What Should You Know About Annuities?

MARK RIEPE: I'm Mark Riepe, and I head up the Schwab Center for Financial Research, and this is Financial Decoder, an original podcast from Charles Schwab. It's a show about financial decision-making and the cognitive and emotional biases that can cloud our judgment. 

I think annuities are one of the more interesting instruments in financial services. They're both simple and complicated, and that combination often means they're frequently misunderstood. 

If we just focus on the English word "annuity," it simply means a fixed sum of money paid to someone each year, typically for the rest of their life. 

My guest Rob Williams is here to shed some light on the topic. Rob heads the Financial Planning, Retirement Income, and Wealth Management team here at the Schwab Center for Financial Research. He's a CERTIFIED FINANCIAL PLANNER™ Professional and holds the Retirement Income Certified Professional and Certified Private Wealth Advisor® designations. 

MARK: Rob, thanks for being on the show again. 

ROB WILLIAMS: Great to be here. Thanks, Mark. 

MARK: So Rob, we're here to talk about annuities, and going in, we're kind of making the assumption that not everyone is super familiar with annuities. It's kind of a complicated financial instrument. So to kick things off, why don't you just give the listeners a kind of a summary of what annuities are, and what are those fundamental building blocks that make up an annuity? 

ROB: Yeah, thanks, Mark. And I would agree. It's annuities. I've been at Schwab for 15 years and worked on retirement income planning for much of that time. And annuities, they're an important tool in that toolkit, but also one that can be really complicated for some and feel like they have a negative stigma at times.  

So explaining them can be a bit challenging. 

Annuities are contracts between the investor and an insurance company that serve as long-term investment vehicles designed for retirement purposes. Because annuities can provide a unique combination of insurance and investment features not available with other types of investments, they can complement other retirement plans or may make sense for a portion of someone's overall investment portfolio. 

MARK: Yeah, I think that is a good starting point. That's kind of the what, what an annuity is. Let's talk a little bit about why. You and I've talked many times—it's like, you know, you invest, you're trying to solve a problem, you're trying to accomplish a goal. So what problems are annuities designed to solve? 

ROB: I think that's really the best way to think about it, and any financial tool, really, is what's the problem you're trying to solve. And the more you understand that, the more you're going to be successful in learning about and picking the right tools. So with annuities, there are three main goals really worth touching on.  

Two of these goals—tax-deferred growth and guaranteed investment returns—can be common for people in the stage of accumulating savings for retirement.

For tax-deferred growth potential, this may make sense earlier in an investor's life. Generally, you've already maxed out all the tax-deferred contributions you're allowed to make to, say, a 401(k) or an IRA, but you still want to save and invest for retirement in a tax-deferred way, particularly if, say, you're in a high tax bracket. 

Now, the second, for guaranteed investment returns. Some annuities offer a guaranteed return over a certain period of time. So any growth earned is deferred from taxes until you take withdrawals. Those can be really useful prior to retirement or, again, if you've maxed out other retirement savings vehicles. 

Now, the third is the one that I think is really the most important. It's the purest form of benefit for an annuity is the guaranteed income. So once you've saved, you've invested for a period of time, you get to a certain age, say, retirement, and then you want guaranteed income to supplement Social Security, maybe income from your portfolio. And that's really the main tool that the annuity can provide. It builds confidence. The annuity is a form of insurance. It really adds that cushion and that protection to help generate income, in addition to a portfolio, generally to help your savings last. 

MARK: And that's really where the guarantee comes from, right? It's the agreement with the insurance company, and insurance companies are designed and structured in a very different way than asset managers, right? 

ROB: That's right. Investments are really important. We know that. We believe that they're an important part of a retirement income plan. But the one thing an annuity can add is that insurance protection. You can think of it as pooling risk with other retirees. Yes, some may not live as long as others, but those who do live longer can benefit from that pooling of that money, the insurance protection, the guaranteed income that it provides.

Again, maybe not a substitute for investments, but a complement to it. Annuities offer options for guaranteed income that lasts for life. Now, all guarantees associated with an annuity—whether it be the lifetime income stream, a guaranteed rate of return, a death benefit, or any other feature—are backed by the claims-paying ability of the insurance company that issued the annuity contract.

