One of the financial products often sold by financial advisors, brokers, registered reps and insurance agents is an annuity. There are various types of annuities, but at their core all are essentially vehicles to accumulate money and create a retirement income stream.
What Is an Annuity?
An annuity is a contract with an insurance company by which you pay the company a certain amount of money, known as a premium, either via periodic payments or a lump sum. The insurance company invests your premiums and in return will pay you a stream of income either immediately or at some point in the future. You may also be able to take a full or partial lump-sum payment as well.
Annuity premiums are paid with after-tax dollars, and the money is taxable at ordinary income tax rates. The money in the annuity grows on a tax-deferred basis. Annuities can also be held in a retirement plan such as a 401(k), 403(b) or an IRA.
Types of Annuities
Immediate annuities generally allow you to begin receiving payments within 30 days of paying your premium.
Deferred annuities allow you to make a premium payment(s) and then defer annuitizing until a later date.
Variable annuities are invested in subaccounts that are much like mutual funds. The amount available for lump-sum distributions or to annuitize is a function of the amount of premium contributions and how well the underlying investments have done.
Fixed annuities offer a fixed, guaranteed interest rate for a fixed time period.
Indexed annuities track the return of a market benchmark like the S&P 500. You receive a portion of gains on the index with downside protection that limits your potential losses or provides a minimum level of return.
Hefty Fees and Expenses
One of the disadvantages of many annuities are their high fees and expenses, coupled with the fact that often the details on these fees and expenses are nearly impossible to find within the documentation provided.
It is not uncommon to see annuities with internal expenses exceeding 2%–3%. Additionally, many contracts have steep surrender charges that kick in if you try to remove funds from the contract prior to a set date.
Mortality and expense (M&E) fees are the charges rendered by the insurance company to cover the costs of the insurance guarantees and the administrative expenses of selling and servicing the annuity. These charges are built into the contract and deplete the underlying returns and value of your account.
Surrender charges are used by insurance companies to limit withdrawals from the account during the early years of ownership. A contract might carry a surrender charge of 8% for the first few years that then gradually decreases over time. A contract might have a surrender period of 8, 10 or more years. I’ve seen some as high as 15 years.
Using 8% and a $100,000 balance, this equates to an $8,000 surrender charge if you tried to withdraw your balance, including trying to roll it over to another annuity at another company. These charges can be significant, so be sure to find out all of the details before writing a check.
Investment management fees are the expense ratios of the investment subaccounts, which, similar to mutual funds, are the underlying investment vehicles used in variable annuities. The expense ratios on an annuity subaccount are rarely as low as or lower than those on an equivalent mutual fund. Often the M&E charges are part of the subaccount expense ratios.
Do Annuities Make Sense for Retirement Savers?
The answer, of course, is “it depends.” Annuities have both pros and cons. These are both in general terms and specific to the contract you might be looking at. Keep in mind the industry truism that annuities are most often sold, rather than a person having planned to purchase one. This means too many annuity purchases are made as the result of aggressive sales tactics.
Here are some pros in favor of annuities:
- Your benefit is guaranteed by the insurance company. That said, make sure the company is financially sound. Though defaults on annuities are very rare, if the company can’t meet their obligations, your backstop is the appropriate state insurance commissioner. That may or may not cover your entire benefit.
- An annuity can be another leg on your “retirement stool,” complimenting other sources of income such as Social Security, a pension, and withdrawals from retirement accounts like a 401(k) or an IRA. The lifetime income can be a backstop, should you spend down your other accounts too quickly.
Some cons regarding annuities:
- High expenses on many contracts. This is especially noticeable on many variable annuities. Vanguard claims their contracts have average expenses of 54 basis points (0.54%), with a range of 44 to 73 basis points. This compares to an industry average of 224 basis points.
- Non-qualified annuities are taxed at ordinary income tax rates. These are annuities that are not held inside of a qualified retirement plan or an IRA. Your premium dollars do grow tax deferred while invested in the contract, but the amount that is gain is fully taxable when withdrawn. For lump-sum partial distributions, all distributions are treated as gains until that “layer” is used up. The rest is considered a withdrawal of your premiums and is not taxed. When annuitized, the payments will be considered part gain, part return of premium, and a portion will be taxed. Annuitants can outlive the payout of their premium, and any remaining payments would be fully taxable.
- A lack of transparency in many contracts. Trying to decipher the underlying expenses in some annuity contracts is a frustrating experience. These contracts are written by attorneys, and the language often doesn’t resemble plain English.
Annuities in Retirement Accounts
There is much disagreement among financial advisors as to the wisdom of holding an annuity in an employer retirement account such as a 401(k) or 403(b), or an IRA. There is no added benefit, as the distributions will be fully taxable upon distribution, unless some of the contributions were made with after-tax dollars. Some say the ability to annuitize is the benefit. You need to weigh the costs of the annuity to determine if this benefit is truly worth it.
Options for Beneficiaries
Annuities do have a beneficiary feature and the options for non-spousal beneficiaries can be complex. For spouses, continuation of the annualization payments can be an option, though there are others. The rules for a trust being a beneficiary are complex as well. Before buying a commercial annuity, it is wise to understand what happens to the contract upon your death and to decide if this fits with your plans.
It is often said annuities are sold, not bought. If an annuity makes sense as part of your retirement planning, then become knowledgeable and informed. Don’t allow yourself to be sold a contract that is high priced and may not meet your needs.
Annuities offer a stream of guaranteed income that can enhance your retirement income. It is important to understand all the implications of buying an annuity, both pro and con.