- 13 min read

Annuities: The Four-Letter Word of Finance

Updated: Mar 26

Over the next few weeks, I’m going to go headfirst into a topic that is extremely polarizing in the financial world–Annuities. In the spirit of full disclosure, I have biases just like everyone else in the industry. However, my goal is to be objective and fair while offering some insights on these divisive products.

In writing about this topic, I have no expectation of converting the most vehement critics of annuities. There’s no question that annuity skeptics, critics, and haters are legion on the internet. Some of their disdain for annuities is warranted, while much of it is simply misdirected.

Annuity contracts can be complex or simple, yet these products are often given the same general description–annuities. Over the years, I have read countless articles from journalists and financial professionals that use the term annuities but never specify the kind of annuity being discussed. It’s kind of like insurance salespeople who call themselves financial advisors. Misdirection seems to be the point.

I believe that annuities are just tools. There are many different kinds of tools, and they can be used in different ways. Some annuities can be good, bad, or ugly. However, the sales tactics that are used to pitch these financial tools are often misleading, incomplete, or potentially unethical. In my view, consumers should look at planning processes first, products second.

Wouldn’t more consumer education about annuities help?

Fat chance. Education in the annuity space isn’t lacking. Consumers typically don’t want to do extensive financial research because they expect anyone calling themselves a financial advisor to already have done the research. In my opinion, this is completely fair. Besides, a large chunk of “education” that is available on the internet is really just marketing cloaked in an education wrapper.

Clients of financial advisors should expect us to be learned and trustworthy when it comes to the financial universe. This is why they seek out trusted advisors for financial planning and advice. They don’t know or understand all of the potential options available to them, and they want someone to guide them as they make decisions.

If you are calling yourself a financial advisor–especially an advisor that works with retirement income planning–you better know your stuff when it comes to annuities. It doesn’t matter if an advisor uses or recommends annuities, it is the competency that matters.

A common theme with financial advisors, especially those who claim to uphold a fiduciary standard, is that they don’t use or recommend anything that pays commissions. I’ll speak more about compensation later (because it’s a huge piece of the puzzle), but part of being a fiduciary is competency. The CFP Board puts it this way in their Code of Standards:

I use the CFP Board’s exact language because I consider the CFP® designation to be the gold standard for financial planning.

The world of annuities is vast, and it is continually evolving. Keeping up with the latest product developments and research is time-consuming and complicated. I’m sure that my best effort at this topic will still fall short of being an exhaustive feature on annuities. My hope is to frame this conversation objectively so that consumers who are considering annuities as part of a retirement plan or other financial objective can have a reasonable starting point. So, let’s begin.

What is an Annuity?

Let’s start with the most basic definition of an annuity. An annuity can be defined simply as a “stream of payments.” The word itself is has a Latin origin that comes from annus, which is Latin for “year.”

In ancient Rome, annuities were offered to soldiers in return for their military service. In the Middle Ages, annuity contracts were used to help fund wars and military contracts. Thus, the idea of recurring payments to one party from another is nothing new.

The Most Popular Annuity in the United States

Despite historical precedent, few people have nostalgia when they hear the word “annuity.” As someone who consistently works with retirees in crafting retirement income plans, I find this perplexing. After all, most retirees are frequently concerned with starting the most widely held annuity we have here in the United States—Social Security Income.

Holding to our definition of an annuity mentioned above, Social Security income was received by more than 69 million people in 2019. Think about that. Over 69 million Americans have a recurring income payment coming to them from the US Government.

“Not So Fast,” you say.

“Social Security is just paying me back my own money.”

For many retirees, it feels like they are finally getting their funds returned after years and years of paying into the system. Some people feel the need to “get what’s mine” before the system runs out. I have heard this argument so many times. So, let’s unpack it.

We pay into social security through our payroll tax system (FICA tax). Many young workers learn about FICA when they receive their first paychecks. There’s an infamous clip from Friends where Rachel receives her first paycheck and immediately asks, “Who’s FICA and why is he getting all my money?”

If you are a W-2 employee, you don’t pay the full amount of FICA tax. Your employer shares the burden with you:

In the example above, you can see that $75,000 in wages will be responsible for $11,475 in FICA tax. However, the employee’s portion of that is $5,738. Of that amount, $4,650 is paid into the social security system (50% of $9300). It’s also important to point out that there is a cap on the amount of wages that can be taxed for social security income.

In 2022, this cap for FICA taxes (the social security portion) is applied once you earn over $147,000 in wages. Note that the Medicare portion is applied on all wages, and there is an additional .9% tax that is applied once you cross over certain income thresholds.

Self-employed workers are not as fortunate when it comes to the FICA burden. Since “self-employed” people often have their income coming to them as a sole proprietorship, partnership, or LLC; they often pay both sides of the FICA tax–as the employer and the employee.

