Annuities may have looked like an ideal retirement vehicle at one time. You put in a lump sum or made periodic deposits, the principal is guaranteed with an insurance benefit, and the headline in the brochure claims you receive $4,000 a month for life. When you factor this in with Social Security, it seems like a reasonable amount to live on in your later years. But annuities have lost some of their glow. There are several reasons behind 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 generally lower-returning mutual funds underpinning most of them. Annuities are no exception, and they are subject to uncertainty brought on by such things as stock market volatility.
- Annuities are financial products that provide individuals with a steady fixed stream of income in the future, usually during retirement.
- Their popularity has dropped primarily because of 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 on earnings are deferred, and there are no investment limits.
- The SECURE Act also allows investors to invest in annuities via their 401(k).
What Makes Annuities Attractive?
Annuities are investment products that pay a fixed stream of income to investors in the future. They offer a simple menu for people who are absolutely disinterested in managing their own finances, especially when it comes to retirement planning. The participant must make only three decisions:
- Lump-sum or periodic payments or contributions
- Deferred or immediate income
- Fixed or variable returns
Many investors choose variable over fixed annuities 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 are re-evaluated due to market variances. As such, contracts simply can’t guarantee 6% if the fund manager is only making all-in yields of 5%.
The old joke about annuities is that you make a fortune on the headline, then the fine print takes it all back. In many cases, this hasn’t been far from the truth. Introductory rates on car loans could be 0% interest and are indeed much like loss leaders in a supermarket promo. But those large promises suddenly evaporate after the first six months or year, when rates are adjusted, and fees begin to kick in.
Here are a few of the fees that can be buried deep within an annuity 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 make withdrawals, the Internal Revenue Service (IRS) gets 10% and the contract writer nets a surrender charge between 5% and 10%. Keep in mind that 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 pre-tax 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 the 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
- Can invest in annuities via 401(k)s thanks to the SECURE Act
Is an Annuity a Good Investment?
The answer depends on you and your personal situation. As with any investment, there are pros and cons to annuities. They provide a steady stream of income for investors later in the future, usually during retirement, and are well-suited for people who don't want to deal with the intricacies that come with investing. But there are some drawbacks to these products. For instance, there are hidden fees that take away from any returns you may generate, including commissions, underwriting fees, and taxes.
How Do Annuities Work?
Annuities are financial products that allow investors to put aside a lump-sum deposit or periodic payments to use as income later in the future—usually during retirement. Investors can choose between deferred or immediate income and fixed versus variable returns. The money set aside grows over time. But there are fees involved, including commissions and taxes. And there are penalties you pay if you decide to make early withdrawals.
What Are the Different Types of Annuities?
There are several different types of annuities. Deferred annuities begin paying out after a certain age while immediate annuities start to pay the investor income after they deposit a lump sum of money. Fixed annuities provide consistent payments to the investor over the life of the contract. On the other hand, variable annuities (which most people opt for) pay the investor larger sums when the fund does well and smaller payments when they do poorly.
The Bottom Line
After considering all the 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 so make sure you do your research. You can buy annuities below your state's protection limit from several companies 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.