MARK: And like we were just talking about, a lot of different types of annuities, a lot of different bells and whistles and features. So maybe as the next question, can you drill down a little bit and give me a sense as to what some of the different subcategories there are within this kind of big universe of annuities? 

ROB: Yeah, I think I tend to think of them in terms of phases. There's a lot of sort of alphabet soup of different types of annuities and the abbreviations they have. But think about it in those phases.

Are you saving for retirement in a tax-deferred way? Are you at the point where you're transitioning to retirement? You want to invest some money but have some protection or do you want the guaranteed income once you get to retirement? Now annuities—one annuity can combine all of those three in phases. You can convert from one to the next, but those are really sort of the phases in terms of how to think about the subcategories of annuities. 

So that first type where you're really still saving is often called a deferred annuity. That means you buy it, but you don't need or want any income now. You want it later. So that income you're deferring. You're saving, investing. You're deferring taxes. And you want that income later. So that's why it's called deferred. 

There are different types of deferred annuities. Fixed deferred annuities are pretty simple. When you purchase a fixed deferred annuity, you get a floor of guaranteed return, like a rate of return, and you earn that over time and the growth is tax deferred. That's relatively straightforward. It doesn't have a lot of bells and whistles. It achieves a pure purpose, which is to grow your investment for retirement with some form of guaranteed return and defer taxes until withdrawals are taken or you annuitize the contract. 

Then there are immediate or income annuities. And those help you create a regular income stream when you retire. 

You have a lump sum. You turn it over to an insurance company and send that upfront premium, and in exchange they pay you a promised amount every month for a term you choose, which can be a fixed period of time or for the rest of your life or the life of yourself and a spouse. So that's a real pure form of protection. So I tend to like those two as the starting point for most to understand the two main types of annuities, really the phases of them as an effective and useful tool in retirement planning.  

There are others, certainly, and some are more complex, have more details, fees, but focus on those two big categories I mentioned, deferred and immediate, and then that might make it simpler in terms of choosing which is right for you. 

MARK: Hearing you describe that, it's a little bit, sometimes you go to the grocery store, and there's a very specific flavor and size of a thing that you're looking for, and you're just going to keep looking until you get that one thing that really matches up perfectly. And other times you're just looking for something relatively generic, and you sort of get lost in all the details and all the choices that you have. Do you think that analogy works? 

ROB: I think it does, and I think of it even beyond that. I think of it as individual tools work well together. So a portfolio can work well with Social Security and an annuity. Now, if you try to do a Frankenstein's monster and have one—think about the vacuum cleaner, you go to the store, you try to buy, that tries to do everything, including toast bread for you. I'm not sure I've seen that, but I can imagine it might exist somewhere. And that's really not the most efficient or effective vacuum cleaner you could have purchased. 

So getting the product or the solution that is the purest tool to do the thing you want, and then they aren't in isolation. You combine it with other things is how I generally suggest. When you get complicated, you try to be all things to all people with one solution or product. I think that's where it can become more complex and sometimes may not do the thing you really want as purely as you'd like. 

MARK: Yeah, I think that's a good principle to think about with lots of different types of products. Let's move on and talk a little bit about fees. We've mentioned many times on this show about the importance of understanding what you're paying for, and making sure you're lowering fees is typically a good way to improve your return. So what are some of the kinds of fees typically associated with annuities?

ROB: Well, this is one of those topics that I think it's oversimplified quite often. One thing that probably would surprise many is that one type of annuity that I talked about, which is income annuities, often called single-premium immediate annuities, don't have any fees at all. There's no fee you pay on an ongoing basis. The cost is embedded much like an insurance policy you buy in a car. 

If you end up needing the protection, you benefit more than people who don't. If you live longer than average, you'll benefit. And if you don't, then that's where the insurance company will generate some revenue. They're pooling all that money, and they're paying it out in insurance policies in the form of payments, and there's no explicit fee at all. 

Now, there may be some other implicit costs like ability to get access to your money, or if you don't live as long, etc. But there are many other types of annuities that do have explicit fees. 

And many of those are the more complex types, variable annuities with living benefits. It's a type we haven't gotten into here. They can be useful for some investors, but they do have underlying insurance, some management fees, etc., and some of those are where some of the controversy and discussion comes from is what are those fees? Do consumers understand them? And are they worth the costs? 

