Explaining the nuances of annuities to clients

In 2008, when the U.S. was navigating the Great Recession, annuity sales set a record when they reached $265 billion. That record was broken last year. Driven by market volatility and concerns about a possible recession, annuity sales surpassed $310 billion in 2022.

As worries about a recession linger, should advisors encourage their clients to join the trend and add annuities to their portfolios in 2023? The answer to that question, just like annuities themselves, is complicated. Advisors who weigh the value of annuities for their clients in the current investing landscape should consider their clients’ goals and understand the risks involved.

Carefully consider clients’ overall goals

Annuities are a great investment option currently because of the recent market downturn, which has been exacerbated by a wave of technology company layoffs. Annuities offer the benefit of reducing risk by providing a steady income stream, thus making retirement savings more secure and less reliant on stock market performance. Additionally, annuities are tax-deferred, and many investment gains can be transferred into annuities without suffering any taxes or penalties.

However, some clients may have investment goals that are not supported by the characteristics of annuities. For example, clients with short-term needs might prefer to invest their money in risky assets such as stocks, bonds or mutual funds with the potential for higher returns than the fixed rate offered by most annuity products. Also, some clients with financial security simply want access to their savings and do not want their funds locked up in an irrevocable contract such as an annuity plan.

Another factor to consider is that annuities reduce liquidity. Clients who are heavily invested in annuities may not be able to access needed funds in a reasonable time frame if an emergency arises or other financial goals must be met. Cashing out annuities or transferring their holdings before a contract’s expiration date typically triggers high surrender charges or penalties.

Leverage indexed annuities to address inflation risk

One of the main risks for those using annuities as an income-producing option is inflation risk. Inflation decreases the value of funds over time, so it is important for investors to choose a form of annuity that can help them stay ahead of inflation, such as index-linked annuities or variable annuities linked to equity indexes.

Index-linked annuities provide a rate of return that is baked into a stock market index. Because they establish limits on potential gains and losses, index-linked annuities involve less risk than do non-annuity index funds. However, those limits could also keep investors from achieving the returns one might receive from traditional index funds.

When recommending index-linked annuities or variable annuities linked to equity indexes, there are several factors that should be considered. They include the participation rate, loss floor, return caps and minimum guaranteed return, which could provide a profit even when the index shows a negative return. Advisors also should consider whether indexed annuities include provisions to lock in gains periodically, which can help investors preserve market gains in times of market volatility.

Clearly communicate the components of annuities

Annuities are complex investment instruments that comprise many moving parts. In order to help clients understand the nuances of annuity investing, here are the main components that should be explained.

» Fees: With any annuity product, buyers should pay special attention to the associated fees. It is important for advisors and consumers to be aware of all the fees that will be charged and to ensure that fees are reasonable, transparent and clearly outlined before making a purchase decision. Advisors should also examine the history of annuity fees from specific providers in order to get an accurate understanding of what clients can expect in terms of the costs that will be associated with the purchase.

» Surrender charges: Consumers should understand how surrender charges apply to their particular annuity and make sure that these expenses won’t impose major limits or restrictions on liquidity or access to funds. When researching potentially suitable annuities, consumers and advisors should look for products with flexible surrender charge schedules, which can include no long-term penalties or no additional costs associated with early termination.

» Liquidity: Advisors should pay special attention to the degree of liquidity provided by a particular annuity so that consumers understand exactly how soon they could access their money in an emergency. Some annuities provide instant liquidity, while others may have more severe limits on when cash can be accessed through loan provisions or partial withdrawals. Knowing this ahead of time helps advisors and clients adequately plan for potential market movements.

» Inflation protection features: Most annuities offer protection against inflation, a feature that has become more common over time due to increasing consumer demand for good retirement income streams. Advisors should pay close attention to the various inflation adjustment indices used by different companies’ products in order to find the option that best aligns with a consumer’s financial goals and time frame.

» Tax benefits: Understanding what savings and tax advantages can be taken advantage of through any specific product will help determine which option will save more money given its potential risk/return profile as well as any other available features.

Understand annuity implications for different income levels

Annuities can be beneficial for anyone, regardless of their income tax bracket. The main benefit of an annuity is income protection, which any investor can leverage for retirement planning. Generally, annuities are most beneficial for those who are not able to adequately save for retirement on their own or secure other forms of income.

However, the tax-deferral benefits of an annuity make it particularly advantageous for those in higher tax brackets because it empowers them to earn more cash value and lower their overall taxable income. Those in lower tax brackets may not realize as much tax savings from investing in annuities and may want to consider other forms of investments with smaller fees and the potential for greater returns.

Overall, annuity benefits are most helpful for those nearing retirement who want a guaranteed stream of income for life. However, an annuity also can be beneficial for other clients, such as those needing life insurance coverage and those wanting to set aside money for future goals such as college tuition. For any investor, annuities can help protect against market swings, allowing the investor to have peace of mind knowing that their money is secure no matter what market conditions exist at any given time.

Mina Tadrus, M.A., J.D., is the CEO of Tadrus Capital and general partner of Tadrus Capital Fund. He may be contacted at [email protected].