An investment vehicle that is very popular among investors is the annuity. This is a product offered by insurance companies that repays the money invested in it over time. The attraction is that with many annuities the payments continue for your lifetime, even if you live more than long enough to have been fully repaid with interest. That appeals to people who don’t want to outlive their money.
What I described above is the simplest kind of annuity, called a fixed annuity. You pay the insurance company, say, $100,000. They agree to make annual payments to you of $6,414, for as long as you live. This at first glance seems to be 6.4% per year. Banks are paying much less on 10-year CDs, so that sounds pretty good.
What Is Your Real Rate of Return on an Annuity?
In fact, the return on the annuity would depend on how long you live. If you lived forever, that $6414 return would in fact be 6.4%. If not, then it would be less. If you lived for 20 years, that $6414 annual payment would only represent about a 2.5% rate of return. This is because most of that $6414 being paid to you each year is your own principal being returned to you. After all, for there to be any return, you must recover your principal.
If you lived 30 years, in this example your return would be about 4.9%; if 40 years, about 5.7%.
If you only lived five years, the return on the annuity would be negative – you paid in $100,000, and did not collect all of it. Some fixed annuities will pay the balance of your original principal to your beneficiaries if you don’t live long enough to collect it, so that you do not have a negative return. In that case, the effect is that you will have given the insurance company free use of your money for your whole lifetime and achieved a zero percent return.
The annuity payment is calculated based on actuarial information about how long you are likely to live. If you live longer than expected, then your return is higher than the insurance company intended to pay you. If not, it is lower.
You can think of it as making a loan to the insurance company. They estimate how long they think you will live, say 20 years. They then calculate the amount of a loan payment that would pay back your principal, plus interest at the actual rate of return (which is usually a little more than the rates on CD’s for the same period), over that 20-year period. At a 2.5% actual ROR, that payment would be $6414. But there are a few differences:
If you live longer than the insurance company expected, they keep paying anyway. Those “extra” payments increase your overall return from that 2.5% by a little bit every time you collect another payment. If you don’t live as long as expected, then your return is less, as described above.
The small additional premium you are receiving over CD rates is not free. CDs are insured by the government, while annuities are not. You should think of the small increment in extra return as compensation for the extra risk.
The taxation of interest payments on CDs is different than on annuity payments also. It is typically a little less for the annuity. However, there can be tax penalties for withdrawing more money than the scheduled annual payment from an annuity in some cases.
Also keep in mind that most insurance companies charge Surrender Fees on early withdrawals. These would be in addition to any tax penalties.
To increase the appeal of annuity products, insurance companies can add many bells and whistles such as first-year bonuses, “Multi-year Guaranteed” rates vs. “Banded” rates, “market value adjustments” and a whole lot more.
And so far we are only talking about variations of so-called fixed annuities. There are a number of other categories of annuities including variable annuities, equity-fixed annuities and indexed annuities.
All of this makes the products complex and hard to value, which is a salesperson’s dream come true. One thing that all annuities have in common is that their salespeople receive lavish commissions.
So, is an annuity a good choice for anyone? Only in certain circumstances. If the particular cash flow and tax benefits offered by an annuity are a perfect fit, and the investor doesn’t mind knowing that they are helping to make the insurance company and its salespeople much richer than they are, then maybe. In most cases, you can do better elsewhere with the proper knowledge.
This video offers an in-depth look at the different types of annuities and their uses.