But even some of the more straightforward types—like fixed deferred annuities, which I mentioned earlier, may offer additional optional features through what is called riders, for which there is generally a fee.

So again, many types. Make sure you understand which one you have. And then it's easier to understand and ask about and make sure you understand the fees involved. 

MARK: And like any other financial products, you know, shop around, right? Because not all the fees are the same, depending onwhich provider is issuing the annuity. 

ROB: That's true, but it's also different benefits. And that's where it can be complex. And if you really want to understand the more complex types, I don't think that some of these made it as easy as possible for people to understand all those underlying fees. 

That's where some of the bad, sort of more negative rap, can come from, maybe justifiably for some because they can be complex. So not just shop around for cost, shop around for benefit. The two of those things go together, and unfortunately that's not always standardized.

MARK: So another kind of key feature that people certainly need to understand is how do they get their money out? What are the withdrawal options available to the annuity owner? And are there any kind of kind of penalties or charges that might be associated with those? 

ROB: So again, it depends on the type of annuity, and how you want to withdraw it, and when. So for a deferred annuity, when you're saving for retirement, you can take money out after age 59½, generally with no tax penalty. So that's the IRS says that these are tax-advantaged retirement savings vehicles. Much like IRAs, if you take money out before age 59½, there may be a penalty that the IRS would levy. So it's to encourage people to save too and use the money for retirement generally. 

Now, when you get to the point where you own an annuity or you have a lump sum, and you purchase one for, say, for income. If you're saving, you can take a lump sum out of an annuity and just take the money. Just know that much like an IRA, if you take the money out, any earnings that you earned within it that were deferred from taxes, taxes will be due. So you may have a fairly large tax bill. So thinking about guaranteed income and periodic payments generally is a more cost-effective way to take withdrawals, but you can take it in a lump sum if you choose. 

MARK: Yeah, tax deferred is not the same thing as tax free. Sometimes people will come across the term "surrender charges." Is that referring to that kind of pulling money out before the contractual period? 

ROB: That's right. There can be some charges, surrender charges or other penalties, for withdrawing money earlier than a specified period in the contract. And again, the reason for that is the insurance company might be saying that we can pay you a higher rate than you might earn by buying an investment in the market because you are telling us that you're willing to keep your money in this annuity for, say, three, four years, whatever the terms of the contract are. If it's in this case a fixed deferred annuity where you're saving and investing. 

MARK: So I think that actually leads into a nice question about risk. I think inability to not need the money once you've moved it over to the insurance company, that's a form of risk. What are the types of risks are there that people need to worry about? 

ROB: Well, annuities are really a way to manage risk more than create risk, but risk can be defined in many different ways. You mentioned one is liquidity risk, which just means can you get access to your money when you need it?

That is one of the things to consider, say, for the deferred fixed annuity where you're putting money in to earn a return while you're saving for retirement. There's a surrender fee, and you may not be able to get access to it. So if suddenly you have an emergency, it's best to have other funds available to pay for them. So it's a liquidity risk. 

Once you get to the point where you want income, say, an income annuity, that once you purchase those, you give up access to your lump sum, to your money, but you get payments for a period of time you choose or the rest of your life. So again, there's a liquidity issues there. The way I tend to suggest managing that is again, to combine an allocation or a portion of your retirement income plan and annuity along with cash and investments so that, again, these work well together and offset the risks of each other. 

A portfolio doesn't have guarantees that it'll last as long as you do. So that creates longevity risk, we call it. So the annuity can offset part of that, whereas the portfolio can provide liquidity if it's needed. 

There may be other risks, depending on the type of the annuity. So for example, some annuities allow you to participate in the market or earn returns tied to the market. And these generally have a risk for loss of principal. But again, there are many types, and some of these offer some downside protection. 

MARK: I want to talk a little bit about that typical annuitant. They're getting older in years, and they're trying to, maybe they've retired, they're about to retire. They're trying to figure out how to replace the paycheck that they're no longer going to get from working. So annuities could be part of that puzzle. Social Security is part of that puzzle. There are other types of investments. How do you kind of put that all together? How do you—what are some ways to maybe pair annuities with other tools that people can use to generate retirement income? 

