The average person probably knows far less about annuities than he or she does about individual retirement accounts. That can make annuities dangerous ground if you would like to invest in one. There are a few things you need to know before buying an annuity.
Annuities are essentially investment contracts that you take with an insurance company.
While an insurance agent or company will offer them as the solution to all of your investment needs, they’re generally considered to be at least a cut below the typical investment vehicles that are available to the average investor.
Let’s focus on what you need to know before buying an annuity.
1. Are Not Substitute Retirement Accounts
Annuities have certain tax advantages that are similar to retirement accounts, but by no means identical. Though they do offer tax deferral, in much the same way that tax-sheltered retirement plans do, they are not retirement plans in the strict sense of the term.
Insurance agents are quick to offer annuities as a preferred investment vehicle to hold within an IRA, but you need to resist the sales pitch. First, since annuities already have the tax-deferred feature, there is no advantage to including them in the tax-deferred IRA. They‘re better held outside of an IRA, as a supplemental investment product.
Second, annuities come with fees that are substantially higher than what you will pay on the vast majority of mutual funds and exchange traded funds. You’ll be better off going with those funds within your IRA, and hold the annuity as an entirely separate investment.
2. Are Not Tax Deductible
One of the more significant differences with annuities is that even though they have the tax-deferred feature, the contributions that you put into an annuity are not tax-deductible.
If you have a choice between funding a tax-deductible IRA, or an annuity, you should always go with the IRA first, and then put any additional funds over and above your allowable contribution limit into the annuity.
3. Have Limited Investment Choices
Annuities are not investment democracies. You will be limited to the investment choices offered by the insurance company, and will not have access to more common investment types available in non-annuity investment vehicles.
The insurance company will invest your annuity funds in “sub-accounts” that function something like mutual funds offered by the company. You have to be careful with these — though they often promise minimum investment returns, they also tend to cap out your returns if they exceed a certain limit.
For example, for a sub-account loosely tied to a common index, they cap your return at something less than the actual return provided by the stocks that make up that index.
4. Include High Fees and Commissions
Though you may be able to buy no-load and low load (1-3%) mutual funds elsewhere, the funds that you’ll invest your annuity in will always have fees, and they are often much higher than what you will pay on low load mutual funds — typically in the range of 5% to 8% of your investment principal value.
The size of these commissions are another major reason why you don’t want to hold annuities in your IRA. They will reduce your investment returns to levels that are well below what are available for the general market, and that will have a material effect on the size of your portfolio at retirement.
5. Often Have Surrender Charges
As if the high fees on annuities weren’t bad enough, they also often include surrender charges. This is an exit fee designed — in addition to increase revenue to the insurance company — to prevent you from withdrawing your money from your annuity contract.
The amount of the surrender charge will vary depending upon the type of annuity that you have. On certain annuities — such as equity indexed annuities — the surrender charge can be particularly steep, going as high as 20%.
Worse, unlike mutual funds which typically charge back loads (at much lower rates) for anywhere from 1 to 3 years after making your investment, the surrender charges on annuities can be in effect for many years, preventing you from being able to get out of a bad investment.
6. Might Face Forfeiture Provisions
This is probably the ugliest provision when it comes to annuities. Under certain types of annuities, it’s possible for you — or more specifically, your beneficiaries — to forfeit your investment principal in the event of your death.
This can be the case with immediate annuities that are set up to provide lifetime income. An immediate annuity is one where you invest a large amount of money all at once, out of which the annuity begins paying you an income for life.
But if you should die shortly after the annuity begins paying out, your beneficiaries may not be entitled to the remaining principal balance in the contract. It will be forfeited, and revert to the insurance company.
Annuity contracts known as longevity annuities are particularly prone to this type of provision. Longevity annuities are set up to prevent you from outliving your money. As such, you generally must wait to begin collecting distributions until you reach the age of 80. However, should you die before reaching that age, your annuity will be forfeited to the insurance company, without ever having paid you a single distribution.
What makes it worse is that not even your heirs will be entitled to the principal amount you had invested in the longevity annuity. The entire annuity contract will be lost without the insurance company ever having paid out a dollar to you or your family.
7. Most People Don’t Need Annuities
Not many people invest in annuities and the reason for this is that not many people actually have a need for them. If you have a retirement plan at work, a self-employed retirement plan, or simply a well-funded IRA or Roth IRA — and invest it in no load or low load mutual funds and exchange traded funds — you are already getting more benefit than you would with a typical annuity.
If you meet an insurance agent who wants to sell you an annuity, politely decline and send him on to your worst enemy.