Why Annuities Are Better Than Equities
If you’re saving for retirement, it’s advised that you focus on assets that drive portfolio growth. And, two of the best opinions that will achieve th...
If you’re saving for retirement, it’s advised that you focus on assets that drive portfolio growth. And, two of the best opinions that will achieve this goal are variable annuities and stocks.
Both vehicles offer growth potential. At the same time, they have their own risk profiles, as well as costs and tax considerations. Moreover, annuity types like fixed and fixed-equity won’t provide as much growth; it greatly reduces risk.
So, which is better? Annuities or equities?
I know a lot of people don’t like this answer. But, honestly, it depends.
For starters, growth with most annuities is limited. The exception is variable annuities. Like stocks, their performance is based on how your investments are performing in the stock market. On the flip side, fixed and fixed-equity annuities have less volatility and provide predictability.
Another key difference? How taxes stack up.
Annuity earnings are subject to ordinary income tax. Equities, like dividend stocks, on the other hand, have a lower tax rate. And you don’t have to pay taxes if you’re in the lowest two tax brackets.
And, we certainly don’t want to overlook fees. Generally speaking, annuities are chock full of fees. As such, an annuity can be an expensive retirement product. Equities, however, are much cheaper. In fact, dividend stocks are one of the cheapest assets you can own.
But, to really help you make the right decision, let’s dig deeper into the worlds of annuities and equities.
As a refresher, annuities are contracts that you sign with a life insurance or annuity company. Their main purpose is to provide you with a guaranteed income in retirement. While there are several different types of annuities, they tend to share a number of similarities.
Annuities create a guaranteed stream of income from their account balance for either a specific period of time or for life. Regardless of the type, all annuities undergo annuitization, which is the phase when the annuity begins making payouts.
Furthermore, all annuities offer tax-deferred growth. The growth within annuities is not taxable since they are structured as retirement investments.
Additionally, all annuities include a life insurance component. And, most offer optional benefits that can result in higher amounts being passed down to your heirs.
The Different Types of Annuities
“Annuities can be one of three types: fixed, variable, or indexed,” writes Kate Underwood in a previous Due article.
“A fixed version is what it sounds like: it pays you a fixed amount, guaranteed,” she adds. A variable annuity will “vary in rates of return and payouts, offering the potential for both greater risk and greater returns.” And, finally, there’s “an indexed annuity provides a guaranteed minimum payout, but another portion of returns is connected to a market index like the S&P 500.”
To ensure that you select the right type of annuity, let’s dig deeper.
The most common type of annuity is a fixed annuity — which should be available through almost every life insurance company. They also just so happen to be the easiest to comprehend.
The reason? The interest rate on funds deposited into a fixed annuity is predetermined. At the time of purchase, the insurance company declares the rate. For example, with a Due Fixed Annuity, you get 3% on every dollar deposited.
The drawback, however, is that the growth potential isn’t as high. But, your initial investment is protected so that you’ll never lose money with this type.
Variable annuities aren’t that much different from mutual funds. This is because both products have an investment component. Specifically, variable annuities consist of sub-accounts. These sub-accounts contain mutual funds that you get to pick.
Whatever is deposited into these accounts must be allocated between these sub-accounts. However, you can choose as many sub-accounts as you like. As such, there’s more growth potential with variable annuities.
The disadvantage is that there aren’t guarantees, so you’re taking on more risk. Also, your balance is directly impacted by the stock market. So, if it tanks, you might be in trouble. It should be added that you can adjust how aggressive you want your investments to be.
While not as common as fixed or variable annuities, equity-indexed annuities have grown in popularity as of late. Why? Because it’s essentially a hybrid of a fixed and variable annuity.
Like a variable annuity, the value of the account is linked to the performance of the stock market. In most cases, through an index like the S&P 500. But, indexed annuities are also fixed products.
In other words, you have an opportunity for growth when the market performs well. But, if it underperforms, you’re protected against serious losses.
The Pros and Cons of Annuities
Without question, the main advantage of an annuity is that it will provide regular lifetime payments.
“These recurring payments can provide a supplemental income during your retirement in addition to Social Security and pension benefits,” explains Due Founder and CEO John Rampton. “And, this will help put your mind at ease if you’re concerned that you haven’t saved enough or will outlive your savings to cover your regular expenses. Considering that outliving your savings is a worry for half of Americans, an annuity seems like an effective solution.”
