126R | What is an Annuity

126R | What Is An Annuity

Brad and Jonathan tackle a listener question about annuities and discuss some updates to the travel rewards landscape.

Second Generation FI

Many people in our community struggle with how to pass along the lessons of FI to their children. Brad shared stories about passing FI lessons along to his children.

The little things really are the big things in life.

Brad and Laura take the opportunities to teach their kids about the FI lifestyle as they come up. Although they aren't lecturing their kids about FI every day, they are teaching them the thought process that makes it possible.

Whether you are answering their questions or talking through a problem, these are teachable moments that your kids can learn from.

Brad's challenge to our community is:

Find those little lessons in life that you can pass on to your kids. I think that these little things go a long way.

You can even try to make a game out of it. Take any opportunity and make sure to not gloss over teachable moments.

Travel Rewards And The Chase Sapphire Preferred Card

Although our travel rewards episode was recorded several years ago, many of the tips are still relevant.

Importantly, the Chase Sapphire Preferred Card is still the best place to get started with travel rewards.

In Brad's opinion, the Chase Ultimate Rewards points are the most valuable travel rewards points. The points offer you the most flexibility and value possible.

When you choose to redeem your points, you have three different options:

  • Redeem your points for cash at 1 cent per point.
  • Redeem your points through the Chase Ultimate Rewards Portal at 1.25 cents per point.
  • Transfer your points to a travel partner. Some of the best travel partners to work with are Southwest, Hyatt, United, and British Airways.

Read our full review of the Chase Sapphire Preferred Card. Start your travel rewards adventure today!

Related: How Chase Ultimate Rewards Actually Work

Playing With FIRE Update

The documentary will be airing these seven cities in early June:

  • San Diego June 1st 2019 – Buy Ticket Here
  • San Fransico
  • Seattle
  • New York City
  • Detroit
  • Washington D.C.
  • Atlanta

As the tickets become available, we will provide links. For now, keep an eye on the Playing with FIRE website for ticket information.

If you don't see your city on the list, don't worry! Connect with a ChooseFI local group to get more information about a potential showing in your area. It could be a great way to introduce the concept of FI to a friend.

Question From Jean About Annuities

My name is Jean and I just recently found ChooseFI and I’m really grateful I've found you guys. I've actually been looking for you all my life. I just finished listening to J.L. Collins' series on stocks and investments, particularly, episode number 36, and listened very closely to his comments on annuities.

Well, I am just sick to my stomach because I had a financial advisor sell me an annuity last year for $150,000 which was more than half of my assets. I’m 61 years old and I have been seeking answers on the best way to invest for a secure retirement.

I can't tell you how many people I’ve asked and how many other advisors about whether or not an annuity was a good option for me. And what I kept being told by the advisor that sold it to me is that it would provide a long term pension for me. You know, I anticipate living to be into my 90s just because I’m basically healthy and my parents and grandparents have lived long lives. I thought this would be a good option for me.

So, my question to you all, so that I can sleep better at night, what can I ask my advisor who sold me this (but is no longer managing my equities because I realized that he was getting everything he was getting out of me from the annuity and I was not going to continue letting him siphon off my equities account.) So my question to you all is, how can I reconcile this choice that I made of purchasing an annuity. I guess my biggest fear is that when I’m 85 this company will go bankrupt. Any thoughts on this are appreciated.

Answers With Big ERN

Big ERN, from Early Retirement Now, was on the show today to answer Jean's question. Based on his research, this is his take on annuities

Types Of Annuities

  • Immediate Annuity. With an immediate annuity, you will hand over a certain amount of money to the insurance company. Immediately, they will start to pay you a pension-like “salary.”
  • Deferred Annuity. With a deferred annuity, you hand over a certain amount of money to the insurance company but the payments do not start right away. The advantage of this waiting period is that your payments will be larger.

Both types of annuities will tie up your money at the insurance company forever. Plus, if your death is untimely, there is no way to pass this money along to your family.

With the sheer amount of bells and whistles offered on annuities, it is impossible to delve into each component. An annuity could include a cost of living adjustment, a minimum number of years, a joint annuity between spouses, and a multitude of other options. You would need to take a closer look at the type of annuities offered to you before you make a decision.

In general, Big ERN recommends against an annuity. Unfortunately, Jean has already signed up. So, she should check with the insurance company to see if she could get out of it, but it is an unlikely option.

Either impossible, extremely difficult, or disadvantageous to get out of the annuity now.

Advantages Of An Annuity

Once you sign up for an annuity, you are likely stuck with it forever.

