Financial planners, insurance agents, and stockbrokers have been investing their clients’ retirement money in annuities for decades. That practice has its detractors, with the criticism focusing on the high commissions paid to their advocates and the high fees charged to investors in annuities compared to other choices for individual retirement account (IRA) savings.

There's one more concern to add, though: Many people who invest their IRAs in annuities don't understand how they work until after they retire, and it may come as a rude surprise when they do.

Key Takeaways

  • When you invest in an annuity, you're buying up-front a series of regular payments, usually as a life-long supplement to other retirement income.
  • The amount you receive is based on the balance in your account when you retire plus your personal life expectancy.
  • Annuities have been criticized in the past for charging high fees compared to other investment choices, but this perception is beginning to change.

Defining an Annuity

An annuity is a long-term investment product purchased from an insurance company. The investor pays a sum of money, up front or in payments over time. It is repaid in installments, usually as a lifetime supplement to retirement income. The dollar amount of the installment payments is determined by the balance in the account and the life expectancy of the investor.

The advisor who recommends an annuity may be motivated by the commission. The commission for selling an annuity can be much higher than one for a direct mutual fund investment.

In the years before the buyer retires, the money is deposited in investments that the buyer selects, usually mutual funds.

To put it bluntly, when you die, any money remaining in the account belongs to the insurance company. But if you live happily to 135, the insurance company still has to send you those regular payments.

Variations on the Annuity

The investor in an annuity has various choices.

  • An annuity may cover both spouses. The payments continue until the death of the second spouse. The amount of the payment depends on the life expectancy of the younger spouse as well as the balance in the account.
  • An annuity can be for life or for a set period of time, say 10 years, instead of for life.
  • An annuity can be variable or fixed. That is, you can choose a payment that goes up or down with the investments in your account, or a payment that is set at the time you begin to make withdrawals.

And, as noted, the investor has a choice of investment options. Most are mutual funds but the investor can select a conservative bond fund or an aggressive stock fund, or something in between.

The Cons of Annuities

Critics note that investment counselors who recommend annuities are motivated by commissions. The commissions for selling annuities are almost always higher than the commissions for direct mutual fund investments.

Here's an example of the commissions for mutual funds and for annuities:

Say an investor rolls a $500,000 balance in a 401(k) into an IRA. If the money is invested directly in mutual funds, the financial planner might make a commission of about 2%. If it is invested in an annuity that is invested in the same or similar mutual funds, the advisor could make a commission of 5% to 7%, or even higher. Therefore, a $500,000 rollover into mutual funds would pay the planner a $10,000 commission at most, while the same rollover into an annuity could easily pay the planner $25,000 to $35,000 in commission.

Not surprisingly, many planners will direct their clients into an annuity.

High Fees

Most variable annuities do not assess sales charges up front. That may make them look like no-load investments, but they do have fees and expenses.

Annuity contracts assess annual maintenance and operational charges that often cost more in the long run than mutual funds.

Note: This has been changing in recent years due to criticism of annuity fee structures. Some are offering comparatively low annual expense ratios. As always, read the fine print before you sign.

Annuities also have hefty surrender charges. That is, if you withdraw from the contract, or take money out for a period of some years after investing in it, big fees can be levied.

No Added Tax Benefits

Annuities are tax-sheltered vehicles. Your contributions reduce your taxable earnings for the current year, and your investment earnings grow tax-free until you begin to draw income.

Any traditional IRA has the same tax benefits, however. The investor in an IRA isn't gaining anything by putting that money into a so-called "tax-deferred" annuity. It’s like wearing a belt and suspenders.

The Pros of Annuities

Despite their downsides, variable annuities do offer advantages for the cautious investor.

Insurance Protection

Variable annuity proponents argue that clients should insure their retirement plans the same way that they insure any major asset. You would never think of owning a house or a car without insurance, so why risk a retirement plan? Your annuity cannot disappear no matter what happens.

Guarantee Riders

Most variable annuity contracts today offer living and death benefit riders (at an added cost) that offer important protections for investors who want to have some exposure to stocks during retirement.

For example, the guaranteed minimum income benefit rider provides a payout that grows at a specified rate regardless of the actual performance of the underlying mutual funds. A client who invests $500,000 in a variable annuity and opts for this rider can be certain of a guaranteed growth rate, say 5%, throughout retirement.

Other riders can periodically lock in the contract value and guarantee that the investor will never receive less than that value, even if the actual market value of the underlying funds declines substantially.

These riders come at an additional price but many planners argue that the cost is justified, particularly for older clients who might not be able to wait to recoup market losses.

Auto-Pilot Management

Variable annuities contain a number of professional money-management features such as dollar-cost averaging, value averaging, and periodic portfolio rebalancing.

Annuities also typically offer a wide choice of funds and fund families.

One Solution

One choice for the investor is to stick with direct mutual funds until retirement and then switch to an annuity that has that downside protection rider. That keeps the fees to a minimum during the investor's working years but guarantees a steady income in retirement.