I get clients come in every week telling me, “I have an investment, but I don’t really know what it is. My advisor told me that it was a guarantee that I can’t outlive my money or something like a pension.” What they’re describing is an annuity, which is an insurance company product offered by many financial advisors. Annuities can fill an important need and can absolutely be a great solution to a client’s unique circumstances, but they are complex in nature and often misunderstood. Sold by insurance companies, it is important first for a potential investor to know that the annuity contract and the benefits it promises to provide are only as good as the financial health of the insurance company. Please ask about the particular insurance company’s credit rating by Standard & Poor’s or Moody’s and how that measures up among the universe of insurance company ratings.

Annuities, at their most basic level, come in three “flavors”: fixed, variable and indexed. A fixed annuity promises to pay an investor a fixed amount of income based on prevailing rates. A variable annuity is subject to value fluctuations, and therefore, the payments to investors may fluctuate. Variable annuities are invested in “sub-accounts” which are like mutual funds. The sub-accounts are chosen for the investor by the financial professional and there may be exposure to stocks, bonds, “stable value” money-market-like funds, or a mixture of these. Without the purchase of additional guarantees, your account can go down in value. Indexed annuities are a bit of a hybrid. Their performance is tied to underlying investment indexes like the S&P 500 or a bond index, but they have “floors’” so that if the underlying investment indexes have a negative year, the value of the account is not impacted. There’s a caveat, though. Investors are insulated against “down” years, but if the underlying index has a blowout year, the investor will be “capped” in their gain and not be able to fully participate in the total market gain.

Here’s a simple, hypothetical example of how an indexed annuity invested in the Dow Jones Industrial Average, with a “cap” of 8.00% works: In 2019, the Dow Jones Industrial Average was up 22%. If an indexed annuity has a cap of 8%, instead of the investor enjoying a gain of 22%, which is what she or he would have if they were invested in a mutual fund that was based on the same index, their gain would be 8%. In 2008, the Dow Jones Average was down 33.84%. If invested in a mutual fund that reflected the Dow Jones, that investor would be down almost 34% on paper (please remember that you don’t actually lose money until you sell investments). If the same investor had our indexed annuity, he or she would not have a loss to the account value. Protection with a cap on gains may be the best of both worlds to some investors. Detailed conversations with your advisor about your goals and appetite for risk are crucial in deciding whether an annuity is right for you and what type best fits your circumstances.

It’s also important to fully understand the fees you will pay as you won’t receive an invoice for the annual fees you will pay; they are “taken off the top” of your account. Every annuity has an M&E fee, shorthand for Mortality & Expense charges which is the fee for the insurance part of the annuity contract. You may or may not be sold “riders” which are added benefits to you and could involve guarantees to you while you are living or guarantees to your heirs after your death. There are costs to riders, so please have your financial professional explain the contract “promises” clearly with real-life examples, detail the annual cost of each to you and then show you the total annual cost to you of the investment so you can make an educated assessment of the risks and rewards of the annuity versus a low-cost mutual fund or individual securities.

Surrender periods are another annuity subject around which you need to get some clarity. Annuities are meant to be long-term investments. Funds invested in an annuity are monies to which you won’t need access in the short-term. All annuity contracts are different, but a great majority have a number of years, detailed in the contract, that you won’t have access to the total of the funds you’ve invested unless you pay a fee to the insurance company. This is called the surrender period and the annuity contract will spell out the percentage of the contract value you will forfeit if you need to access your
money early. Usually, this percentage decreases the longer you hold the contract until you reach a period, often 7 years, when the contract is said to be “out of surrender” and you can access the full amount. Every contract is different and it is important to know the particulars. Some contracts allow investors to take out a small amount like 10% per year “free” from penalty. Some contracts allow “free” withdrawals in certain circumstances such as the investor becoming a permanent resident of long-term care. Please, please, be sure in your mind under what circumstances you can access your money if a need arises.

Some financial professionals sell annuities to investors as a vehicle to leave a legacy to heirs. This may be entirely appropriate. Tax laws can always change, but please know the difference between leaving an annuity to heirs versus leaving mutual funds or individual stocks or bonds to heirs under current tax laws at the time this article goes to print. If you invest $ 10,000.00 in an annuity and name your children as beneficiaries of the annuity at your death and the value at your death is $ 30,000.00, your children will owe Uncle Sam tax on the $ 20,000.00 in capital gain that your account grew. If you instead had invested $ 10,000.00 in a mixture of stocks and the value had grown to $ 30,000 on the date of your death, the cost basis of your investment gets “stepped-up” to $ 30,000.00 and your heirs can sell the stock upon inheritance and pay the capital gains tax on the much lower capital gains of the difference between the new $ 30,000.00 basis and the market value on the date of sale.

If you have an annuity or have an investment that you heard called a “guarantee” or a pension and want to drill down into the nitty-gritty and gain more clarity, I invite you to call your financial professional or reach out to me for a complimentary “annuity check-up”. I can be reached at 563-949- 4705 or at [email protected]. Healthy Cells Friends, please accept my best wishes for a joyful holiday season.

Securities offered through J.W. Cole Financial, Inc. (JWC). Member FINRA/SIPC. Advisory services offered through J.W. Cole Advisors, Inc. (JWCA). Huiskamp Collins Investments, LLC and JWC/JWCA are unaffiliated entities.