It’s a typical story I see play out time and time again, whether with new clients, longtime neighbors, or business contacts. I tell them I’m a financial advisor, and we start talking about money, investments, and eventually retirement. They say to me, “I also have this thing… I think it’s called an annuity? My guy at (fill in the name of a large broker dealer) told me it would make my retirement easier.”
That statement often makes me pause and take a deep breath. Why? Because I know that annuities are far from the simple, cure-all retirement solution they’re often presented as.
I’ll start with the spoiler alert: I (mostly) hate annuities. In my fifteen years in wealth management, I have yet to be excited about an annuity a new client shows up with. I’ve only recommended an annuity in a small handful of cases. Nine times out of ten, I think of annuities as a hammer in search of a nail. They are products that are hocked as solutions, unnecessarily complicated for consumers, extremely restrictive, and generally quite expensive. Those are four big negatives that are hard to overcome.
But the careful reader will note my use of the word “mostly”. I concede that there are circumstances in which annuities can be useful. But how is a consumer to know when that’s the case? What should you be aware of with annuities, and most importantly, how do you know if an annuity is right for you?
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What is an Annuity? Understanding the Basics of This Retirement Product
Let’s start with the facts. An annuity is essentially an insurance product. Insurance agents, financial advisors, and brokers who work on commission often sell them as a retirement tool. Their claim to fame is the promise of stability – a stable income stream that is partially or wholly insulated from market movements. You put some money into an annuity, and then at some point, that big chunk of money turns into regular payments back to you.
Some annuities track the stock market, others don’t. Some pay out immediately, while others won’t pay out for decades. Some have riders that offer benefits while the owner is alive, and other benefits when an owner dies. There are also many types of annuities that all behave differently, so it’s important to understand that each type has its own risks, advantages, costs, and restrictions. If I went through every kind of annuity and customization possible, I would definitely lose you as a reader – so let’s focus on the pros and cons of these products.
The Hidden Costs of Annuities: Fees That Can Eat Away Your Retirement Savings
Annuities offer many different options, and none of them are cheap. If an annuity promises to insulate you from the downside of market movements, you can be assured that they will charge you a pretty penny to do so. When you start layering on the administrative fees, investment fees, rider/add-on fees, and mortality fees (to name a few), the numbers really add up. And if you want to get out of your annuity? Prepare for surrender fees, which can cost around 7% of your investment!
Decoding Annuity Complexity: Why These Contracts Are So Hard to Understand
I’ve seen annuity contracts that are nearly 100 pages long. That alone should give any consumer significant pause. What’s in all that fine print? Why do we need so many disclosures, graphs, exclusions, and riders? How does the annuity actually work? These are designed to be custom products, and few people fully understand how they work under different circumstances. Participation rates, yield caps, surrender fees… these products come with a whole new vocabulary set. Not to mention that once you’re in, there are very strict rules and costs associated with getting out.
Before signing an annuity contract, there are some important steps to take:
- Read the entire contract: Yes, all 100 pages. If you don’t understand something, ask questions. Don’t sign until you fully comprehend what you’re getting into.
- Get a second opinion: Consult with a fee-only financial advisor who doesn’t sell annuities. They can provide an unbiased assessment of whether the annuity is truly in your best interest.
- Understand the fees and liquidity restrictions: Ask for a clear breakdown of all fees associated with the annuity, including administrative fees, mortality and expense fees, and rider fees. Also, understand the surrender charges and when they apply. Make sure you won’t need the money during the surrender charge period, and that you’re comfortable with the liquidity restrictions.
- Compare alternatives: Ask how the annuity compares to other investment options. Could you achieve similar results with a more flexible, lower-cost strategy?
- Understand the tax implications: Consult with a tax professional to understand how the annuity will affect your tax situation, both now and in the future.
Remember, an annuity is a long-term commitment. Take your time, do your homework, and don’t let anyone pressure you into making a decision before you’re ready. If an agent or advisor is pushing you to sign quickly, that’s a red flag. A good financial product will stand up to scrutiny and careful consideration.
Annuities vs. Direct Investing: Why Your Returns Might Suffer
Some annuities, such as indexed annuities, offer a way to participate in market gains while providing protection against losses. However, this apparent win-win comes with a significant catch. While annuity companies shield you from market downturns, they also limit your potential gains when markets perform well. This cap on returns is how these companies manage their risk and ensure profitability.
It’s important to remember that despite short-term volatility, markets tend to rise over extended periods. While annuities might provide a sense of security for risk-averse investors, this peace of mind often comes at the cost of substantially reduced long-term growth potential. In many cases, investors may find that a well-diversified portfolio of stocks and bonds can offer a better balance of growth and stability compared to the limited upside of most annuities.
The Impact of Annuities on Taxes and Estate Planning
When it comes to estate planning, annuities present some significant drawbacks that are often overlooked in the sales pitch. To understand why, let’s compare them to other types of assets you might leave to your heirs.
Most taxable assets receive what’s known as a “step-up in basis” upon the owner’s death. This means the cost basis of inherited assets is adjusted to their fair market value at the time of death. It’s a powerful tax benefit that can substantially reduce capital gains taxes for your heirs when they eventually sell the inherited assets.
Annuities, however, don’t enjoy this advantage. Instead, they come with a tax burden that can take a big bite out of your beneficiaries’ inheritance. When your heirs cash out an inherited annuity, they’ll owe taxes on the growth – and at ordinary income tax rates, not the lower capital gains rates that apply to many other investments. This difference in tax treatment can result in a significantly larger tax bill, potentially reducing the value of the inheritance by thousands of dollars.
These tax implications make annuities one of my least favorite tools for estate planning. While they may offer some benefits during your lifetime, they can create unnecessary tax complications for your heirs. For most people, there are more tax-efficient ways to leave a legacy that don’t compromise the value of the assets you’ve worked hard to accumulate.
When Annuities Might Make Sense: Three Potential Use Cases
1. Insurance against living too long
If you think about life insurance as guarding against living too short, annuities can provide assurance that you will not outlive your money. While I believe good financial planning and investing can accomplish this, annuities can provide peace of mind for some truly skittish investors. If this is something you’re truly guarding against, then a very deferred income annuity that starts at age 80+ could do the trick. But remember, these are expensive, and buying this product may cause tradeoffs in your lifestyle before you start collecting.
2. Protecting a spendthrift
Occasionally in my practice, I’ve encountered inheritors who are in no position to manage their own money. Whatever comes into the bank account goes out. If there are no other options for helping that individual from draining their investment account, an annuity can be a solution to save them from themselves.
3. Tax deferral, emotional support, and investment downside protection
All of these things are bundled together under the category of “worth mentioning but not worth their cost” in my opinion. Annuities can grow in a tax-deferred way until one annuitizes, which is advertised as a benefit. Because there are minimums and caps with annuity performance, this can provide some investors peace of mind. And when markets fall, that investment downside protection can feel good. But I think there are better (and cheaper) ways to achieve investment success.
Making an Informed Decision: How to Determine if an Annuity is Right for You
While annuities aren’t suitable for everyone, they can play a role in specific financial situations. Do your homework and be aware if the recommendation is coming from someone who stands to profit from selling you an annuity. Take your time and get a second opinion from a fee-only, CERTIFIED FINANCIAL PLANNER™ (CFP®) who doesn’t sell annuities to get an unbiased perspective. CFP® professionals receive comprehensive training on annuities and can provide insights tailored to your unique financial situation.
Remember, annuities are complex products with long-term implications that are often easy to get into but difficult and costly to exit.