“While most annuities will provide you with a guaranteed lifetime income, you can opt to receive payments for a specific period of time,” he adds. “What’s more, the value and number of your annuity payments will vary. Usually, this depends on the type of annuity you’re bough and the terms of your contract.”
But, wait. There’s more. Additional perks of annuities include;
- Premium protection
- Tax-deferred growth
- Unlimited contributions
- Choice of investment options
- Legacy benefits
- No mandatory withdrawals
- Long-term care riders
The disadvantages of annuities.
There are also downsides associated with annuities. Most notable, the fact that annuities are illiquid. That means it can be difficult and expensive if you need to make a withdrawal. For example, if you’re under the age of 59 ½, you could be charged a penalty of anywhere between 5% to 20%
Another knock against annuities? They can be expensive. “In addition to surrender charges and early withdrawal fees, annuities have a number of fees attached to them, including administrative fees, commissions, investment expense ratios, and mortality & expense risk charges,” adds Rampton.
“And, if you add-on annuity rider like a death benefit or long-term care, expect to dish even more money for your annuity.”
Other disadvantages to be aware of are;
- Misleading high yield rates
- Difficulty passing on to heirs or getting out the contract
- Financial risk if the insurance company goes bankrupt
- Missed opportunity costs
- Annuities can be complex and difficult to understand
For the uninitiated, equities are the same as stocks. That means you purchase shares of a company. As such, you’re considered a partial owner. For some employees, when you join a new company, namely a startup, you may receive “equity” in the company.
Unlike annuities, you don’t receive a fixed interest rate or guaranteed income. Because of this, equities are like playing with fire.
So, why do people invest in equities then? That’s simple. Equities have the potential for high returns.
The assumption when buying equity is that it will grow in value via capital gains, or generate capital dividends. Thus, if an investor sells their shares at a higher price than they paid, they’ll receive the difference in value. This is also true if a company’s assets are liquidated — just as long as its other obligations have been met.
Additionally, this assists in diversifying a portfolio since stocks can strengthen their asset allocation. However, you can lose money if the value of your stocks plummets.
There is a consensus that young people can afford to invest more in equity. And, so will likely wish to buy more stocks as they could earn sizable returns over time. However, equity exposure becomes more of a risk as you near retirement. Because of this, many older investors convert at least some of their investments to bonds or look at products like annuities.
Equities & Dividends
Your equity holdings increase in value when your shares rise in value over the initial purchase price. However, there are other ways to earn money through investing in equities.
One such example is dividends. This is when companies pay out a sum of money from their own profits to shareholders. While not guaranteed, they can provide major benefits when available. Dividends can either be reinvested or taken as income for investors.
Also, when you own stocks, it’s vital to know the difference between dividends and capital gains. Capital gains are the difference between the purchase and sale prices of your shares. Capital gains are classified as either long-term or short-term — each of which has its own tax rate.
Taxes on dividends are similar to those on capital gains. The catch? Just as long as they’re “qualified dividends.” If you have shares of stock, you should receive a 1099-DIV form that details your dividends and capital gains.
What is Preferred Stock?
A preferred stockholder has more access to earnings and assets than a common stockholder. Typically, preferred shareholders receive regular dividend payments (usually at a fixed rate) before common shareholders do.
As with everything in life, there is a catch. Dividend rates, at least for preferred shareholders, are generally fixed. As such, they won’t see their dividends rise as much as the business becomes lucrative.
What happens if a company goes bankrupt or is liquidated? Priority is given to preferred shareholders when it comes to assets and earnings. As the creditors of a company that collapses, bondholders are first in line to take the company’s assets as they’ve provided the company with money. Next are preferred shareholders, followed by common shareholders.
Can You Get Equities Through Your Job?
Let’s say you receive a job offer containing a salary, health insurance, 401(k), and equity. That actually may be more likely than being offered an annuity. Regardless, in this case, what is “equity”?
As long as you’re still employed by the company, you’ll have either ownership in your new company now or when the equity “vests” — which is when it becomes official. Equity can sometimes be transferred outright. There are also times when you have the option to purchase stock at a reduced price.
However, don’t base your decision on equity alone. Until the company goes public or is sold, equity won’t put money into your bank account. Additionally, since your salary is already linked to the performance of the company, the more stock you own, the more of your savings you’re putting into the one basket.
