Passing the Buck: The Hidden Costs of Annuities

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 seems like plenty 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 unknown effects of the recent Republican tax bill and the extreme stock market volatility of early 2018.

Why Are 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 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 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 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, 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.

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 quality of 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). For example, you can buy annuities below your state's protection limit from several companies, instead of buying just one larger annuity from a single company. Know that 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.