ROB: Yeah, it's the $10,000 question, and I tend to think of it as layers. What are going to be the layers of income that you're going to be able to generate? I tend to start with the predictable and guaranteed sources. 

So Social Security first, and timing of when you take Social Security is very important. So depending on when you retire, having a plan to determine when the best time for you to file and start taking benefits. You may have a pension. Fewer Americans certainly do, but if you do, count yourself as fairly fortunate. That adds to the layers.

Maybe you have rental income and other things, part-time work. Now you're getting up to, how do I use my savings and my assets and position them to continue to build that layer cake of income sources? 

So annuities can be another source where you say, hey, I want to use some of my investments or perhaps I had a deferred annuity, and I was using this as a savings vehicle, and now I'm ready to start taking income from it. So you add that to the layer, and that's guaranteed. 

Then you move up to the portfolio, and you may use interest payments or dividends from the portfolio. You might have a plan where you're systematically selling assets, etc. Now that's a layer cake because the lower ones are more certain, more secure, more like insurance. And the ones up further are more dependent on markets, etc.

So what's your layer cake looks like is going to be different for each investor, depending on your health, your tolerance for managing these risks yourself. But those are the basic building blocks of a retirement income plan. 

MARK: We'll come back to my conversation with Rob in a moment. Now that we're all up to speed on the basic elements of an annuity, I wanted to talk a little bit about an oddity of annuities.  

The concept of getting stable payments is attractive, especially for those in retirement. In fact, in an episode from years ago, we mentioned the fact that the Roman Emperor Augustus wanted to provide for soldiers after they left his service. His solution was a pension plan that had many annuity-like characteristics. 

It's been a puzzle, though, that many people when, given the choice of an annuity-like payment that will be spread out over time or a lump sum where you get all the money immediately, will prefer the lump sum payment. They prefer to take the jackpot now rather than spread the payments over the next 30 years or so, even though the payments are adjusted to reflect the time difference in when the money is received. 

Now, I'm not saying that one is always better than the other, but the fact that we often prefer the lump sum can be traced to some decision-making biases. In the second half of my conversation with Rob, we'll get into some of those.  

MARK: So Rob, I thought we'd finish up by going through kind of a handful of kind of the well-known, persistent, cognitive and emotional decision-making biases that occur. And I was hoping you could just kind of talk a little bit about how that bias is relevant, or maybe not relevant, for the person who's thinking about purchasing annuities. And the first one is loss aversion. 

So we know that the sting of a loss hurts about, you know, two and a half times as much as the benefit, you know, or the joy, if you will, you get from a gain. So I think actually, correct me if I'm wrong, but annuities might be a good thing if someone who's very loss averse. What do you think? 

ROB: Yeah, there's a couple of ways to think about this. And it's a fascinating question because there's more than one angle. Sometimes I hear and we see that loss aversion might also be losing access to your money. And yes, you are getting payments every month for the time you choose and the rest of your life if that's the option that you choose, but you've lost access to that money. And that can feel like a loss. 

Now the other side of it I think you're getting at is loss aversion when it comes to the markets. And that's where the insurance features come in and part of this annuities puzzle comes up, which is why would investors, retirees, really want to take so much risk that the market may go up or down and have to manage that? 

If you do feel that way, and this is a personal choice, I think that whether you choose to use an annuity or not is partly a question of preference, tolerance for retirement risk, market risk, etc. If you are very averse to loss or concerned about the markets and really managing it yourself, then annuities can be a way to alleviate some of that concern. 

MARK: Let me push on that a little bit because do you think there is a case to be made that some people go a little bit overboard? They're so enamored of that guaranteed income for life that they kind of go overboard and put too much money of their portfolio into an annuity, and they're kind of sacrificing maybe some liquidity that might actually be good for them. 

ROB: You know, it's funny, if that were the problem, then I think we might have a little bit more of a secure retirement sort of certainty and confidence level. We see that actually the opposite happens. 

Now, what we do see is that people who do—or, say, someone who had a pension—in surveys they tell us they're the most confident and happy, you know, on average, relative to other investors, other than maybe those who just are very overfunded for retirement. They just have so much money that they don't have any concerns about spending it or managing it. 

