7 Reasons to Avoid Annuities in Retirement

Perhaps you’ve been contacted by an insurance sales representative urging you to consider buying an annuity. You’re not quite up to speed on these annuities, but the pitch sounds good: You get regular monthly payments for the rest of your life.  All you have to do is sign on the proverbial dotted line.

What you may not know unless you know where to look and how to read and understand the fine print is that annuities can have hidden costs and other confusing provisions that most annuity sales reps never tell you about (in some cases, they may not even be aware! the insurance companies train their salespeople to emphasize those points most favorable to their own goals and rarely train them on the drawbacks) 

In most cases, unfortunately, the person trying to sell you an annuity product is not a disinterested observer – their livelihood and income depend on selling!  Given these skewed incentives related to commission payouts that can vary widely depending on which annuity product and contract riders you decide to buy, you need to be aware that some annuity distributors may have a conflict of interest that could impair their ability to advise you on what you should do. 

Read on below as we reveal some of the most common hidden issues and pitfalls related to annuities – secrets that many never figure out until it is too late!

Annuities 101

An annuity is a contractual arrangement between an insurance company and a private individual or purchaser, often an investor thinking about retirement, where an upfront lump sum is paid by the individual to the insurer in order to receive future or immediate payments at regular intervals. Consequently, the subject of annuities often comes up in retirement planning. 

There are four main types of annuities: Immediate Annuities, Deferred Income Annuities, Fixed Annuities, and Variable Annuities. Let’s look at each type (though a comprehensive discussion of these is beyond the scope of our topic today):

  • Immediate Annuity. This is the easiest type to understand. You make an upfront, lump-sum payment to an insurance company. You then immediately become eligible to receive regular payments from the insurer. The length of payment can be over a fixed period or the rest of your life.
  • Deferred Income Annuity. These are similar to an immediate annuity except that your payments don’t begin right away. Instead, you will begin to receive them sometime in the future. Some people use deferred income annuities to hedge against the possibility that they’ll live too long and run out of other retirement funds.  Typically a deferred income annuity will give you a stream of payments a bit higher than an equivalent sized immediate annuity would provide (because of the waiting period).
  • Fixed Annuities. This is an insurance contract that enables you to accumulate capital on a tax-deferred basis. The capital accumulates at a regular fixed rate, determined by prevailing interest rates at the time the contract is established. Additionally, in most cases there is a provision in the contract guaranteeing that your principal will not decrease.  Fixed annuities often appeal to conservative minded investors.  Since interest rates are so low today, the returns of fixed income annuities are naturally muted at the present time.
  • Variable or Index Annuity. These are similar to fixed annuities in that gains within the annuity grow on a tax-deferred basis. The returns that can be achieved are tied to a specific market, often the U.S. stock market, whose returns vary from year to year. Variable annuities often come with some protections, such as minimum amounts of income once payments begin, withdrawable cash options, and death benefits.   Variable annuities can have riders that provide downside protection against stock market declines, however, this protection can be expensive and has to be paid for from the upside that an investor would enjoy overtime from an equivalent sized direct investment portfolio held outside the annuity wrapper (more on annuity taxation later in this article).

Of course these categories are not mutually exclusive.  So for example, you can have a fixed immediate or deferred annuity.  Another popular hybrid combination is the index annuity or the fixed index annuity (more on this later).

What’s in it for the Insurance Providers?

At first glance, annuities with their “guarantees” sound like a good deal for the buyer.  In many cases the pitch seems to imply that annuities give you the best of both worlds for the intrepid investor – good upside with little or no exposure to the downside.  This sounds like nirvana to many investors.

But, why do insurance companies offer them in the first place if they are such a good deal for the purchasers? As we all know, insurance companies are sophisticated entities with teams of actuaries and are generally far more sophisticated than the customers who they sell to.

First of all, the seller of the annuity, the insurance company, gets a hefty upfront premium. This is money they can immediately invest and some of the gains (and sometimes some of the principal) can be used to pay for sales commissions and other costs as well as generate profits for the insurance company over time. 

Money paid upfront to insurance companies in exchange for future payments generates “float” – money that the company gets to use and invest in the meantime.

Insurers price their products so that they can make a bigger overall profit on this investable money than they will pay out. This “spread” between their anticipated investment profits and the lesser amount they believe they will have to pay out is how they make their money.

But what if they’re wrong and their investment doesn’t pan out? They also generate a solid ongoing income stream from high costs that they are often built into annuities to charge for insurance “coverage” and riders.