These examples are important because many workers retire thinking that they’ve paid exorbitant amounts into social security, yet few could actually explain the breakdown of FICA taxes.

I’ve yet to meet anyone that I would describe as a cheerful taxpayer, so I’m not here to debate the fairness or current concerns over the solvency of the social security program. The point I’m attempting to illustrate is that our nation already uses annuity payments in the form of a social insurance program. And yes, that’s what Social Security was initially designed to be – social insurance.

The Social Security Act was officially signed on August 14th, 1935. Initial payments came back to workers in the form of lump-sum payments. However, the Act was amended in 1939 to add coverage for spouses and dependent children, along with provisions for monthly benefits to begin in 1940.

The first recipient of monthly social security payments was a lady named Ida May Fuller. Whenever I talk with people about longevity risk and social security, I reference Ms. Fuller. In my view, she was a canary in the coal mine for the evolution of social security’s place in our society.

As I mentioned above, Social Security was initially proposed as a social insurance program. The intent was to create a program that would attempt to prevent aged Americans from becoming destitute once they could no longer work and earn a wage. In the wake of WWI, WWII, and the Great Depression; many Americans supported the idea of a social safety net for the elderly.

Under this pretext, social security was not designed to be a retirement income program. Some may dispute this claim, so I offer you this chart:

The purple line shows a blended life expectancy for the US. In the 1930s and 1940s, you can easily see that life expectancy was significantly lower than it is today. I would wager that the original framers had no idea that many Americans would see their life expectancies increase at such a huge rate.

Remember Ida May Fuller?

She was a canary in the coal mine. Ms. Fuller began collecting payments when she was 65 years old, and she lived to be 100. According to the SS Administration, she paid a total of $24.75 into the program and received an eye-popping $22,888.92!

Annuities: The Insurance Product

Aside from Social Security benefits, consumers may also be fortunate to have a private pension benefit from an employer. These defined benefit pension plans are also designed for a stream of payments for retired workers. With the creation of 401(k) or defined contribution plans, many companies no longer offer a pension to their workers.

Companies that offer pension plans have taken various steps in recent years to relieve their financial obligations to an aging workforce. Some of them have transferred their pension (and risk) to an insurance company instead of handling the pension fund themselves. Other companies have stopped offering the benefit while simultaneously offering existing participants a buyout. One thing is for certain–traditional defined benefit plans are going extinct.

What should workers do if they like the idea of guaranteed income payments in retirement, and they worry that social security won’t be enough?

The insurance industry has a potential solution for this puzzle. Unfortunately, the concept of an annuity has morphed into a multi-headed hydra. The rest of these articles will attempt to unpack the various kinds of annuities, their potential uses, and their potential drawbacks.

As I previously mentioned, I believe that annuities are simply a financial tool. I tell people all the time that there is no perfect savings or investment tool. If there was, all of us would simply do that and go about our lives with less financial worry.

Like other investments or saving strategies, annuities can be used correctly, incorrectly, or reprehensibly. They can be misrepresented or sold by salespeople pretending to be financial advisors. They can also be used well and unfairly attacked. A tool that is being misused isn’t the fault of the tool itself.

I definitely have my own opinions and biases, yet my goal is to offer an objective view on each of the annuities discussed and the ways they may be presented to consumers. However, I won’t leave you wondering about my personal opinions. That wouldn’t be fair.

Annuities aren’t for everyone. But, they can be very useful for some people. I hope this introduction was meaningful. In the coming weeks, we will look at the various kinds of annuity products you may encounter in the marketplace, their shortcomings, and their potential uses.

Annuities Are Retirement Products

As I’ve mentioned previously, annuities are tools. These tools can have multiple features, uses, and added benefits; however, my view is that the primary use for these products should be retirement income planning. Since we have millions of baby boomers entering retirement each year, annuities are not going anywhere.

Annuities seem to be ubiquitous because:

Annuities are marketed very aggressively
Regulatory requirements allow some annuities to be “sold” with only an insurance license. This exponentially increases the number of people discussing annuities.
Annuities are often used as a one-size-fits-all investment recommendation.
There are many different types of annuities
Compensation often incentivizes annuity sales over other products

It is almost impossible to Google “annuities” and find anything positive. The top search results that share opinions are almost always negative. Anyone who has attempted to get straightforward reporting from our mainstream media should be able to agree that online search results can be misleading or skewed.

Our financial media is no different. Many large institutions, financial content creators, and investment advisors will pay significant dollars to get you to see what they want you to see. This article isn’t about search engine optimization or how you can pay for search results online, so I won’t bore you with the details of how or why search results can be manipulated.

