Annuities are often marketed as a safe and reliable way to secure income for retirement. However, while they can be useful in certain situations, they are not a one-size-fits-all solution. Plenty of annuity products are highly illiquid, costly, and inappropriate for many investors.
Let’s explore when they might be beneficial and when they could be a detriment to your financial planning.
When Annuities Might Be a Good Choice
At their core, Annuities are contracts with insurance companies that may promise a steady stream of income or some level of guarantee, making them attractive for risk-averse investors and retirees who worry about outliving their savings. There are several types of annuities to consider, and it can get quite confusing when trying to understand the terms and benefits. Here are a few of the most popular:
Immediate Annuities: You can convert a lump sum into guaranteed payments that start almost immediately. The payments are guaranteed for your life, and in some cases can continue to a beneficiary for a period of time after your passing.
Fixed Annuities: These offer a guaranteed interest rate over a set period. They may feel very similar to a bank CD, but are insured by the financial strength of the offering company, not FDIC. These products tend to be more popular in low-interest rate environments where CD’s and High-Yield Savings rates are not as attractive.
Fixed Indexed Annuities / Equity-Indexed Annuities: These are often marketed as “safe alternatives” to stocks, but they come with caps on returns, high surrender charges, and confusing payout structures. They do offer downside protection, but usually at a cost of limiting profits.
Variable Annuities: Invest in mutual fund-like subaccounts, with potential for growth but also market risk. These also can offer a limited level of downside protection thru use of “buffers” or “floors” that can limit losses. They offer tax-deferred growth, but withdrawals are taxed as ordinary income. Income riders can also be added to provide a guaranteed income benefit.
Registered Index-Linked Annuities: These are a sub-form of Variable Annuities that also offer limited downside protection, but also have corresponding caps or percentages on the growth of an index such as the S&P 500. They can offer greater growth potential by allowing the risk to be tailored to your preference.
Why Annuities Can Be a Bad Decision
Many annuities have comparatively high fees, restrictive terms, and limited growth potential. Let’s detail some of the biggest drawbacks that may cost you more than you expect.
High Internal Costs: Some annuities have mortality and expense (M&E) charges, rider fees, admin costs, and other things that build an expense ratio that is untenable and can eat away at your returns. For instance, Variable annuities can have annual fees anywhere from 2 to 4%.
Limited Liquidity: Most annuities impose surrender charges for withdrawing funds early lasting 7,10, and even up to 14 years. Consider your financial plan back in 2012 compared to today. Maintaining flexibility and having the choice to pull money if you needed is a luxury annuities lock away, making them undesirable for many.
Complexity and Lack of Transparency: Many annuities have complicated structures that make it difficult to understand their true costs and benefits. Perplexing terms and hard to find fees can trap investors in unfavorable contracts. For example, it is not uncommon for an annuity contract to include a clause that will reduce the rates of return below what was originally offered if economic conditions change.
Tax Inefficiency: While annuities offer tax deferral, their withdrawals are taxed as ordinary income rather than at lower capital gains rates. Maybe not a big deal for someone making less than $50,000, but for a high-net-worth investor, this could create an unnecessary tax burden.
Inflation Risk: Fixed annuities having no upward adjustments, and can erode your purchasing power over time.
Consider this: A 10yr fixed annuity that agrees to pay 3% annually in 2015 with no cost-of-living adjustment agreement or rider, would have not kept up with inflation over the past several years, essentially causing the funds to lose some of their purchasing power over time.
Loss of Capital: With some annuities, an annuitized annuity that has started the lifetime payout is only obligated to pay for the lifetime of the beneficiary, which means if that person passes prematurely, the insurance company keeps the whole value of contract.
For example, a $500,000 annuity with a life-only option has started paying monthly payments of $2500/mo – guaranteed for the life of the annuitant. If the annuitant dies prior to depleting the full $500,000, the insurance company that issued the annuity keeps the remaining funds.
Let’s Pull Back the Curtain: How Are Financial Advisors and Insurance Agents Paid on Annuities?
Unfortunately, one of the reasons we find annuities are heavily promoted is due to the high commissions they offer to financial advisors and insurance agents. Unlike traditional investment products like Index Funds or even ETFs, annuities generate significant upfront, and even ongoing, compensation for the salesperson.
An advisor or agent offering annuities could expect to be paid handsomely with upfront commissions. Fixed annuities can pay upwards of 4% on the investment amount, while Indexed, Variable, and Deferred annuities can pay anywhere from 3% to 10% of the investment amount.
Consider this: A $500,000 annuity can possibly pay a commission between $15,000 to $50,000, providing quite a lucrative payday for the advisor or agent.
Ongoing Fees are also a benefit for the advisor or agent. Some annuities provide trailing commissions, which are annual fees paid to advisors for as long as the annuity remains in force. These typically range from 0.25% to 1% per year and create an incentive for advisors to keep clients locked into the product.
Many annuities offer optional riders, such as income guarantees or death benefits, which add to the overall cost. These additional features increase the total fees and can also generate additional commissions for the advisor.
Three Key Questions to Ask When Offered an Annuity
- How much are you making from this sale? A Fiduciary Advisor should be transparent about the upfront commissions and any trailing commissions.
- Are there surrender charges, and for how long? Consider long surrender periods of 7 years or more to be a serious red flag.
- Ask yourself, “Do I completely understand the fees, terms, and limitations? If the annuity terms and limitations are too complex to understand, or if the salesperson doesn’t explain them clearly, consider walking away from the idea.
What Are there lower-cost alternatives?
Many times, simple investments like stocks, bonds, mutual funds, and ETFs are a more flexible and cost-effective alternative. Most Advisors and Agents that solely offer annuity products lack the needed securities license requirements to offer many other alternatives, so be informed on what other choices they offer, if any.
Many Registered Investment Advisors (RIAs) have access to Advisory Annuities that offer better rates, lower surrender charges and lower costs than commission-based products because they don’t charge commissions, but the advisor may charge a fee off the value of the annuity itself.
So Are Annuities Good or Bad For A High Earner?
Well, that truly depends on if they are the right fit for your financial situation, as well as if they provide some comfort on the way you feel about your investments. We all need to be able to sleep at night when we consider our investments and retirement planning.
A primary win for a high-earner investor is contributions to annuities are unlimited and allow for tax-deferred growth compared to the maximum contribution limitations that 401ks and IRAs have.
Annuities can surely serve a purpose for those who feel they need a guaranteed income and don’t require liquidity, but you also need to be willing to accept the limitations they may come with.
For high-earning investors with a conservative mindset that are not willing to accept the unpredictability of the stock market, there are annuity products that limit risk and put guardrails on market volatility.
Just remember, annuities are often loaded with fees, restrictions, and tax inefficiencies that make them a poor choice for most investment situations when compared to cheaper and more efficient alternatives.
Many Registered Investment Advisors (RIAs) have access to Advisory Annuities that can offer better rates, lower surrender charges, and lower costs than commission-based products.
Because they don’t charge commissions on these annuities, it may sound favorable over other options. However the RIA Advisor will charge an annual advisory fee based on the value of the annuity itself, and you would still have most of the same risks such as the lack of liquidity and inflation risk.
Once established, annuities really have little to no maintenance items for an Advisor to manage until they annuitize or the contract ends.
If you’re considering an annuity, it’s always best to work with a Fiduciary Advisor who is legally required to act in your best interest. This can help ensure you avoid mistakes that could cost you and future generations.