These fees will be spelled out in the contract in some detail, but most purchasers of annuities lack the patience, time, or expertise to thoroughly review and digest the annuity disclosure documents (called a prospectus) that sellers are required by regulators to prepare and distribute.

One very important point to keep in mind is that annuities are highly complex instruments – no two forms are exactly alike.  Moreover, as contracts they are only as good or as bad as the language and the promises and the credit backing them up. As such it is critically important to read and be well aware of the “fine print.” 

In fact, an annuity is an intangible based on a promise to provide contractual financial payments in the future.  As with any contract, if you don’t have the time, interest, or expertise to thoroughly review the terms and conditions in the disclosure documents, it may be a good idea to consult an expert who knows what to look for and is watching out for your interests as a prospective purchaser.

Of course, for an investor who truly needs or desires the guarantees and or is unwilling or unable to make investments that could create greater income by cutting out the middle-man, annuities can definitely be worth considering as one of many options suitable for conservative investors.

Beware of High Fees, Expenses and Costs

High annuity fees can be quite a drag on the investor’s overall bottom line. Let’s look at this more carefully.

Fees associated with annuities can include investment management fees, rider charges, insurance charges, surrender charges, and perhaps a few more.

  • Management Fees. Especially important in a variable annuity, a management fee is often applied periodically when the annuity is invested in a stock or fund portfolio managed and monitored by the insurance company or their outside subadvisors. This fee can range anywhere from about .25% to well over 1%.  This fee is often “built-in” to the individual funds and so can’t be seen on your periodic statement in many cases.
  • Rider Charges. You can add a rider to the annuity for specific features that you deem important. For example, you might wish to have a cost-of-living adjustment made annually on your payouts. Riders will generally cost you extra money. Typically, rider charges can cost 1% or more annually.
  • Insurance charges. These fees are designed to cover the expense of providing and promoting the annuity coverage plus covering the cost of the guarantees provided in many annuities. Moreover, these charges can be quite high, often 1% or more.
  • Surrender Charges. Some, but not all, insurance companies make you pay a surrender charge if you want to get out of your annuity contract. Surrender charges can be steep, up to 7% in some cases.  A surrender charge is like paying a large fee just to get your own money back.  It is there for a very good reason: when the salesperson sells you the annuity, they need to be paid their commission check mostly upfront.  The insurance company however, needs time to use your money to recoup this sales cost which they expect to do over time as long as you leave your money with them.  If however, you want to pull out your money early, they need to recoup this cost so they often charge you a penalty – called a “surrender charge”.  Surrender charges generally decline over time (it is not uncommon for the level of surrender charge to decline each year and go to zero between 5 to 10 years depending on the annuity contract).

As you can see, when added up, the fees associated with many annuities can be steep indeed – sometimes in excess of 3% per year.  This is the reason that on after-fees basis and especially in a low interest rate world, fixed annuities often incorporate relatively modest income returns within their assumed projections.

Return on Investment vs Return of Investment

So if most fixed annuities are incorporating relatively low returns, especially after fees and expenses, why do the payments sound so attractive in the insurance company projections and the sales pitch?

This leads us to a critical point that relates to what portion of your annuity payments consist of returns on your investment in the annuity versus a return of your investment.  The important point to understand is that a significant portion of your payments may actually be return of your capital rather than return on your capital.

Let’s illustrate this point with a simple example.  Let’s say that someone age 70 purchases a $100,000 fixed annuity and in exchange is promised a stream of income of $800 per month for as long as they are alive.  In this example, $800 is just for illustration purposes and the actual number could be higher or lower depending on a variety of factors.  A simple calculation shows that the annuity purchaser will be getting $9600 of payments from this annuity, which sounds like a great deal and may even feel like a 9.6% return on the original investment.

However, remember that even with a 0% interest return, it would take more than 10.4 years to simply deplete the original principal amount of $100,000 that was invested.  Since in our example, we are illustrating a life annuity, our purported annuity purchaser would never even get their original money back unless they lived past 80.  Assuming some modest return rate – like 3 or 4%, the breakeven point just on the original principal plus interest would be pushed out by an additional 4 or 5 years.  Of course, those who live much longer than average  benefit as the lucky “winners” of the annuity lottery – getting back more than they put in by virtue of beating the odds and outliving everyone else.

It is important to realize that since annuity payments often end upon the occurrence of some event that is certain to happen but uncertain as to timing (such as death of one or more annuitants), it is critically important when evaluating an annuity contract to separate that portion of the annuitized payment that is likely to come from return of investment versus return on investment.

