While there are several ways to look at this question, compared to other “safe” investments, like bonds and CDs, annuities are expensive. They have higher internal costs than those others and typically pay advisors handsome commissions. What’s more, these costs are typically hidden, so making an objective comparison is difficult. But that is not the whole story.

I was on the website of one of the big-box home improvement stores recently and came across a page for hammers. There were dozens of listings, including one for a Stiletto 19-ounce hammer with a hickory handle. It listed for an astounding $241. For a hammer! On the same page was an Anvil hammer of similar design priced at $4.71. To my untrained eye, the two hammers were identical, or nearly so. So, is the Stiletto hammer “expensive?”

A hammer is a tool. If your use of a hammer is limited to hanging pictures around the house, the four-dollar hammer will surely be more than adequate. If, on the other hand, you’re a carpenter who swings a hammer all day, every day, the Stiletto hammer may be the biggest bargain in your toolbox.

Investments are also tools. In making a wise choice, an investor must first figure out the job that needs to be done and then pick the appropriate tool. If your goal is to save for next summer’s vacation, an annuity would be impossibly expensive – a ridiculous choice. But, if you have a different objective, to generate a lifetime income; or to sock away more than your 401(k) plan allows; or to shelter Social Security payments from taxation; or to better prepare for a nursing home confinement that might otherwise bankrupt you or your spouse, an annuity might not only be a perfect tool for the job, it may be the only tool that will work.

What Are Alternatives to Annuities?

Annuities are safe investments. By safe, I mean not subject to loss from the ups and downs of the markets. It is possible to lose money with an annuity. It’s also possible to lose money with a CD if you withdraw it before maturity. Annuities are safe because their value does not vary in the way the stock market varies. If you put $50,000 into an annuity, in one year, five years, and twenty years, there will always be at least $50,000.

So, what are other kinds of safe investments?

• Cash. Assuming it’s in a bank and not stuffed under the mattress, cash is safe, and, except for inflation, it will never lose value. Cash is the ultimate safe investment.
• Certificates of Deposit. CDs are just cash with a time element. In return for giving up some liquidity, you will earn a higher rate of interest. The longer the term, the higher the rate.
• Money Markets. Typically, a money market account is a type of mutual fund that holds only very short-term bonds or other debt instruments. While not foolproof, they usually don’t lose value, pay a better rate of return than cash, and are just as liquid. Some money market accounts even come with checks and debit cards. The government does not guarantee them as it does with bank deposits.
• US Treasury Bonds. This is a complex topic and this brief discussion should not be considered the last word. But, to an informed investor, government bonds can provide tremendous peace of mind. Treasuries, as they are called, are issued at maturities ranging from one to thirty years. Held to maturity, the return of your principal is guaranteed. Until then, their value can and will vary as interest rates move up and down. Interest – bond interest is called a dividend – is paid out quarterly and is also guaranteed by the government.
• Municipal Bonds. “Munis” are bonds issued by state and local governments, typically to fund construction projects like roads and schools, but not always. Again, this is a complex topic that deserves greater study. Municipal Bonds are not guaranteed, and defaults have happened. Two recent examples are a default by Puerto Rico in 2016 and the bankruptcy by the City of Detroit in 2013. Still, munis are considered safe and are typically exempt from Federal Income taxes, an important factor to consider when calculating returns.
• Bond Mutual Funds. A mutual fund that contains only bonds is generally considered safe. The professional managers who run the fund can typically steer clear of the next Puerto Rico or City of Detroit and diversify widely enough to make the impact of a default negligible. They are not guaranteed, and losing money is possible, especially in times of rising interest rates.

Should I Invest in an Annuity?

There are several situations that if you find yourself in, you should probably invest in an annuity. There are others where the right annuity might be an excellent choice, and you should consider investing. Then there are others where an annuity investment is not a good idea.

The most important thing is to do your research and to get objective advice. Sometimes, getting non-biased advice can be the hardest part of the job! There are several online resources I recommend: Investopedia is a good one. Seeking Alpha is another, although it often deals with topics in a more complex manner. Morningstar Annuity Reference is an excellent tool, but it requires a subscription and is directed at advisors, not consumers. You may want to ask any advisor recommending an annuity to provide you with the Morningstar report.

You should invest in an annuity:

• If you are concerned about outliving your money. The principal characteristic of an annuity, the thing that sets it apart from all other investments, is the guarantee of an income you cannot outlive. This is an important consideration and you should not overlook it.
• If you have safe money funds that you don’t need and if you have a combined income above $25,000 (or $32,000 for a married couple). The Social Security income of even moderately high earners is subject to Federal income taxation. You may be able to shelter some, or all, of your Social Security by investing in an annuity. Unlike the interest earned on cash or dividends earned on bonds, annuity earnings are not counted as income until you withdraw them. For a more thorough discussion of the topic, visit https://www.ssa.gov/planners/taxes.html
• If you are concerned about rising interest rates. When compared to bonds of similar duration (or time to maturity), annuities are typically better suited to deal with a rising interest rate environment. While your bond income will not be affected by an increase in rates, the principal value can drop dramatically. The value of an annuity is not affected by rising rates and in some cases, you might even see an increase in your returns as interest rates rise.

Annuities are long-term investments and they have significant penalties for premature withdrawals (called “surrenders” for annuities). For a long-term goal, an annuity can be a wise choice or a good choice. For a short-term goal or for funds that might be needed sometime in the short term, an annuity is a very bad choice indeed.

Annuities are tools: complex financial tools. They are neither the solution to every problem their advocates and salesmen claim, nor are they always the wrong choice as their detractors often claim. They are tools. In the right hands for the right job, they offer a combination of security, guarantees, tax benefits, and returns that make annuities one of the world’s largest investment classes.

I no longer sell annuities but if you have a question on this, or any other personal finance topic, please email me at bill@financialanimal.com. I promise to get back to you promptly.