I usually advise against going with an annuity. But there is one advantage of an annuity that I have to concede, there is something to it… The advantage is that this is a safe and efficient and simple way of turning one big chunk of money into a stable cash flow.

The one advantage is that you can turn a large chunk of money into a fixed income. Stable cash flow is an envious way to live your retirement. It is just not as simple to produce a steady stream of income through your net worth.

With the 4% withdrawal rule, it is possible that you could run out of money.

The 4% rule is also, in the worst possible case you exhaust the money after 30 years. That's actually one of the reasons why I believe we shouldn't use the Trinity study results and expand them from 30 years to 60 years… because in the worst possible case the 4% rule would also exhaust the money after 30 years. Of course, in the best possbile case you have tons of money left over after 30 years.

As our retirement years grow, it is a good idea to withdraw a little less than that to preserve capital over a longer term.

The insurance company is able to hedge its longevity bets in a way that the individual investor cannot. You do have the ability to create a CD ladder or bond ladder that simulates the fixed income of an annuity. However, you cannot predict when you will pass, so if you live past the horizon of your fixed income ladder then you will be in a tough spot. The insurance company is ensuring that you have a fixed income for the rest of your life, no matter how long you live.

Disadvantages Of An Annuity

The most obvious disadvantage is the money is in the control of the insurance company. The money is completely gone as soon as you sign over your rights. It is an extremely illiquid asset, even though you will be receiving a monthly income from it.

The fees associated with an annuity are also difficult to justify. Many of the fee structures are not transparent but it seems that the salesperson could be taking up to a 10% commission off of the lump sum. However, it is likely there are many other levels of fees that we cannot see. The high fees might negate the advantage of longevity payments by the insurance company.

If You Already Have An Annuity

The best part about the annuity is the fixed income.

The volatility of equities is balanced by your ability to weather the storm.

You can build your drawdown plan around this stability. On the equities side of your portfolio, you should be comfortable with higher risk exposure. As you make more contributions to a retirement account, they should be made aggressively. Avoid a target date fund if you have most of your portfolio in an annuity.

Big ERN would not be very worried about the potential bankruptcy of the insurance company. These companies are very heavily regulated, so that should be a minimal concern.

If You Still Want An Annuity

If you are intrigued by the idea of a lifetime income, then you might still consider an annuity. The most important thing to do is to compare plans.

People shop around for a $500 TV. You definitely want to shop around before you put $150,000 into an annuity.

Look into Vanguard or Fidelity, they might offer a lower fee structure. Do a baseline comparison with a minimum amount of extras to effectively compare your options.

Also, make sure to look into the ratings of the insurance company offering these annuities. You will likely want to stick with an immediate annuity if you choose to go this route because the numbers don't make sense for a deferred annuity.

Big ERN would wait until 68 before committing to an annuity. If you are still interested in annuities at that point, then you can make your purchase then. At that age, an immediate annuity would be the way to go. Also, if you choose this path then you likely will want to delay Social Security as late as possible.

The deferred annuity is a riskier move because there is the unfortunate possibility that you could pass away before the payments start. You would not be able to pass along that money to your loved ones.

Alternatives To An Annuity

An annuity is a high cost and illiquid asset. Instead of an annuity, you could build a CD ladder or bond ladder that can carry you the first five to ten years into retirement. The fixed income of these CDs or bonds could help you sleep better at night.

A CD ladder is an alternative to tying up six figures of cash for many decades.

If he built a CD ladder, then Big ERN would create is around the average length of a stock market cycle. The rest of his assets would be invested 80/20 in equities/bonds.

Essentially the CD ladder would create a “glide path” into retirement. If you want to learn more about glide paths, then check out these articles on Early Retirement Now.


CD ladder toolkit

As a first approximation, just say you divide up the lump sum by the number of years and spread it out equally.

Once the glide path has completed, then hopefully you'll have enough money left in stocks to run from there. If you want to learn more about building a CD ladder, then check out this resource.

Related Episodes:

Your Financial Resilience Toolkit

Affiliate Disclaimer

ChooseFI seeks to uncover helpful services that help you be financially resilient. However, we may receive compensation, at no cost to you, from the issuers of some products mentioned in this article, including from CardRatings for our coverage of credit card products. Opinions are the author’s alone, and this content has not been provided by, reviewed, approved or endorsed by any of these entities. See our disclosures for more info.

We've updated our Top Cashback Card! Check it out!

