In the last post of this series, we examined the internal anatomy of an annuity and explored the many moving parts that make these contracts so complex. Once you understand how those pieces fit together, the next step is understanding the different types of annuities available today.
Although annuities are often discussed as if they were a single product, the reality is far more nuanced. Fixed, indexed, and variable annuities operate under very different structures, each with their own costs, risks, and tradeoffs.
Understanding these distinctions is important because the structure of the annuity often determines whether it supports a financial plan or simply adds unnecessary complexity. Periods of market volatility naturally have led investors to ask an important question. Is my portfolio built in a way that can withstand uncertainty?
That question is a prudent one and is a sign of the seriousness we look for in working with people. Markets move through cycles, and uncertainty will always be present. The real goal of financial planning is not to eliminate volatility but to build a strategy that anticipates it.
At LeConte Wealth, our role is to help clients build Purpose-Built Plans that are designed to weather those cycles. When a strategy is constructed thoughtfully, volatility becomes something we prepare for rather than something we react to.
Periods of uncertainty often create an environment where fear can influence financial decisions. It is during these moments that some advisors position products to avoid volatility and create certainty.
Annuities are frequently introduced in these conversations. Before deciding whether an annuity fits into a financial plan, it is important to understand how these contracts are structured and what tradeoffs they introduce.
Immediate and Deferred Annuities
Annuities are generally categorized as either immediate or deferred depending on when income begins.
An immediate annuity begins paying income shortly after the initial investment is made. These contracts are designed to convert a lump sum into a predictable stream of income.
A deferred annuity accumulates value over time before income begins. During this accumulation period, the funds may earn interest, track a market index, or be invested in market-based subaccounts depending on the structure of the contract.
Most annuities investors encounter today fall into the deferred category and are marketed as growth vehicles first and income products later.
Fixed Annuities
A fixed annuity is the simplest form of annuity. In many ways it functions similarly to a certificate of deposit issued by an insurance company. The investor deposits money and receives a predetermined interest rate for a set period.
These contracts can provide stability and predictability. The tradeoff is limited growth and surrender schedules that may restrict access to funds for several years.
Indexed Annuities
Indexed annuities link potential growth to a market index such as the S&P 500 while protecting against market losses.
At first glance this sounds appealing. Investors are attracted to the idea of participating in market gains without the risk of losing principal. The complexity lies in how returns are calculated. Participation rates, caps, spreads, and crediting methods often limit how much of the market’s performance the investor receives.
While indexed annuities may offer downside protection, they often achieve that protection by limiting upside potential.
Variable Annuities
Variable annuities allow investors to allocate funds among investment subaccounts that function similarly to mutual funds. Because these investments are tied to the market, they offer the potential for higher growth.
The tradeoff is cost. Variable annuities often include several layers of internal expenses including mortality and expense charges, administrative fees, rider costs, and the underlying investment expenses within the subaccounts. These subaccount fees tend to be higher than your average portfolio because of their limited invested options.
When combined, these costs can significantly reduce long-term performance.
When an Annuity May Be the Right Tool
Despite their complexity, there are situations where an annuity can serve a purpose.
Consider a retiree who has saved diligently but does not have pension income. Their primary concern is creating predictable income they cannot outlive. In this situation, allocating a portion of assets to an annuity designed to provide reliable income may help address that concern.
When an annuity truly fits a client’s situation, the focus should always shift to structure and cost. The goal is to use the simplest and lowest cost version available, avoid unnecessary riders, and prioritize structures that reduce conflicts of interest.
The product itself should never be the starting point. The client’s needs should always come first.
When Annuities Are Often the Wrong Fit
In many cases, annuities were not purchased because they were the best solution for a financial plan. They were heavily marketed and often paid significant commissions to the selling advisor.
A common situation we encounter involves investors approaching retirement who were encouraged to move a large portion of their savings into a variable annuity with several riders attached. These riders may promise income guarantees or enhanced benefits that sound reassuring during the sales conversation.
Years later, the investor discovers the contract carries several layers of fees that add up to a fee much higher than the client anticipated. On top of that, the contract may have a surrender schedule that limits the liquidity of the investments for several years, and in most cases the investment options are limited compared to a modern-day diversified portfolio.
In these situations, the annuity often served the structure of the sale more than the long-term interests of the investor.
Things You Should Be Aware Of
If you currently own one of these products, here are a few things to look for on your monthly or quarterly statement.
Start by looking at how the annuity is registered.
If an annuity is held inside a retirement account such as an IRA, it may warrant closer scrutiny. Annuities are often marketed with tax deferral as a key benefit. However, retirement accounts already provide that same tax deferral on their own.
In many situations, this structure adds cost and complexity without providing additional tax advantages, making it an important area to review carefully.
Next, look at the surrender schedule. If your contract still lists surrender penalties for withdrawals, your flexibility may be limited.
Then review the fee disclosures. Multiple internal charges such as mortality and expense fees, rider costs, and investment expenses can add up quickly.
Finally, examine the investment options within the contract. Most variable annuity contracts utilize mutual funds as their primary investment option for their subaccounts. This method of investing is many years behind the technology and capability of modern-day fiduciary wealth managers.
These signals do not automatically mean the annuity should be replaced. They simply suggest it may be time for a closer evaluation. We strongly encourage our clients and our community to seek guidance of a fiduciary adviser when asking questions about annuity products.
Looking Ahead
Understanding the structure and type of an annuity are the first steps toward determining whether it still serves your long-term goals.
Some annuities may continue to play a useful role within a financial plan. Others may have been sold in ways that introduced unnecessary costs, restrictions, or complexity.
At LeConte Wealth, our job is not to sell clients a new product. Our responsibility is to evaluate what they already own and determine whether it still fits within their individual Purpose-Built plan.
In the final post of this series, we will walk through the process we use when reviewing annuities for new clients. We refer to this as our annuity triage process. It helps determine whether an annuity should remain in place, whether it can be improved, or whether it may be time to transition toward a more transparent and flexible investment strategy.
When financial decisions are guided by clarity rather than confusion, investors are far more likely to move forward with confidence.
