There is perhaps no topic more divisive in the investment community than annuities. Some people hate â€˜em; some love â€˜em. Research shows that lifetime income is what physicians and their families need. Annuities can provide it, but there are drawbacks.
Like smoke billowing from a magic show filled with lights and distractions, many physicians today are caught up in the mystery and enigma of annuities.
They are told, “You can’t possibly lose money!” Yet, there’s a cost behind such a promise.
There is perhaps no topic more divisive in the investment community than annuities. Some people hate ‘em; some love ‘em. Research shows that lifetime income is what physicians and their families need. Annuities can provide it, but there are drawbacks.
Annuities are the opposite of life insurance. Life insurance provides financial protection against dying young. Annuities can offer lifetime income—insurance against living very long. Life insurance pays a lump sum to beneficiaries in return for a stream of premiums. Annuities can pay a stream of lifetime income in return for a lump-sum premium.
First, annuities can provide tax deferral outside of retirement accounts. This means you don’t have to pay income or capital gains tax annually. This can lead to lower taxable income during your working years when you are accumulating dough.
Second, through annuitization (or with living benefit and/or death benefit riders on equity indexed or fixed annuities) you can have insurance against downturns in the financial markets. It ensures that you can have a guaranteed asset value or a guaranteed stream of income.
This kind of insurance-company guarantee is something that a financial advisor could never offer an investor in a brokerage account invested in stocks, bonds, and other securities that can fluctuate up and down. But there is a price for it.
First, most annuities have surrender charges. This means that if you want all of your money back after a year or 2 in, you’ll get hit with a penalty for pulling out the money early. Note that some annuities impose surrender charges longer than others. A few have no surrender penalties while many have penalty periods lasting for 4, 7, or even 10 years.
Second, annuities are costly. The insurance company is in the annuity business for a reason—to make money! Annuities are typically more expensive than if you invested money in a brokerage account. On top of the cost of managing the underlying investments, the insurance company charges money for just holding the money, plus charges for the aforementioned living and death benefits.
The question physicians have to ask themselves is, “Do I trust the markets to provide consistent rates of return? Can I weather the ups and downs? Do I have a sizable cash cushion outside of the annuity?”
If you are not sure about the financial markets and you have a sizeable cash cushion or other investments, an annuity could be helpful.
However, realize that your money could be tied up for some time and your maximum rate of return is lower than it could be by simply holding money in brokerage accounts.
Remember this: The less you have in liquid assets, the less money you should consider having in annuities, which are less liquid.
Don’t get seduced by this siren using non-retirement money when you could be paying back debt, maxing out your retirement plans, using the Back-Door Roth IRA, and ensuring you have a substantial cash cushion to fund your goals.
Fixed Annuities vs. Equity Indexed Annuities
Fixed annuities pay a stated interest rate every year. There truly is no stock market risk. However, the amount that they pay can vary. There is a minimum guarantee rate which can range from 1% to 3%. This can be further reduced when you factor in living benefit guarantees that most agents add on.
Make sure to understand the length of the commitment, how much money you could walk away with at a minimum, and the minimum guaranteed rate. Watch out for annuities that force you into annuitization (taking a stream of income).
Today, we are in a very low-interest rate environment. Thus, I don’t currently recommend fixed annuities to any doctors because there isn’t much reward for the commitment you would be making. They’re safe, but pay very little.
Equity-indexed annuities, or EIAs, are a combination of a few different characteristics. The name comes from the fax that their returns are indexed to an equity market. They have a floor (minimum rate of return) that is typically 0% and a cap (maximum rate), which can range from 3% to 10% depending upon the contract. The rate is declared annually and can change from year to year. (As an aside, I’ve even run across some that have NO cap, but then you are tied to a dynamic index that can shift from stocks to bonds and vice versa, very difficult to fully wrap your arms around.)
EIAs are similar to fixed annuities in that they have a limited downside. Yet at the same time, there is higher potential upside through some partial stock market participation. What’s even more interesting is that there are some equity-indexed annuities that have recently come out that don’t have a cap.
EIAs have different ways to participate in market growth. You get to pick the stock index that you want it to be marked to—such as the S&P 500 or the Dow Jones Industrial Average or the Russell 2000.
Insurance companies may protect themselves and limit their risk by changing the cap rate, participation rate, the indices that investors can select, and some other moving parts. Make sure to understand what can and cannot be changed for any investment you may consider in an EIA.
As you can see, EIAs are very complex. Some are much better deals than others. It’s difficult for nonprofessionals to evaluate them. If you’re interested in an EIA, make sure you get competent, unbiased advice.
The Bottom Line on The Annuity Magic Show
In my opinion, annuities can be a good fit for the right physician if they are scared of the markets and cannot stomach the risk.
However, that doctor is giving up a lot of liquidity and higher potential returns to do so. As a matter of fact, it may even delay their retirement because their assets are not growing quickly enough to keep up with inflation and are being outpaced by the financial markets.
Further, consider how right now fixed annuities are unappealing because the rates are so low. Perhaps, they could be worth considering in the future when interest rates have doubled from their historically low levels.
Meanwhile, equity indexed annuities are extremely complicated. They can change and change quickly at the whims of the insurance company, with some minimum promises.
The insurance company is pulling rabbits out of hats and waving a wand that looks like a fun magic show.
Remember, the tickets aren’t free and you may be stuck in that show for years!
Dave Denniston, Chartered Financial Analyst (CFA), is an author and authority for physicians providing a voice and an advocate for all of the financial issues that doctors deal with. He is the author of “5 Steps to Get out of Debt for Physicians,” “The Insurance Guide for Doctors,” “The Tax Reduction Prescription,” and his new book, “The Freedom Formula for Physicians.” He’s glad to answer any questions about annuities or other financial matters. You can contact him at (800) 548-1820, at firstname.lastname@example.org, or visit his website at http://www.DoctorFreedomBook.com to get a copy of “The Freedom Formula for Physicians.”