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—which, along with Social Security, seems like a reasonable amount to live on in your later years. However, annuities have somewhat lost their glow. There are several reasons for this, including:

  • Market performance
  • Fine print on returns
  • Hidden costs

Every retirement vehicle (to be fair to annuities) has become less certain due to the generally lower-returning mutual funds underpinning most of them. Annuities are no exception. They are subject to uncertainty brought on by such things as the stock market volatility of late 2018.

Key Takeaways

  • Annuities have lost some of their luster primarily because of their market performance, the fine print on returns, and their hidden fees.
  • Fees can include underwriting, fund management, and penalties for withdrawals prior to age 59½, among others.
  • These retirement vehicles may still be attractive because record-keeping requirements are light, taxes are deferred on your money as it grows, and there are no investment limits.

What Makes Annuities Attractive?

For people absolutely disinterested in managing their own finances, annuities offer a simple menu. The participant must make only three decisions: lump or periodic inputs (contributions), deferred or immediate income, and fixed or variable returns. Many investors have chosen variable annuities over fixed ones at times, usually when roaring mutual funds meant 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 year, when rates are adjusted and fees kick in.

Here are a few of the fees that can be buried deep within an annuities contract—or not shown at all:

  • Commission: An annuity is basically insurance, so some salesperson gets a cut of your return or principal for selling you the policy.
  • Underwriting: These fees go to those who take actuarial risk on the benefits.
  • Fund management: If the annuity invests in a mutual fund, as most do, the management fees are passed on to you.
  • Penalties: If you are under age 59½ and need to pull out your contributions, the IRS will get 10%, and the contract writer will ask for a surrender charge between 5% and 10%, though this charge often drops the longer you hold the annuity. 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, you could be in trouble.
  • Tax opportunity cost: After-tax dollars that you invest in an annuity do grow tax deferred. However, the benefits cannot compete with putting pretax dollars into your 401(k). Annuities should begin only where your 401(k) ends, once 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.

If you want to transfer funds to another insurance company without penalty, let your accountant handle the transaction—receiving the check yourself could cause trouble.

Reasons to Invest in Annuities

After all the downsides and hidden costs, there are still a few upsides:

  • No heavy record-keeping requirements
  • Deferred taxes on your growing money
  • 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 company behind the contract isn’t sound.

There are some state protections for some annuity funds, but they are limited (and worth researching for your state). You can buy annuities below your state's protection limit from several companies, for example, instead of buying just one larger annuity from a single company. But if you move from a state with a high limit to one with a lower limit, your new state's level will generally apply should the annuity fail after you move.

Low fees and high-quality writers increase the safety of your contribution and your chance of long-term happiness with your annuity.