Although fixed, indexed and variable annuity contracts have been around for decades, many critics have panned them for having excessive fees and features that are often too complex for consumers to understand. Those who use these products tout their income guarantees and the security that they offer while paying higher rates than certificates of deposit (CDs) or Treasury bonds. But it is possible to invest in an annuity without getting soaked. The key lies in understanding how they work.

A Unique Product

Annuities stand alone in the investment world as the only vehicle that can grow tax deferred without having to be purchased inside an individual retirement account (IRA) or other retirement plan. However, some experts discount this feature, because all earnings that are generated in non-qualified annuity contracts must be taxed as ordinary income when they are withdrawn. Buyers also cannot access their contract funds before age 59½ without paying a 10% early withdrawal penalty (although certain exceptions apply). For these reasons, many planners recommend that annuities be purchased inside IRAs or qualified plans, where capital gains treatment is prohibited regardless of the type of investment that is used. Of course, a Roth IRA is the best place to use them, as all distributions from a Roth contract are tax free regardless of their source. Those who purchase nonqualified contracts can also reduce their expenses by simply waiting until retirement to take distributions and thus avoid the early withdrawal penalty.

Fees and Expenses

Most annuity contracts charge several different types of fees and expenses. Variable contracts that place the premiums inside mutual fund subaccounts will charge a mortality and expense fee on an annual basis as well as subaccount management fees and an annual contract maintenance fee. Indexed contracts may also charge an annual fee that is debited against the growth in the contract before paying the investor.

Most annuities also have a back-end surrender charge schedule that declines to zero after a certain amount of time, such as seven to ten years. These sales charges are often used to pay for the commissions that are given to their vendors. But most contacts also allow for a certain amount to be withdrawn each year without penalty, such as 10% or 20% of the contract value. These charges are also usually waived for events such as the death or disability of the annuitant or contract owner. Riders that offer guaranteed streams of income also usually come at an additional cost that is deducted from the contract value on a periodic basis. (For more, see: Annuities and Baby Boomers: The Pros and Cons.)

The Smart Way to Buy Annuities

To put it simply, the way to win with annuities is to stay in them for the long term. Consumers who want to secure their retirement savings or be able to count on a guaranteed stream of income can often get perks such as initial bonuses (sometimes as high as 12%) when they purchase a conventional annuity contract. The first question that a smart annuity buyer will ask themselves is whether there might be any real need to withdraw an amount from the contract that will exceed the allowed exception amount during the surrender charge period.

For example, a financial planner could show a client a contract that has a 15 year surrender charge schedule. If the client takes out more than 10% of the contract value in a given year during the next 15 years, then a surrender charge will be assessed on the excess amount. If the client feels that this will not be a possibility, then there is no real reason to balk at this feature in the product. Clients can also look at carriers that offer no-load products that do not have surrender charge schedules and have fewer fees. (For more, see: Retirement Portfolios: Adding Crucial Alternatives.)

The Bottom Line

Annuities are complex products that can do great things for investors who seek principal or income guarantees. But many of them also come with an array of fees and expenses that consumers need to understand in order to buy them intelligently. Investors who are seeking total liquidity are probably not good prospects for annuities, especially if they are under age 59½. For more information on how to avoid overpriced annuities, consult your financial advisor. (For more, see: The Pros and Cons of Hybrid Annuities.)