Fixed-Income Splurge : Should You Join the Rush to Buy Annuities?

They aren't the sexiest investment on the block, but they're selling like hotcakes all the same. Americans are buying more annuities than at any other time this century. The rush to secure the fixed-income product comes amid market volatility, recession fears, rising interest rates, and inflation.

The appeal lies in iron-clad income security. In exchange for an upfront lump sum, insurers pay out a steady stream of cash to annuity holders, either for a fixed period or to their life's end. It sounds like a simple strategy, yet is this the wisest investment for one's retirement?

Here's what professional advisors have to say about how Americans should approach buying annuities.

Retirement Jitters

Sales of annuities in the U.S. eclipsed $310 billion last year, according to estimates by insurance industry body Limra. That record-setting revenue tally surged 17% higher than the previous peak year for annuities – 2008 – when buyers spent $265 billion on the product.

The unique circumstances of last year's economy, which saw the concurrent rise of interest rates and high inflation, also boosted the product.

The Fed's interest rate hikes mean higher yields for annuities. Yet bonds, which typically serve as fixed-income safe havens during market retreats, had their worst showing on record.

For retirees who can't handle the stock market rollercoaster, annuities may be a safer play.

“Humans are not wired to rationally deal with large fluctuations in their investments – this is where annuities fit in,” says Tim Dyer, President at Dyer Wealth Management. “To have a part of their retirement income (typically the non-discretionary part) not tied the uncertainty of the stock market is very important for most.”

“If used correctly and appropriately, that can dramatically improve the potential outcomes in retirement. Retirement is about income, not assets and studies show the happiest people in retirement are those that have sufficient predictable income,” adds Dyer.

Neither This Nor That

There are several types of annuity products, yet most, like home loans, fall into one of two categories: fixed or variable. With the former, the annuity holder can lock in a constant rate, while with the latter, the return may fluctuate up or down.

This makes annuities something between a pension-like paycheck (fixed) and dividend distributions (variable). Straddling that divide can make them somewhat difficult to define.

“Depending on the type of annuity, they could be considered to be an investment or an insurance product,” says Jon McCardle, AIF and President of Summit Financial Group of Indiana.

“Variable annuities would fall into the investment category and therefore can lose principal in adverse market conditions depending on the investments chosen within the product,” he adds. “Fixed annuities… would fall under insurance because those financial tools cannot ‘lose money.'”

Unfortunately, their complexity and the nuances of an annuity strategy are often not communicated to buyers.

“It is all too common that investors are sold annuities without a complete understanding of the benefits and their drawbacks,” says McCardle. “We continue to see insurance products sold to the consumer as a one-size-fits-all which is not to the fiduciary standard of care.”

Advisors suggest making sure an annuity fits within the client's overall plan.

“Before we even talk about annuities as a tool, we need to determine the goals and strategy of the client,” says Chris Berry, J.D., CFP with Castle Wealth Group. “There are too many insurance-only professionals that are just trying to sell the tool. That is one reason annuities may get a bad reputation.”

In weighing up an annuity plan, buyers should consider the rate of return and term length, payment options, surrender period, taxation and fees, potential death benefit, and other factors. By considering these factors in light of personal circumstances, one can identify the optimal annuity plan but be aware of shortcomings.

“Most plans will have a surrender period of 6-years, so liquidity risk is a concern,” says Michael Acosta, CFP and Founder of Genesis Wealth Planning. “This is why I don't recommend allocating your entire asset base toward an annuity only a percentage of total assets.”

Some variable plans give exposure to the upside of the stock market while canceling out the losses.

“There are also strategies available that can be used for secure growth,” Doug Oosterhart, CFP and Owner of LifePoint Planning.

“For example, a fixed-indexed annuity can credit one's account based on the growth of the S&P 500 up to a cap in returns. An example of this might be a 10% cap in any given year. In turn… a fixed-indexed annuity usually has a 0% floor, meaning that if the market return is 0% or negative, the annuity holder's principal does not go down.”

Annuities may also function as a pillar for tax optimization in a retirement plan.

“One could argue that tax deferral on non-qualified assets for high-income clients makes sense, especially over a more extended period, e.g., 15-20 years,” says Jay Rishel, CFP and Financial Advisor at Overman Capital Management, who worked at one the largest U.S. annuity firms for over 13 years before becoming a financial advisor.

“Why not defer taxes (dividends, capital gains) as long as possible while you're working and then pay the income tax on the distributions when you're (presumably) in a lower tax bracket in retirement? Several variables are at play here, but I think there is a case to be made.”

Like all financial products, annuities require careful research. Guaranteed income, an inflation hedge, and potential tax benefits make them attractive. However, their capped returns, limited liquidity, and potentially high fees should give buyers pause.

The myriad factors involved can make it difficult to assess their long-term value, especially for those with limited financial knowledge. Yet as long as volatility persists in the economy, we can expect the appeal of annuities to endure.

This article was produced and syndicated by Wealth of Geeks.