As I mentioned in my last article, very few topics in the world of personal finance generate as much heat as annuities do. If you listen to the personal finance experts on TV, annuities are the very devil. If you listen to many financial advisors and insurance salesman, they are the greatest thing since sliced bread.
The reality about annuities, as is the case with most things in life, lies between those two extremes. It helps to view annuities as financial tools, just like mutual funds, ETFs or CDs. Given the right circumstances, an annuity might be just the tool for the job.
In this article, I’m going to give you my top three advantages to annuities as well as my top three disadvantages.
Advantage #1: Low Risk Tolerance
Nobody likes opening their investment statement and seeing losses. But some people can handle it and others cannot. If you are among the latter group, then you may want to consider an annuity. A fixed annuity or a fixed indexed annuity guarantees that you won’t have investment losses. Variable annuities will lose money just like mutual funds and other securities. However, you can add living benefit riders that provide guarantees that can potentially offset this risk. Some guarantee a certain minimum rate of return for a certain number of years, after which time you must begin taking an income stream. The insurance company specifies how much you can take out. As long as you don’t exceed that amount, your income is guaranteed for your lifetime.
Advantage #2: If Longevity Runs in Your Family
If you think you may live to a ripe old age, then you may want to consider an annuity that offers a guaranteed lifetime income. Immediate annuities are worth a look. Also, you could check out fixed indexed or variable annuities with lifetime income benefit riders. When an insurance company prices annuities, they start by looking at mortality tables. The Annuity 2000 mortality table shows that a 65-year-old male has a 50% probability of living another 20 years, and a 65-year-old female has a 50% probability of living another 23 years. If you think you might live longer than that, an annuity may be a good deal. (For related reading, see: Life Expectancy: It's More Than Just a Number.)
Advantage #3: Tax Benefits
Annuities are tax-deferred investments, meaning that you don’t pay taxes until you withdraw money from them. It’s worth noting that I’m specifically referencing a non-qualified annuity. Some people put annuities into IRAs or other retirement plans which fall under different sections of the tax code. When you do pull money from an annuity, any gains are taxed first at ordinary income tax rates. Once the gains are withdrawn, then your principal comes out tax-free. If you have an immediate annuity the tax benefits are even more pronounced. There are other investment vehicles that offer tax benefits that probably deserve your attention before annuities, such as traditional IRAs, Roth IRAs, 401(k)s and other qualified retirement plans. If you are fortunate enough to have already maxed out your retirement plans and you are in the 25% tax bracket or higher, you may want to consider an annuity. Be careful, however, if you are under 59.5. If you withdraw money prior to that age, gains will be taxable as income and will also be assessed a 10% penalty. (For related reading, see: Immediate Annuities: More Income and Lower Taxes.)
Disadvantage #1: High Fees
While fixed and immediate annuities don’t have fees, variable annuities do. I’m seeing a lot of fixed indexed annuities tacking on fees lately as well. Variable annuity fees typically range from high to very high. According to Morningstar, the average variable annuity charges 2.35%. In addition, living benefit riders increase the average annuity expenses to 3.4%. There can be other fees for enhanced death benefit riders as well. One annuity contract I analyzed had annual fees of 5%. With fees that high, it’s hard to get ahead.
Disadvantage #2: Liquidity
It’s difficult to get your hands on your money once you invest in an annuity. With immediate annuities, there typically is no liquidity. You give your money to the insurance company in exchange for a guaranteed income stream. The decision is irrevocable. With deferred annuities, there is a surrender charge period, ranging from three to 20 years. Most typically cluster around 10 years. The annuity company usually allows you to withdraw up to 10% of your money after the first year without surrender charges. While that should take care of most income needs, you need to be sure you won’t need more than that.
Disadvantage #3: Changing the Rules
I have four daughters, and sometimes it is fascinating to watch them play games. Often, the oldest will make up the rules, which inevitably means that the deck is always stacked in her favor. But, every once in a while, her sisters start beating her at her game, so guess what she does then: She changes the rules. Although I can’t prove it, I sometimes think some annuity companies do the same thing. It seems to happen most often with fixed indexed annuities. The company offers a product that is incredibly competitive. Then, once they’ve attracted a lot of money to it, they raise the fees or lower the caps, which essentially lowers the potential interest rate you can earn.
So, are annuities right for you? Only you can answer that. For some, the benefits outweigh the drawbacks. For others, the disadvantages are insurmountable. Many of my clients have no money in annuities. Some of my clients have a portion of their money in annuities. I certainly don’t think anyone should have all their money invested in them. As with anything else in the world of finance, due diligence is always the key.
(For more from this author, see: 4 Mistakes to Avoid if You Want Retirement Income.)