Annuities (are Trash)
1: What’s an annuity?
As you get older, people are going to try to sling you annuities. If you want the short version so you can go ahead and leave: I think they’re almost always a bad choice and most average folks should avoid them.
For those who are curious, annuities are strange things. They’re always compared to stock markets, but you’re actually investing in insurance contracts. Basically, you’re giving a loan to an insurer who is going to use your money to buy some other investment on your behalf. That is typically going to be investment grade bonds.
Then, they collect all the money from the interest paid on the bonds and pass part of it on to you. If you’re familiar with how bonds work, you’re already screaming, “Why would you do that?!” And if you’re not familiar but you feel like screaming, I’ve got an article about bonds, too.
2: What are the pros?
So you give a bunch of money to an insurance company and they’re going to give it back to you over time with some profit. What’s the downside compared to stocks?
First, if you just invest directly into the S&P500, you’re going to experience the full effect of the swings of the market. If your investment portfolio goes down 10,000 bucks, you lose ten large. If it goes up 10,000 bucks, you make a rack. More traditional investments can be higher reward, but higher risk.
But with annuities, you have a “participation” value. It’s usually 80% of the upside. You’re basically paying protection money to the insurer. In exchange for protecting you from extreme downsides, you’re capped at 80% of the upside. If you would’ve gone up 10K, well, now you’re only up 8K.
3: What are the cons?
“Wait, Nika, I like the idea of being protected from extreme downside…but shaving 20% off the top is a bit much, don’t you think?”
Well, sure but buying stock with a broker has risks. For instance, what happens if your broker were to go bankrupt?
Brokers are regulated by the Securities Exchange Commission and insured through the Securities Investor Protection Corp, so it’s fine! You’d be able to transfer you stock holdings to literally any other brokerage.
What about annuities?
They’re not SEC registered or regulated at all! They can be complete scams and you have no way of knowing! And if they lose all their money or go bankrupt, OOOOOPS!
Still, if you’re terrible at managing your own money and just want someone else to do it for you, annuities sound pretty safe. SEC stuff aside, they make as close to “guaranteed” investments as possible. And you get 80% participation rate, so if the market rips up 100% you do still get 80% of that.
4: What’s the catch?
Do you really get that 80% rip? Did you read the fine print? You get 80% of the market upswing up to your cap rate, which is probably 8% of your portfolio value.
So if the market goes up 5% this year, your participation rate is 80% and you get a return of 4%. Okay, fine. But if the market goes up 20%, you don’t get 18%. You get 8% because your cap rate says that’s the maximum you can earn.
Cool, I hate making money! Sign me up!
But wait, there’s more! When you invest in the S&P500 in an index like SPY, you get a dividend which is usually another 1–2% profit. Guess who’s keeping any investment dividends on your portfolio money. Hint: not you.
5: Where’s all my money going?
Don’t forget, someone is selling you this annuity. It is someone’s job to get you to buy this, and he has to get paid, too. Where does that money come from? Well, it comes from giving him 10% of your profits, of course!
Not feeling so hot about this anymore? Want to get out? You want to take your money out of the annuity and just let it ride on the normal, SEC-regulated insured markets?
Okay, no problem, you can do that. But since annuity contracts are for 6 to 10 years or more, there’s going to be a penalty fee…which will be another 10%.
6: Why do people actually buy this trash?
It can’t be that bad, can it? People are out there buying annuities all the time, especially old-timers with lots of money who want steady income. Isn’t it all about steady income? How does this really stack up to investing in the stock markets?
The target demographic is usually middle class folks in their 60s or 70s who are looking at steady income in retirement. What the annuity salesmen love to do is have a seminar. This will sound fake, but it’s actually what they do: they’ll have a seminar and offer you a free steak dinner. Free steak dinner! I’m in!
You go and they pitch these annuities as being safe. They tell you how the world is at war, and there’s famine-plague-terrorism-death-the apocalypse, China-Russia-Zimbabwe dollars, cancer, the ozone, pugs can’t breathe properly, all of it is bad, it’s all bad and the world is in turmoil and in these horrid times you want the safety of an annuity.
Then they hand you a chart that looks like this. This is a real sales pitch chart provided by FinancialDave’s Blog:
This claims to show the annuity in blue versus the SP500 in orange over the course of 20 years. As you can see from 1998 to 2019, the annuity is outperforming by tens of thousands of dollars.
7: The long con
That’s pretty handy since 2018 was a crappy bear market for stocks and the chart ends at 2019. Do you know what happened in 2020? Corona hit and stocks had a micro-crash followed by an insane bull market. So if you add one year, the chart looks like this:
All right, say that’s a fluke. It crossed up for one year, but the whole rest of this time the annuity is killing it.
Sure, if you compare raw price growth. But that’s not really how stock portfolios work. We don’t care about how much a lone share of SPY goes up. We care about how much our invested portfolio (which does get dividends and is insured) goes up. So if we compare actual portfolio performance, we get this:
Our 100K portfolio starting in 1998 and ending in 2020 ends up outperforming the annuity by about 165,000 dollars. And because that portfolio will have dividends and dividend reinvestments rolling, that performance gap will only widen if you extend this out another 20 years.
But remember, they’re targeting people who are looking at retirement. Their targets don’t have 40 years. You get shilled the hardest for annuities when you’re about 60 or 70 years old.
It’s already insane to be investing in something with a 10 year lock-in period when you’re 70 because you probably won’t be alive to enjoy any of the growth over 20 years anyway, so these charts are pointless.
8. What happens when an investor dies?
What happens to stocks when you die?
You kick the bucket and you’re sitting on stocks, what happens? What’s that stock do when you die?
It’s no problem! Your next of kin just shows a death certificate to the brokerage proving you died, maybe a copy of the will from the attorney saying they get all the stuff, then it can be transferred to them.
What happens to annuities when you die?
Ah-hahaha! They are so inefficient! They can be wildly expensive to transfer, too. The money could be tied up in probate practically indefinitely, and when it does finally get transferred to your heirs, they might not even get all of it!
9. Why, Nika? Why do people keep buying these things when they’re not appropriate for almost anyone?
That’s a tough question. I think a lot of it has to do with financial illiteracy, which is why we’re here talking about it. But also, these aren’t SEC-regulated brokers selling annuities. These are basically just used car salesmen trying to pay their bills.
A lot of the time, people who are selling annuities don’t really fully understand what they’re selling. The guy selling you a crappy annuity might genuinely believe what he’s saying and own one too, thinking he’s doing the responsible thing. Limited downside risk, taking advantage of market upsides, what’s bad about that?
Well as it turns out, the answer is…almost everything. They’re not regulated, they take your dividends, they lock you in for long periods of time, they’re hard to pass on if you die, and the amount you stand to make is capped.
They target middle class people because they have just enough money to make exploiting them profitable, but not enough financial literacy to understand that they could just go buy the bonds themselves and rake in that same passive income while also claiming the bonds’ face values for potentially tens of thousands more in returns.
10. In what universe would I want to buy an annuity, then?
You might want to participate in some kind of annuity if a company is buying it for you. You might also buy in if you’re comfortable enough with the return cap and don’t care about (or need) more than ~8% a year.
Maybe you’re setting it up for someone who can’t manage their own money, like someone with a mental impairment such as Alzheimer’s or dementia. It can also be great for someone who’s in assisted living and just needs to make sure the bills get paid with reliable revenue while they enjoy retirement stress-free.
There are fringe cases like that where an annuity might be something to consider, but as far as normal, average people out there, you can basically just cross it out and consider it a scam.
Annuities, like mutual funds, are an investment vehicle designed to enrich the person selling them, not the person investing in them.