Pitfalls of Annuities

Buyer beware!  Annuity salespeople are out in droves. They are conscious that volatility in the stock market over the last couple of years has made some investors approaching retirement reluctant to stomach the ups and downs of their investment portfolios. The allure of a lifetime stream of income to combat investment uncertainties is very tempting, but it comes at a steep price.

As some wise person once said, “Annuities are sold, not bought.” The insurance salesperson or financial advisor will earn a lucrative commission for selling you this product. If you get past the salesperson’s self-interest before buying an annuity, you first need to realize what it is. An annuity is a complicated insurance product. Therefore, the buyer must be familiar with the contract to avoid any potentially unpleasant future surprises.

The most universal drawbacks of annuities are high fees and costly penalties. The upfront cost can average from 4%-8% due in part to the high commission paid to the salesperson. As a function of the annuity’s fee structure, the annuity’s value can start well below the buyer’s initial investment. In some cases, the first year's return will simply be recouping the upfront costs. There are also mortality and administrative fees that cover premature death, record keeping and accounting. These fees can range from 2%-3% of the annuity’s value annually. Annuities have surrender charges which limit the liquidity of the annuity assets for the owner.

These penalties are applied to withdrawals made from the annuity during the surrender period. These charges can be as high as 8% the first year and might reduce by 1% annually for the next eight years. The typical surrender period lasts six to eight years. Additionally, the IRS will assess a 10% early withdrawal penalty if the owner is under 59 ½ when taking a withdrawal.

Insurance salespeople highlight the tax deferral benefit offered by annuities, which can make them appear attractive when it comes to taxes. However, annuity withdrawals are taxed as ordinary income, not capital gains. When comparing the two tax rates, the ordinary income marginal tax rate for middle-income households ranges from 22% to 35%, whereas the long-term capital gains tax is 15%. Another drawback is that annuity withdrawals use the Last In, First Out method for taxes. This means that all the taxable earnings are withdrawn first before any of the tax-free principal.

Also, unlike stocks, bonds, mutual funds, and real estate annuities do not have a step-up in cost basis to reduce the tax liability to heirs, if they retain any value at all. For example, if an annuity was purchased for $10,000 and had a death benefit of $20,000, the beneficiaries would have to pay tax on the $10,000 in gains at their ordinary income tax rate.

Another selling feature for annuities is the claim of guaranteed income for life. An annuity's guarantee is only as good as the financial strength of the insurance company offering the annuity. Annuities are not insured by the FDIC like bank accounts or SIPC for brokerage accounts. If an insurance company fails, it will either be taken over by another insurance company or policies will be covered by the state guaranty association. Each state sets their own coverage limits.

Also, the guaranteed income feature is only triggered when the annuity owner “annuitizes.” The positive aspect of annuitization is that the annuity owner will receive a series of periodic income payments, usually for their own life and the life of a surviving spouse in the case of a joint life arrangement. However, upon their death, the remainder of the annuity is kept by the insurance company.

If market volatility has you concerned, and you are looking for alternatives. Provident Investment Management can help by introducing dividend-paying stocks and bonds to your portfolio, resulting in less volatility and likely greater returns and lower costs than an annuity.

If you are still interested in an annuity, it is critical to read the prospectus thoroughly and understand all the ins and outs along with the fee structure before signing the contract.

Dan Krstevski, CFP ®