At one time, annuities may have looked like an ideal retirement vehicle: you put in a lump or periodic sum, the principal is "guaranteed" with an insurance benefit and the headline in the brochure claims you'll receive "$4,000 a month for life" - this seems like plenty to live on in your golden years. However, annuities have somewhat lost their glow. There are several reasons for this, including:
- Market performance.
- "The fine print" on returns.
- Hidden costs.
Every retirement vehicle (to be fair to annuities) has become less certain due to the less predictable, lower-returning mutual funds underpinning most of them. Annuities are no exception. Global uncertainty, brought on by the crisis in Europe and events such as the 2008 recession, is a good indicator of this fact.
Why Are Annuities Attractive?
For people absolutely disinterested in managing their own finances, annuities offered a simple menu. The participant must decide on only three things: lump or periodic inputs (contributions), deferred or immediate income, and fixed or variable returns. Many investors have chosen variable over fixed annuities at times, when roaring mutual funds usually mean high returns compared to the conservative and seemingly "safe" fixed option.
In the fine print, "fixed" usually means the returns will be re-evaluated in one to five years due to market variances. Contracts simply can't guarantee 6% if the fund manager is only making all-in yields of 5%.
Why Have Annuities Lost Their Glow?
The old joke about annuities is that you make a fortune on the headline and then the fine print takes it all back. In many cases, this hasn't been too far from the truth. Introductory rates may be like 0% interest on car loans, and are indeed much like loss leaders in a supermarket promo. Those large promises suddenly evaporate after the first six months or a year when rates are adjusted and fees kick in.
Here are a few of those fees that can be buried deep within an annuities contract, or not shown at all:
An annuity is basically insurance, so some nice salesperson gets a cut of your return or principal for selling the policy to you.
These fees go to those who take actuarial risk on the benefits.
- Fund Management
That's right, if the annuity invests in a mutual fund as most do, the management fees are passed on to you.
If you are under 59.5 and need to pull your contributions out, the IRS will get 10% and the contract writer will ask for a "surrender charge" between 5 and 10%. Better writers have declining surrender fees at a lower percent, and allowances for 5 to 15% emergency withdrawals without penalties.
You cannot borrow against your contributions, but Uncle Sam will let you transfer the funds to another insurance company without penalty. However, let your accountant handle this. If the check comes to you first, then you could be in trouble.
- Tax Opportunity Cost
Granted, annuities are one of the few remaining dinosaurs in the endangered species known as tax shelters. However, producers advertising them as "tax deferred" may not be quick to tell us that this is not the same as a 401(k) tax benefit.
Even if the annuity manager is careful to meet all the regulations that allow your (after-tax) dollars to return deferred, the benefits cannot compete with putting pre-tax dollars into your 401(k). Any investment like an annuity should begin only where your 401(k) ends, when you've maxed out on contributions. This is doubly true if your employer is matching contributions.
- Tax on Beneficiaries
If you leave your mutual fund to your kids, the IRS allows them to take advantage of a step-up valuation, or the market price of the securities at time of transfer. This doesn't work with annuities, so your beneficiaries are likely to be charged taxes at the gain from your original purchase price. There are ways to soften this blow with estate planning.
Reasons to Invest in Annuities
After all the downsides and hidden costs, there are still a few upsides:
- No heavy record-keeping requirements.
- A legitimate tax shelter.
- Tax-free transfers between annuity companies.
- No investment limits.
The Bottom Line
After all consideration of pros and cons, it's important to remember that your entire investment in an annuity, or much of it, can be lost if the quality of the company behind the contract isn't sound. Low fees and high-quality writers increase the safety of your contribution and long-term happiness with your annuity.
Mutual Funds & ETFsFind out about the Vanguard Small-Cap Value ETF, and explore detailed analysis of its characteristics, suitability, recommendations and historical statistics.
Mutual Funds & ETFsLearn about the Vanguard Intermediate-Term Corporate Bond ETF, and explore detailed analysis of the fund's characteristics, risks and historical statistics.
Technical IndicatorsMarket bottoms often carve out classic volume patterns that let observant traders make fast and accurate calls.
Mutual Funds & ETFsExplore detailed analysis and information of the top three Swiss exchange-traded funds that offer exposure to the Swiss equities market.
RetirementIf your business has receiveables, here's a smart way to leverage them to build up your retirement fund fast.
Investing NewsWhen you business is built on prudence and trust, a lot can go wrong to cost you tons of clients and assets. Here are a few examples.
Mutual Funds & ETFsLearn about the iShares JPMorgan USD Emerging Markets Bond fund, which invests in bonds of sovereign and quasi-sovereign entities from emerging markets.
Mutual Funds & ETFsLearn about some of the most popular and best performing mutual funds that offer investors exposure to the important emerging market economy of China.
Investing BasicsAn unrealized gain occurs when the current price of a security exceeds the price an investor paid for the security.
Investing BasicsA treasury note is a U.S. government debt security that offers a fixed interest rate and a maturity date that ranges between one and 10 years.
A security that tracks an index, a commodity or a basket of assets ...
A financial instrument that represents an ownership position ...
A bond that is issued for less than its par (or face) value, ...
The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
A performance measure used to evaluate the efficiency of an investment ...
A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity ...
The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
Non-qualified variable annuities are tax-deferred investment vehicles with a unique tax structure. After-tax money is deposited ... Read Full Answer >>
The maximum Social Security disability benefit amount for a single eligible person in 2015 is $1,165 per month, but you can ... Read Full Answer >>
You can roll qualified variable annuities, such as other qualified retirement plan accounts, into a traditional IRA. Non-qualified ... Read Full Answer >>
Variable annuities are insurance contracts that provide tax-deferred growth of assets that can later generate a guaranteed ... Read Full Answer >>
The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>