What You Need to Know About Annuities

Over the past few months, GreenLife has acquired several new clients from commission brokers. As a fee-only financial planner this is not unusual for obvious reasons. What makes these clients remarkable is that nearly all have been sold annuities of various flavors from their former advisors. There is typically very little understanding of the details, benefits, and downsides of the annuities. And there are many downsides, as you will learn.

The Usually Not So Great: Fixed Annuities

Fixed annuities are contracts sold by insurance companies. They’re not investments, but ways to transfer investment risk to the insurance company in a contract. In return for your money, the insurer pays you a fixed interest rate for a certain period of time. The insurance company thinks it can make more by investing your money than what it is paying you, otherwise why would the insurer even offer you this deal? A fixed annuity purchaser should be okay with that, as it is the tradeoff by unloading the investment risk to someone else.

There are no expenses to buy a fixed annuity, as that is already factored into the interest rate the contract holder receives. Historically, an insurance agent was paid a commission on the sale of an annuity, but now there are zero-commission fixed annuity products available to fee-only advisors. The interest rate on these products can be a little bit higher since there is no commission paid to an agent.

Fixed annuities guarantee a fixed interest rate for a set term. You can withdraw a certain percentage each year without penalties, and after this term you can withdraw the entire balance. The contract is tax-deferred, meaning you will pay taxes only when you withdraw money. If you withdraw before age 59.5, you’ll face a 10% penalty on the gains, plus income taxes.

Single premium immediate annuities (SPIAs) are like personal pensions. You give the insurance company a lump sum, and it pays you a fixed amount every month for life.

Deferred income annuities (DIAs) are SPIAs with a later start date. By deferring the start date, you can increase your monthly income. Deferred fixed annuities offer steady returns for a set period. But the rate is often low, and it can reset at the insurer’s discretion. It becomes like an expensive restricted version of a CD. Selling a CD is easy. Ditching a fixed annuity usually suffers stiff penalties and, potentially, a tax hit. It’s usually not worthwhile, unless it resides in a pre-tax retirement plan. Then maybe it is worthwhile.

The Just Plain Bad: Variable Annuities

These are like the harmful cigarettes of investing, says Ken Fisher of Fisher Investments. Variable annuities (VAs) are structured similarly to tax-deferred investment accounts. If you withdraw funds before age 59.5, there are penalties. The main benefit is that there’s no tax on the portfolio until you withdraw funds. However, unlike a 401(k), a VA contribution is not pre-tax, so there’s no upfront tax saving. Strike one.

VAs have very high fees and are often marketed as safe investments with high returns. However, they are invested in stock and bond funds, which can be volatile, the opposite profile of what an annuity promises. On top of the fund fees, there are additional fees for insurance, contracts, and optional rider features. These are typically the most expensive investment products in America, with low returns. Strike two.

There are also potential benefits lost when investing in a VA, such as a loss of a step-up in basis and an inability to harvest tax losses, donate shares of appreciated securities, or use foreign tax credits. Strike three.

VAs are “out” by my strike count, but I’ll continue. VAs often come with a return of premium death benefit, meaning if the policyholder dies, his or her heirs will receive back what the policyholder paid in premiums. However, this benefit is often overpriced in a rider.

VAs also offer Guaranteed Lifetime Withdrawal Benefit (GLWB) riders. These allow the policyholder to withdraw a certain percentage of his or her “income base” annually from age 65, ensuring he or she never runs out of money. However, the fees for these riders can be high and can increase if the contract value drops due to withdrawals and fees.

In conclusion, VAs are complex and often misunderstood, and come with high costs and potential drawbacks. It’s generally better to directly own low-cost stock and bond funds and create a sensible retirement plan. If you require life insurance, it’s typically cheaper to buy a separate term life policy.

And now for the worst of the bunch, just when you thought it couldn’t get lousier.

The Just Plain Yucky: Indexed Annuities

“Indexed” annuities are loosely linked to stock market indexes. Their pitch: Get stocks’ upside without the downside – with little to no fees. Sounds too good to be true, and it is. The upside is severely limited. Returns usually omit dividends. Then, most use a “participation rate,” providing just part of the index’s return. If the index rises 10%, your participation rate is 50% and your return is 5%. The insurer keeps the rest.

As if this isn’t bad enough, indexed annuities often include “performance caps” – maximum returns you get in any month, quarter, or year. Envision a 5% annual cap. You miss most of all the bigger up years in the stock index – which is where most of history’s gains come from. Monthly caps are even deadlier. Additionally, the insurer can change the cap rate and the participation rate during your contract! If you read the fine print, it will say something to the effect of “The initial cap rate is 6.00%…the guaranteed minimum cap rate is 1.00%.” What’s the old saying about the devil is in the details? This card deck is “loaded” and it’s not in your favor.


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