Baby Boomers and others planning for retirement are a prime target for those who sell annuities. Annuities are touted as an alternative to the volatility of the stock market, a source of tax-deferred retirement savings growth and a vehicle to ensure income in retirement. Depending upon the type of annuity and the contract’s features an annuity may have those and other beneficial features.
On the other hand, many annuities come with high imbedded fees that can serve to mitigate their benefit. Before writing a check for an annuity Baby Boomers need to look at the pros and cons of the product they are bong sold. (For more, see: Boomers: Twisting the Retirement Mindset.)
Degree of Certainty
In an increasingly volatile world, annuities can provide some certainty in terms of receiving a defined stream of payments over a specified time period. Once the decision to annuitize is made there’s no guesswork about the payment that will be received or the time frame over which it will be received.
An annuity can allow for the tax-deferred growth of the money invested. This is most applicable for a variable annuity which has a number of sub-account alternatives that are essentially like mutual funds. An after-tax or non-qualified annuity is purchased with after-tax dollars and then grows tax-deferred until the money is withdrawn or annuitized. The portion that pertains to the original investment is not subject to tax. The gains are taxed as ordinary income. An annuity can be a good alternative for investors who have maxed out contributions to tax-deferred retirement accounts such as a 401(k) or an individual retirement account (IRA). (For more, see: Best Strategies for Managing Taxes on Distributions.)
Another Leg on Retirement Income Stool
An annuity can be another vehicle to provide retirement income. A retiree may have money in qualified retirement accounts such as an IRA or 401(k), taxable investments and may be eligible for a pension or Social Security. An annuity can offer another source of regular income if needed. Immediate annuities can offer a decent substitute for retirees who do not have any sort of pension from their employer. Some contracts offer guarantees regarding the level of the contract’s principal, some are included as part of the contract others offer these guarantees as riders at an extra cost.
High and Confusing Fees
Annuities also have their downsides. There are often multiple layers of fees in an annuity and these will vary with the company and the type of annuity in question. In a variable annuity there are fees related to the underlying sub-accounts that are similar to the expense ratios of a regular mutual fund. In a fixed annuity the underlying fees are typically the spread between the net interest rate that contract holders receive and the gross interest rate earned by the insurance company. In the case of an indexed annuity product the fees are confusing and often hard to decipher. I’ve had insurance agents who sell these contracts tell me that there are no fees with indexed annuities. Whatever they are called there are internal expenses in these contracts that compensate the selling agent and the insurance company quite well. (For more, see: Watch Your Back in the Annuity Game.)
Mortality and expense charges are fees assessed by the insurance company to cover their costs for guaranteeing a stream of income should the contract holder decide to annuitize the contract. There are wide variations in these and other fees from insurance company to insurance company. Additionally contract holders pay the mortality and expense charges whether or not they ultimately decide to annuitize.
Surrender charges are “handcuffs” designed to keep contract holders from withdrawing their funds for a period of time. Insurance companies and agents will claim that these fees prevent bad behavior on the part of contract holders. In reality they prevent them from moving their money if they find a better product elsewhere. (For more, see: Passing the Buck: The Hidden Costs of Annuities.)
Who is Behind the Annuity?
Annuities are guaranteed by the full faith and credit of the insurance company who issued the contract. This is not necessarily a bad feature unless the company has financial problems. The instances of annuity providers defaulting are rare, but a contract holder’s remedy lies with the appropriate state insurance commissioner. In this era of fiscal problems with many state governments, this is not something to take for granted. Additionally, there are often limits as to how much per contract will be paid by the state.
Loss of Control
Once an annuity is annuitized and the contract holder begins to receive monthly payments they surrender all control of the money to the insurance company. There is no option to receive more money should the contract holder’s financial situation deteriorate, there is no lump-sum to leave to their heirs and unless the contract offers it (at an extra cost) there in no protection against inflation. (For more, see: Taking the Bite Out of Annuity Losses.)
Any gains from an annuity are taxed as ordinary income. There is no preferential capital gains treatment as with investments held in a taxable account. If the contract is not annuitized and partial withdrawals are taken the first money out is assumed to be gains and will be taxed until that layer is gone. If a contract is annuitized than a proportional share of each payment will be fully taxable. This is based upon the percentage of the contract that represents the cost basis and the portion that represents investment gains.
No Step Up in Basis
When an individual dies, assets such as stocks, mutual funds and exchange-traded funds (ETFs) that are held in a taxable account receive a step up in basis when passed on to the person’s heirs. In other words, the new cost basis is the value of the investment at the date of death. The advantage is that there is a higher cost basis with less potential capital gains taxes should the heirs decide to sell the inherited securities. There is no step up in basis on an annuity even if there is appreciation inside the contract. As previously mentioned, all gains on an annuity are taxed at ordinary income rates, there is no preferential long-term capital gains treatment. (For more, see: How to Buy Annuities When Interest Rates Are Low.)
The Bottom Line
Various types of annuities are marketed toward Baby Boomers continuously. An annuity may have a place in a retiree’s toolkit for retirement income. An independent financial advisor, who is not compensated by selling annuities, can be a great help to clients in both helping them determine if an annuity is appropriate and in shopping for the best product to meet their needs. (For more, see: Top 10 Investments for Baby Boomers.)