The Verus Team

Annuities – The Third Rail of Investment Products

Derek Majkowski. Any opinions are those of Derek Majkowski and not necessarily those of RJFS or Raymond James. Opinions expressed are as of this date and are subject to change without notice.

As defined by Wikipedia – The third rail of a nation’s politics is a metaphor for any issue so controversial that it is “charged” and “untouchable” to the extent that any politician or public official who dares to broach the subject will invariably suffer politically.

As a long-time financial advisor, if there is one investment product over my career that can most closely relate to being a “charged” – or in a lot of cases, almost “untouchable” investment vehicle, it has been the annuity.

Very simply and generally put, annuities are products that are offered by insurance companies. They are most commonly bound by a contractual agreement between the insurance company and the insured, or annuitant.

The general goal of an annuity is to provide an income stream from the insurance company to the annuitant either now or at some point in the future if desired.  Basically an annuity is the return of your principal – with some amount of interest or return on the capital – for a specific period of time or over someone’s lifetime.

Depending on the primary objective of the annuitant (preservation, income now or income later, growth, or some combination of one or all of these), an annuity product exists prescribing to address one or several of these respective goals.

In addition, an annuity if purchased outside of tax-deferred retirement accounts works a lot like retirement accounts, and any asset liquidations prior to 59 ½ comes with certain penalties similar to those when taking non-qualified distributions from a retirement account.  Also, like a tax-deferred retirement account, taxes are not recognized until withdrawn.  The growth and appreciation is deferred until withdrawal.  When taken out, the growth above your cost or principal is taxed as income.

Therein lies part of the problem and controversy with the product known as the “Annuity”.  Without the proper understanding and information, it is easy to paint a broad brush that all annuities operate the same way.  This misunderstanding can cause confusion, and in-turn, be viewed first as a negative before seeing how they could fit into an overall investment strategy.

Are there negatives to owning annuities?

In short – sure there are negatives. If an insurance company fails to meet their obligations, or goes out-of-business, then there can certainly be some negatives depending on what you own and what amount you have invested with a particular insurance company.  These companies offer guarantees, but only up to their ability to honor those guarantees.

As for the actual structure of annuities as a product however, I’m not sure I would go so far as to call them negatives.  I think it is more appropriate to call them trade-offs.

I am not suggesting that there are not things I dislike about annuities, or identify as not being suitable for certain situations.  I just feel it is important to have the right perspective about what annuities actually are and are not.

Allow me to explain.  To begin, annuities are technically insurance products.  When I begin with this primary definition, I will often explain to someone that with insurance products, you pay a premium or fee to protect against an unlikely or undesirable outcome.

Some examples I like to highlight is that of owning a car and purchasing car insurance, or owning a home and having home owners insurance.  Each month, quarter or year, most car and home owners pay a premium to protect against an unlikely or negative event and outcome.

If you crash your car, or your house burns down, the insurance that you pay for each year is generally there and intended to replace or repair the negative and unfortunate event that caused loss or damage to your car or home.  I will often ask someone if they are disappointed at the end of the year when they paid those car and home insurance premiums, and they did not crash their car or burn down their house that year.

The answer is an obvious – “of course I’m not disappointed”.

Why?  Well because insurance is intended to protect us, and we are willing to pay the premium for that perceived “peace-of-mind”. Even in the examples of car and home owners insurance it is important to understand your policies and protections, and the details of your coverages.  In essence, with all insurance contracts, you need to know exactly what you are protecting against and what is not covered.

That nuance, fine print, and perceived lack of transparency in the insurance contract is often a criticism of insurance companies and the products they use to insure.  Those critiques at a high level are reasonable, but there are enough checks and balances to protect consumers on these products, and frankly, if fully understood (usually with the help of a qualified agent / advisor), are really about the coverage, terms, and trade-offs between the insurance company and the insured.

A mutual and contractual understanding if you will.

The annuity product – as an insurance product – works very similarly, and they come in a lot of different shapes and sizes.  There are immediate annuities, deferred annuities, fixed annuities, variable annuities, and fixed-indexed annuities to name the most common products.

In each case there is a trade-off between what an insured can pay for, and what an insurance company will provide in return. Depending on what someone is looking for, insurance companies will offer different terms for different prices, fees, or premiums.  There may be terms to a contract where the insurance company wants access to your funds for a minimum number of years, and for that use, the company will provide a minimum rate of return.

There may be access to market vehicles with minimum income payments, or principal protections. There may be death benefits and other enhancements that may be important to someone. All of these protections and trade-offs can be had for a fee or term from an insurance company.

Also, interest rates and general competition between insurance companies will impact what insurance companies are offering. Similar to the way different banks will issue CDs to their customers, when a bank is trying to attract new money to their banks, they will offer a rate higher than the competition on their CDs.

Insurance companies play the same games. Sometimes these insurance companies are offering attractive products, and sometimes they are inferior.  In most cases, insurance companies (as businesses) are managing their own income, expenses, balance sheet, and risk.  They will offer up protections and products to their clients for a premium, price, or term in exchange for some benefit.

With annuities, you may want income now or later.  The insurance company will give you an option and illustration of what they will give you (principal and interest) for the rest or your life or a specific term, or both.

Could you do better on your own? Sure! Will other companies offer you a better deal?  Perhaps!

Say you want to participate with the market, but guarantee if the performance is not there or you lose money, you get a minimum amount of future income, or your family gets the money you put into the contract as a death benefit – regardless of the value of the asset when needed. Or consider the living or death benefit grows from year-to-year regardless of what your investment does.

Is that product available?  Sure, there may be several insurance companies offering you variable market participation with growing benefits too.  All for a price of course, because that’s the way insurance, and in-turn annuities work.

Does that price make sense to pay?  That depends.

The key point when considering insurance and annuities is that there will always be conditions and trade-offs.  When considering the purchase of any insurance -and this includes annuities – do you self-insure and assume the risk, or do you shift some or all of the risk to the insurance company?

When choosing to shift that risk, we pay a price and agree to certain terms.  A price under terms that may, or may not be worth it.  In my opinion, those are the more appropriate questions to consider when contemplating buying an annuity.

Are you afraid of your money running out, or losing the value on the investments subject to market risk, and if so, is the price the insurance company is charging for that protection worth it?  Are the terms of the contract reasonable with your time horizon and goals, and is the company giving you enough of a return for the use of your money?

While it is important to truly understand all of the terms, costs, and trade-offs of a particular insurance / annuity contract, it does not mean they are “bad” vehicles to utilize within an overall plan.  There are times when the annuity products can work better than assuming the risk yourself and vice versa.

As it pertains to an overall investment strategy, it is important to understand what you could protect against, and how an annuity could work within that strategy.  From there, the exercise should be a determination on whether the terms, costs, and trade-offs are worth it.

That is a very personal and specific question within an individual approach, not one that can be generally answered or remarked on.  So while the annuity remains a controversial and “charged” product, a little understanding can make them a lot less threatening – regardless if you choose to own one or not.

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The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Investing involves risk and you may incur a profit or a loss regardless of strategy selected. Raymond James does not provide tax or legal services. Please discuss these matters with the appropriate professional.