So really that confidence tends to boost once you have it and you say, "Well, gosh, how would I live without that guaranteed income?" So yeah, I don't see as much of that sort of over-annuitizing. We don't tend to suggest that anyone would use more than, say, 50% of their retirement savings to annuitize in an income annuity. 

MARK: I wonder if there's an element of mental accounting going on here because the way you've described annuities, they have a lot of similar features to Social Security. Social Security, I think a lot of people don't really think of it as part of their portfolios, this other thing that sits over here. 

Do you think people … it would actually benefit people if people would just kind of separate the portfolio and then the other assets they have that generate income and think about them separately? 

ROB: Yeah, I think that's really important. And it's a behavioral finance concept that's all over retirement income planning. If we just think about pie charts or asset allocation, we don't tend to mentally account for the different parts of a retirement income plan.

There's a theory—I think it's valid—that investors who pay a lump sum premium upfront, you may feel like you've given up something on the front end, but then after that you've mentally accounted for that monthly paycheck that you're receiving that's going to continue for the rest of your life. Mentally, you account for that for simply being the floor of income that you've got under your portfolio that allows you to invest more confidently, etc. 

Also that you're not managing, you don't have to focus on how it's invested or you're rebalancing your portfolio. And doing that, you know, can help people to, one, keep their eye on the ball in terms of what each tool is used for, what's the portfolio for, what's Social Security for, etc. And putting those things together tends to build confidence when building a retirement income plan.   

MARK: Yeah, we've done a few episodes on overconfidence will lead you to think maybe you can generate higher returns than maybe warranted given certain market realities. I think we've also done one episode on actually people who suffer from underconfidence. They're unreasonably … they think much less of themselves than really is warranted. How do you think kind of confidence in your ability to manage the portfolio … talk to me about that in terms of the annuity decision. 

ROB: Well, there's a couple aspects to that. One is, I think surveys would indicate and anecdotally we see that investors who have forms of guaranteed income, be it Social Security, certainly a pension, or annuity, tell us that they tend to feel more confident in their ability to manage their other investments because they don't have to feel that they have to rely on it quite as much. So they can have more sort of flexibility to invest that, not worry as much about the ups and downs of markets if they are someone who's comfortable with investing. That's certainly one of the aspects I think that's important in that equation. 

MARK: Probably the last few on my list here are regret and kind of fear of missing out. And they both kind of tie in, I think, a little bit. Of course, fear of missing out is, boy, there's all this other stuff I could be doing with that money, instead of having it sit at the insurance company generating this kind of steady, albeit boring, you know, kind of paycheck. How do you think about those two kind of emotions? 

ROB: You know, I think we all want to benefit from growth in the U.S. economy. We always think that, well, we could do, if we just invested this or whatever it was, we have a chance to win. 

Well, I wouldn't call a paycheck from work boring. And when you retire, you no longer have a paycheck from work. And Social Security was never designed to be enough, you know, to support the lifestyle of most retirees. It's a portion but not all. So I think it's one way to flip that sort of mentally is to say, "This is actually quite an important thing. I'm giving myself a floor of income to replace my paycheck. And then again, I may have other assets that I can invest more opportunistically and more confidently, and those pieces work together. So that's how I tend to focus on that sort of, I'm giving up my upside. Combine the tools. 

MARK: Rob Williams is a managing director in the Schwab Center for Financial Research. His job is, in my opinion, anything but boring. He and his team work on wealth management, financial planning, all sorts of interesting topics. Rob, thanks for being here today. 

ROB: Thank you. 

MARK: We've only covered the tip of the iceberg, but Rob gave us a good overview of annuities. If our conversation has piqued your interest, you can find more information at schwab.com/learn—and search for annuities.

That's it for this episode of Financial Decoder. Thank you for listening. If you'd like to hear more from me, you can follow me on my LinkedIn page or at X at Mark Riepe, M-A-R-K-R-I-E-P-E. If you enjoy the show, a rating or review on Apple Podcasts is a great way to convey that message. 

We always like new listeners. So if you know someone who might like the show, please tell them about it and how they can follow us for free in their favorite podcasting app. 

For important disclosures, see the show notes and schwab.com/FinancialDecoder.