuitant gets payments for the rest of his life. Period. Nothing more. This is like buying the basic, entry level, stock Toyota Camry--if that Camry would quit working the day you die. If your payments are for life only, and you kick the bucket after just a couple of years of receiving payments, well, the insurance company sincerely appreciates your contribution. Not surprisingly, this option generally has the largest monthly payout. Isn’t the insurance company generous with YOUR money? 

So, when is this a good option? When you are certain that you will live longer than the team of actuarial nerds at the insurance company, who do nothing but study big data in an effort to predict with shocking precision when you are going to shuffle off this mortal coil. You see, with this, as with most annuities, you are making a bet. You are betting that you know better than the insurance company how long you’ll live. Live 10 years longer than they expect you to, and you get paid far more than you’ve given them, meaning they’ve lost money on you. You’ve won. And in some basement somewhere, an actuarial table is adjusted ever so slightly to make sure that doesn’t happen again! 

Period Certain. This option allows you to name a guaranteed time frame that you’ll get paid for. You’ll get paid for a certain period. But, because the financial industry makes even the most basic of terms sound confusing on purpose, they call it period certain. If you elect this option on your annuity, the insurance company is required to pay out the annuity for a certain period of time, even if you’ve already croaked. So, in that case, you get to name a beneficiary to receive the payments for rest of the time. If the period ends before you die, however—no reason to check the mailbox next month. 

Life with Period Certain. The best of both worlds…at a cost. This option allows you to pick a certain period, I’m sorry—a period certain, such as 20 years. If you die before 20 years, the payments continue for the remainder of the 20. However, if you outlive the period, the payments continue until you die. In other words, you (and/or your beneficiary) receive payments for either the greater of the period, or your life. 

Joint Life Annuity. This one will make payments until the last of either you or your spouse dies. The insurance company is on the hook until both of you are gone. Want to guess whether or not this reduces your monthly check? Remember the insurance company has to find a way to keep some of your money you gave them, or otherwise how could they remain profitable enough to stay in business and keep paying people their own money back? In many cases, to further complicate the situation, you can choose either a 50% payout of the monthly benefit, or 100% payout of the monthly benefit for your survivor. 

Increasing Payments. Some annuities allow the fixed payments to increase over time based on increases in inflation (typically the CPI). Again, nothing comes for free, so how this works is that your monthly payments in the beginning would be lower than if you had not selected this option. And then over time, they would increase. 

Cash Refund. Here’s one for you. I’ll take this straight from the TSP website that explains it: 

“If you (and your joint annuitant, if applicable) die before the amount of your TSP balance used to purchase your annuity has been paid out, the remaining amount will be paid to your beneficiary, or beneficiaries, in a lump sum. 

You can add this feature if you purchase a single life or a joint life annuity, and with level or increasing payments.” 

Buy an annuity, but die before it’s all paid out and MetLife will give the rest of what you paid for it to your beneficiary. Seems incredibly generous of them not to keep your money. That of course, is not free, as I hoped you’ve figured out by now. Think: lower monthly payments. 

And on and on it goes. I’m sure with just a few phone calls, you could find an enthusiastic annuity salesman to elaborate on even more options that would be “simply ideal for your situation.” Or, more likely, the pitch will go something like this, “A quality annuity can be an important component of an investment portfolio…” Caveat emptor. 

Summary 

Again, there is zero chance I can cover all of the “ins and outs” of annuities in this paper (nor would I want to!) There are other important aspects I didn’t write much about, like the surrender period (how long before you can withdraw money without being penalized), for example. 

Please don’t let what I’ve written here be your sole rational for deciding whether or not to purchase an annuity. This is simply meant to give you more information so that you can ask the salesman pointed questions regarding annuity features. They are confusing. And I would argue they are confusing for a reason. It’s easier to sell something at a super high commission if the buyer doesn’t fully understand it. 

A good rule of thumb: If you can’t explain it thoroughly to someone, is it smart to put your life savings in? Thus, I encourage you—implore you even—make sure you understand all the aspects of an annuity before purchasing one. And compare it to simply investing in a fund and paying yourself a monthly check later on. Or simply withdrawing a monthly amount from your existing TSP or brokerage account. You might be surprised at just how much an annuity is costing you over time. 

Also, one of the questions you should make sure you ask the salesman is how he gets paid. If he says there is no fee, or cost to you, be wary. Nothing comes for free, especially in the annuity universe. 

So why am I so opposed to annuities? At the risk of over-simplification, I just see no good reason to give my money to someone who then gives it back to me, under certain conditions, while charging me a fee to do so. Whatever security I am looking for in an annuity, I can get myself. It is not that difficult to set up TSP monthly withdrawals based on your life expectancy (sound familiar?). The benefit of that is you retain the balance of the account. Die after a year of receiving payments and your beneficiary receives whatever is left in the account, with no penalty or middleman fee. And, with all of the accumulated investment gains, I might add! Remember that over time, the market has returned more than 3% on average, which is the most the MetLife Annuity purchased through the TSP would give you. 

Just so everyone is clear, when it comes time to withdraw money from your TSP, you can take a lump sum, take monthly payments, transfer to an IRA, or purchase an annuity from MetLife (the current contractor). Purchasing an annuity with TSP proceeds is done less than 1% of the time, based on the last data I’ve read. Which is a good thing. 

If your heart is still set on annuity, go investigate it, but please remember these three things in conclusion: 

1. When you purchase an annuity, you are making a bet that you will live longer than the insurance company. And they are pretty darn good at predicting your demise. 

2. The insurance company is taking your money and charging you a portion to pay you back. In almost all cases, you can accomplish the same thing without the middleman. 

3. And lastly, if you really want to make money in annuities…start selling them! 

Disclaimer: None of the above is meant to be investment advice. Rather it is meant to be investment education. So that you are better armed to ask appropriate questions of your financial professional regarding annuities. Personal finance is VERY personal, and who knows, your situation might be one where an annuity would be the appropriate choice. If you are contemplating purchasing an annuity, please seek a competent, honesty, professional advisor.