What are Annuities?

I hope you all had a fantastic Christmas! If you returned to work for the couple days between Christmas and NYE, I hope this letter allows you to procrastinate while still looking busy. “Getting caught up on emails” isn’t a lie and very believable after a few days off for Christmas.

If I am holding the truth stick, I had no idea what annuities were before researching for this letter. Mike came up with this question, and I am happy he did! So let’s jump into a new topic for me and maybe you as well.

Annuities are accounts that provide fixed income over a specified period of time typically for retirees. They supplement retirement income and help people who are worried about running out of savings. They come in so many different variations, but the general bottom line is this: you give money to an insurance company, they invest it and guarantee fixed payments over a predetermined period of time. 

If you are young and reading this newsletter, you are probably making the correct investment choices now to ensure you have plenty of retirement savings and don’t need an annuity. However, there is always a chance that life gets in the way. A perfect plan doesn’t guarantee a perfect outcome. 

So let’s learn more about how these work!

There are three main types:

1. Fixed - guaranteed payments regardless of investment performance. 

2. Variable - payments based on investment performance, can be funded with pre-tax dollars; your gains and losses are unlimited. 

3. Index - a hybrid annuity that guarantees a minimum payment that can increase based on investment performance; your gains and losses are limited. 

These accounts are funded in two different ways:

1. Lump sum - one large payment to fund the contract/account.

2. Premium payments - monthly payments until a predetermined time or amount. 

Finally, annuities are paid out in several ways:

1. Deferred - payments start on a later date.

2. Immediate - payments start now.

3. Fixed period - payments last for a certain number of years.

4. Lifetime - payments last until you die. 

Annuities are contracts between you and a life insurance company; however, I think it is easier to think of them as retirement accounts with different rules and benefits.

1. You fund the account with your money, and, depending on the contract, may have some  control over where it is invested. 

2. There are penalties, sometimes severe, if you try to withdraw your contributions before a set period has elapsed. 

3. Annuities are used for retirement planning. Usually, payments don’t start until you’re over 65, but this is contract dependent unlike IRAs. 

If you’re thinking, “wow, this seems like a cool way to guarantee money for retirement. Why don’t we all do this?” The answer to that, like everything we talk about, is the worst word in finance: fees. Okay, maybe the worst word is actually: unprecedented. I swear I’ve heard that word at least three times a month since March 2020. 

Annuities have fees of around 2-3% which doesn’t seem high, but a 2% fee over a twenty year, deferred annuity period can equal tens of thousands of dollars. Annuities are similar to life insurance by promising future payments while taking high fees today.

Additionally, money put into an annuity is illiquid. Not only are there fees if you try to pull your money early, it is also difficult to do. If you were born in the ‘90s or earlier, I apologize for what I am about to do. 

“I have an annuity, but I need cash now!” J.G. Wentworth takes advantage of the difficulty associated with getting cash out of an annuity by buying contracts from people for pennies on the dollar. You get a fraction of what the entire annuity is worth, but you get it now. 

Generally speaking, annuities make sense in one specific situation. If you are retired or within five years of retiring, get a lump sum of money (+$100,000) from the lottery or inheritance, and are worried about not having enough savings to last you, a fixed, immediate annuity might be the right choice for you. That was a mouthful. Without enough time to recover from a recession, an annuity might be a safer, guaranteed way to increase your income in retirement. 

In every other situation, +$100,000 placed into an S&P 500 Index fund or a lifecycle mutual fund will generate more money with fewer fees than an annuity contract (probably).

The world of annuities is far too customizable to go into every possible option. At the end of the day, an annuity salesman can make whatever contract to convince you to give them money and pay their fees.

If you want to read more, you can check out Investopedia or Forbes guide to annuities. Also, honorable mention to my wife, Julia, for singing the J.G. Wentworth song when I said I was writing about annuities. I only knew the “call J.G. Wentworth!” portion and not the reason to call them.

Call to Action

2024 is right around the corner! I know it’s not a fun way to spend time off, but a yearly review of finances is a great way to set yourself up for success by maximizing your contributions to your IRA, 401(k), and/or TSP account!

What We’re Reading/Listening To:

All I’ve been recommending lately is podcasts on AI… well I am going to keep that up.

Podcast - The Journal: Why an AI Pioneer is Worried. This episode goes into detail about some of the concerns you may or may not have with AI. If you are very concerned, this episode won’t make you feel better…

Debrief on Deck

Next week is the Monthly Market Debrief for December!

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (X (formerly Twitter) and Instagram).

Until then, stay the course.

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