Only then can you truly make an apples-to-apples evaluation of the annuity option against other options such as investing the principal yourself or with the help of an experienced advisor and taking your own withdrawals from your money instead of doing it through an insurance company structure with its corresponding fees and expenses.

When are Annuities a Suitable Proposition?

Annuities can be a good financial product if you are buying them for the right reasons or for the right person.

An annuity can make sense if it has been thoroughly evaluated and is an integral component of a well-thought-out, long-term financial plan; you understand how it works; your fees and charges are relatively low or at least provide you significant value in exchange for the costs, and you know why you are buying it and doing so with a full understanding of what you are getting.

Another situation in which annuities can be a good fit is if the buyer is spendthrift, and has difficulty saving their income and/or really needs the safety of handing a significant sum over to an insurance company (hopefully a well run and conservatively managed one) whose promise in exchange for the lump sum can provide some security against what they would be likely to do with the money in the alternative.

Yet another situation in which an annuity can be interesting for some people is if they have reason to believe (or simply want to gamble) that they will be one of the longevity “winners” in the annuity pool.  If they live well in excess of the average life-span in the annuity pool they could receive more payments in their later years than they would have gotten otherwise.

In other cases, an annuity may not be the best choice for your money. Beware when someone is trying to persuade you to buy one without looking at your total financial picture. Typically it is not a great idea to buy one unless you have a well-crafted financial plan and buying an annuity really fits into it. Accordingly, don’t be coerced into buying one if an effective salesperson tells you that this particular annuity will be going away soon or if you feel pressured in any other way. 

Fixed Index Annuities and Annuity Taxation

Two other issues with annuities of certain types is that the complexity can obscure some meaningful drawbacks of certain annuity structures.  For example, Index Annuities or Fixed Index Annuities which are probably the most popular annuity by premium volume currently can feature interest crediting methods that are difficult to understand and perhaps even opaque. 

Specifically,  many of these annuities may be crediting based on a proprietary index or calculation formula that is designed to seem more advantageous than it is under a detailed financial analysis.  Some of the crediting formulas have “caps”, for example, that limit the upside that you will receive when the underlying index does particularly well – this can be an issue because capping returns can be quite expensive over time in the form of a much lower overall rate of return for a given index.

One of the reasons so many index annuities are sold is that they are regularly pitched at seminars or sold aggressively to buyers who are mostly unable to perform a thorough analysis of the products themselves.

Taxation of annuities is another potential drawback that many annuity buyers do not fully appreciate when buying them.  This is understandable, since many annuities are sold with the idea that they are tax advantageous to the buyer since the annuity structure creates a measure of tax deferral in that investment income generated inside the annuity contract is not immediately taxable. 

However, from a tax point of view, most non-qualified annuities do not get a step-up in tax basis to the date of death.   Assuming that the annuity was purchased with after-tax dollars, this means that the annuity beneficiary will have to pay taxes on the entire amount attributable to gain on the original investment.

Also, it will be taxed as ordinary income and not at the much lower capital gains rate that a normal non-annuity investment would have enjoyed along with the step up in basis at death.  This leakage from potentially unfavorable tax treatment at the back end offsets the tax deferral benefit at least in part and should be considering whether an annuity is the right solution for a given person.

Finally, there are some alternatives to annuities that might be worth considering.  In some cases, taking the lump sum you would have given over to an insurance company and investing it in a well balanced and diversified portfolio of stocks, bonds, funds, etfs and income real estate can be done at a lower cost and potentially generate higher total payments to the annuitant over time than an equivalent sized annuity might have done.

In some cases the difference can be tens of thousands or even millions in extra payments through the combination of dividends, interest and compounding based appreciation of an overall portfolio.

What If You Already Own An Annuity And Want to Evaluate Alternatives?

Armed with the information above, you now have a far greater grasp of the pros and cons of annuities than most and so are armed to make a far more informed decision in the future.

Some reading this may already have purchased one or more annuities that they already own.  In some cases, you may have realized that the fees and/or surrender charges or investment options in your existing contract(s) may not be giving you the best alternatives for your needs today.

Even if this is your current situation, do not worry or despair.  Even with existing annuities already in place, a good advisor can help you evaluate exactly what you have and identify opportunities for you to restructure your assets and even start doing better going forward.

Among the tools to consider in this case is 1035 tax free exchange from your existing annuity into a better or lower cost annuity option.  Another alternative may be to simply free your capital from a bad contract (as efficiently as possible) and start deploying that capital into a better place to start improving your investment portfolio one step at a time.

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