The Risks and Rewards of Equities
The main benefit of equity investments? You have the greatest potential to elevate the value of the principal amount you invested. Dividends and capital gains are two ways to achieve this.
Equity funds also offer investors a diversified investment option for a minimum investment amount. Moreover, to reach this level of diversification, you need more manual capital investment.
Additional benefits of equity shares include;
- The potential to give returns that are higher than inflation.
- Bonus shares, or free shares, which is a type of dividend given to shareholders by companies.
- Right shares if the company expands.
- Shares are split by reducing their price and resulting in higher investor interest.
- Unlike annuities, it’s easy to sell shares of a company.
- Exercise control over a company.
The Risks of Equities
At the same time, all investments, including stocks, bonds, and mutual funds, carry their own risk profile. The most obvious is losing your principal. Remember, you could lose everything by investing in high-yield bonds or stocks.
Other disadvantages with equities include;
- Equity shares are expensive to issue.
- A company’s excessive use of equity shares may result in overcapitalization
- Dilution of control of equity holders occurs when equity capital is issued. In periods of depression, dividend payments are very low, which causes equity share prices to plummet.
- Dividends are paid from post-tax earnings.
- Since equity shares rise at higher rates, equity shareholders also experience higher expectations as compared to preference shares or debentures. As a result, servicing equity capital generally costs more than issuing preference shares or debentures.
Why Annuities are Better than Equities
A substantial benefit of annuities is tax-deferred income that can grow over time. As the underlying funds grow over time, any capital gains are not taxable. Portfolio income is also non-existent. Overall, a portfolio containing annuities will keep working for, and not against you.
Investors who don’t have a retirement account can expect to pay taxes on both capital gains and dividends. As a result, returns are reduced.
Ultimately, only a portion of annuity income is taxable. Tax-free returns of principal are included in any payments you would receive. A similar investment in dividend stocks or bonds would provide a smaller net income stream.
What’s more, annuity owners are subject to market risk — just like equity investors. However, with the addition of a rider, the risk is greatly reduced. While this is only to a certain extent, it does give you some peace of mind if underlying stocks do not perform as expected.
Additionally, there’s also the option of adding a minimum death benefit to an annuity. This lets the owner name a beneficiary who will receive the annuity’s value and income stream. There isn’t such a provision with equities.
Should You Buy an Annuity or Equity?
While it may seem like an annuity has a leg up over equities, Stan Haithcock, aka Stan The Annuity Man, argues that comparing the two is like comparing apples and oranges.
“Annuities and the stock market ‘argument’ comes down to one thing,” he says. “Do you want to shoulder the risk, or do you want to transfer it? In Stan’s opinion, it has nothing to do with age.
“If you are OK with risk and in a perpetual accumulation phase, then stay in the stock market, ride it out, and trade away,” he adds.
“If you have made the decision that you want to transfer some or all of that risk, then a specific annuity type might fit into your retirement plan,” Stan says. “Whether you want a guaranteed minimum interest rate with principal protection or a guaranteed income stream that you can never outlive, transferring risk to a fixed annuity makes contractual sense.”
For the most part, I agree with his sentiment. Annuities are one of the best options if you want to maximize your retirement income. In fact, studies have found that “annuitized income increases the optimal stock allocation of a household’s investment portfolio.”
And, even though annuities are geared towards older individuals, the tax-deferred growth should be appealing to anyone. Regardless of your age, if you have the finances and contribute to a 401(k), a deferred annuity should be worth exploring.
Moreover, annuities are ideal for those looking to maximize their Social Security and pass on a legacy. And, they’re also perfect if asset protection is of concern.
At the same time, if you want to diversify and drive your portfolio for growth, then it’s wise to have both annuities and equities.
Closing Thoughts on Annuities vs. Equities
In most cases, you should not decide to purchase an annuity without the assistance of a trusted financial advisor. Investing in annuities and dividend stocks can offer both significant appreciation and substantial risk to your savings. Keeping that in mind, there’s no one-size-fits-all solution.
Before committing, always compare the costs, advantages, and disadvantages between annuities and equities. In addition, a financial professional will evaluate your unique situation. In turn, they can provide appropriate solutions by taking into account your risk tolerance and time horizon.
While we’ll be the first to amidst that annuities aren’t for everybody, they do offer benefits and guarantees that are tough to beat.