Save on Existing Loans

Save On Living Expenses

Save & Invest

Financial Emergency Prep

10 thoughts on “126R | What Is An Annuity”

  1. This episode was really timely for me. I got into a variable annuity back in 2011 after leaving a job and rolling my pension into it at the advice of my financial adviser. I’ve been happy with the overall returns but realized that the the fees that I was paying for this product were ridiculous. The product had a couple extra features (death benefit rider & others) that made the ongoing fees over 3%.
    The principle was also subject to market risk even though I was guaranteed monthly payments for life.
    Since I’m expecting pension payments (from a different employer) and social security after retirement, I decided to redeem my annuity. Fortunately, my redemption was completed before the recent downturn in the market so my overall return on this product ended up being ~6% over 8 years. Now I’m faced with the decision of how to invest the funds (over $300k). The remainder of my retirement accounts are invested in the market so I want to be somewhat conservative with this portion.
    The discussion about CD ladders helped me to think about that option and I’m interested in bond ladders too.
    Thanks for providing insight & for helping me think through options.

  2. Some misinformation from ChooseFi podcast about annuities: Not ALL annuities have high fees! Sure, you don’t want to buy a Variable Annuity from an insurance agent (“financial advisor”) because of large fees and surrender charges. If you want a variable annuity, consider an “Investment Only” VA which has low, fixed rates. Vanguard and Nationwide offer these products. You don’t want an Equity Indexed Annuity as even though they are not laden with high fees, they are a crappy product! If you want income, you can get a SPIA (single premium indexed annuity) in your taxable or IRA. These are essentially commoditized and have very low fees. If you want longevity insurance, you can get a DIA (deferred income annuity) in your taxable account or a QLAC (qualified longevity annuity contract) in your IRA. Again, low fees. Don’t hate annuities. They are just tools. That said, DONT BE SOLD an annuity. Know what you want and buy it if it makes sense to you.

  3. Listening to this episode made me think of my father. He is 60 years old and after being bit by the 2008 crash he refuses to invest heavily in the stock market. He invests in CDs instead. I was thinking what an amazing idea it would be to draw up an annuity between him and myself. Promise him 3%-4% withdrawal rate and manage a 80/20 indexed portfolio for him. This gives him security, as I take the risk and the bonus of likely having a nest egg left over to inherit rather than him buying an annuity and giving all his money to an insurance company. What do you guys think?

  4. Shannyn, all the best to you. You are to be commended for your incredible generosity. You will be in my prayers. Can’t wait to hear all about your journey in September on the podcast.

  5. Nice job by Big ERN explaining annuities. One thing to add as wasn’t clear what type of annuity was bought. If it was a variable annuity (or likely other deferred annuity), you may be able to get out of the annuity if you purchased the annuity product but have not yet annuitized (ie, not yet started receiving payments). Unfortunately, I know these products too well from bad experience. Here is an article I wrote a few years ago when freelancing, but info should still all be applicable. Hope that helps!

  6. We have been looking at various ways to protect small portions of our assets from (what we believe) will be a downturn in the market. Our financial advisor has recommended the Lincoln Level Advantage Indexed Variable Annuity to us to put in a small amount (not all of our investments) into as an option. The terms are 6yrs with a growth cap of 125% and downturn protection up to 20%. No cost to us to purchase, and at the end of 6 years we get our principle + growth back out so long as we don’t forget to do all the right paperwork in time. To put it in simple math terms, invest $1000 and at the end of 6 years the most you can make is $2250 if the market goes up more than 125%, but instead if the market goes down you lose no principle unless it goes down more than 20%… and even then if it goes down more than 20% you only risk losing the difference above 20% — 25%-20%=5% risk of loss rather than the full downturn (all 25%).

    Now, this all falls into the category of “too good to be true” for me… but I am trying to figure out what I am missing here. This is NOT a long term strategy for retirement for us. We do not plan to keep this money in an annuity forever. In fact our explicit goal is to get it all back in 6 years at the end of the term. It is really just one of many strategies we are considering to get through what we think is a coming downturn in the economy/market. Unless there are significant fees I am just not seeing here, the only other downside I can see is missing out on some growth opportunity above the 125% growth cap on this thing. What I am missing?

  7. One thing that was said in this episode is that “The money is completely gone as soon as you sign over your rights.” Also that for deferred annuity, if you passed away before annuitization (when income comes in), all the money is gone.

    However that’s not true at all. If that were the case, who would want to buy such product? Most deferred annuity as well as immediate annuity, if you were to pass away before the benefit account (the account that pays out life time income) is depleted, the remaining amount goes to the beneficiary. This is called the “residual death benefit” and therefore, not all the money is gone!

Leave a Comment