Annuities are Marketed Aggressively

In order to understand how annuities are marketed, you must understand a little bit about how annuity products are distributed throughout the marketplace. Insurance companies use various channels and forms of compensation to bring their products to the marketplace. As technology expands, I believe we will see more insurance companies attempt to market products directly to consumers.

However, at the moment, most annuity marketing is not done directly to consumers. Instead, annuity products are often marketed to financial advisors. The goal is to use advisors as agents to distribute and service annuity contracts.

The analogy I use to describe this scenario is grocery stores. Not everyone has the vocabulary to understand the annuity industry, but I believe the majority of people reading this will understand grocery shopping. So, let’s go through it.

When you enter a grocery store, you’ve likely made your choice of location based on a few factors– location, brand recognition, price, and adequate offering of products you need. Many large grocery store chains will have tons of selection, and they may even offer their own brand. You can walk the aisles and select your items, using your personal preferences or prices as a guide for your trip.

Many products will pay extra dollars to the grocery chains so that they can be placed in optimal locations within the store or on the shelves. Never again should you wonder why the cereals with cartoon characters on the box are eye-level for your small children! The grocery store is a business, so there are methods to everything they do.

Insurance companies are no different. Insurance companies often act through intermediaries or marketing organizations that have access to thousands of financial advisors. They will pay various levels of compensation to these intermediaries to market or push their products out to advisors. In turn, advisors are expected to “produce” or write business through the intermediaries.

Here’s a quick (and easy visual):

Just like grocery stores, many people will often select their financial advisor based on location, brand recognition, and price. The confusion can set in when it comes to an adequate offering of products that you need. I’ll spend a significant amount of time explaining the various types of products later in this article.

Ever get one of those “steak dinner” invitations in the mail? What about an invitation to take a “free” retirement planning course at a local college or university? The chances are better than good that whoever is running these workshops uses annuities.

My father and I share the same name, and there was a period of time when I would often get these invites in my own mailbox. They were intended for Dad, but somehow these invitations would come to me. Clients of our firm will often share invitations they receive as well.

Sometimes, annuity salespeople skip right over the warm and fuzzy courtship phase and go right into sales mode. Here’s an egregious example:

Before anyone jumps to conclusions, I’m not slamming dinner seminars or workshops. Our team has used these events to grow our own practice, and there are some advisors out there who provide some seriously good information at their events. The opposite is also true.

I have listened to more than one “educational workshop” that was designed to scare the life out of everyone attending. Information is presented with a clear bias, and the only solution seems to be tucked away at the advisor’s office. Set your appointment quickly before all of the time slots are filled!

Another marketing tactic that is used by some advisors and their marketing teams is credibility building and celebrity status. Controversial opinion here – your financial advisor isn’t famous. Kim Kardashian is famous. Mike Rowe is famous. Your advisor is using PR tactics to boost their profile and build credibility.

I have sat in rooms with marketing groups that promised to do this very thing for me. If I wanted to hire a PR team to get me on the Fox Business channel, no problem. If I wanted to pay a ghostwriter to write a book for me (we could pretend I wrote it), piece of cake. My own radio show? Simple– I just needed to say the word and open the checkbook.

These are all marketing strategies that are designed to create visibility and credibility. Trust me, they work. They work extremely well. Society has programmed us to give greater standing and trust to professionals that appear on outlets that we have already deemed to be credible.

Being known or “heard of” is a massive advantage in the marketplace. Microsoft, Nike, and Ford are well-known brands; however, Apple, Lululemon, and Tesla are brands that have devotion from some consumers. Many financial advisors strive to create similar branding for themselves in the communities that they serve.

There is nothing wrong with marketing and branding a financial firm. Many financial advisors are phenomenal at marketing, and I do all I can to learn from them. We are, after all, business owners that wish to attract clients. Marketing and branding can help with that.

My purpose in highlighting marketing in this article about annuities is that I feel some advisors use deceptive marketing tactics to attract clients. Next, they use misleading language to convince clients that annuities are suitable investments for what they wish to accomplish.

Clients believe they have a real advisor, yet they’ve really entered into a transactional relationship. There is a big difference.

If you find yourself in a meeting with an advisor and they propose an annuity, here are some questions that may help you eliminate fact from fiction:

What kind of annuity is this? Is it a fixed or variable product?
Can I lose my principal investment in this contract?
How long is the surrender period?
What are the guarantees in the base annuity contract?
How does this contract make money?
What are the fees and costs for owning the policy?
Do you have other insurance companies that we should look at?
How are you compensated for offering this contract?

Annuities Are Regulated Differently

(coming soon)

Disclaimer: An Annuity is a long-term financial product designed largely for asset accumulation and retirement needs. All guarantees are backed by the claims-paying ability of the issuing insurance company.

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