Too Good to be True? The facts and fiction of Annuities

On the most basic level an annuity is a contract between you and an insurance company. You pay the insurance company a lump sum or arrange for a set of payments over time; in return, the insurance company has to make payments to you either immediately (i.e. an immediate annuity) or in the future (i.e. a deferred annuity). Although annuities are sold by insurance companies they are not life insurance policies. Let’s start with some useful information about different types of annuities and then some things to be aware of if you are thinking about purchasing an annuity.

Fixed Annuities v. Variable Annuities

Fixed annuities provide a set annual payment amount for a period of time. The insurance company credits your account with a fixed rate of interest regardless of the market conditions. For example, an annuity may offer a guaranteed 4%.  This means you will receive a 4% return whether the market is up 20% or down 8%. Although the advertised guaranteed rates may look attractive now, these could be less attractive in a rising interest rate environment.  Also, often times the initial interest rate is only guaranteed for a the first few years and then resets to a minimum rate.  The average annual return of all fixed annuities was 3.27% (source: Annuitygator.com). The guarantee on fixed annuities is only during the accumulation phase and may contain restrictions about early withdrawal.  Once the payments begin the owner will receive a fixed payment amount based on the accumulated amount.  Fixed annuities are generally appealing to those who are concerned about losing their principal investment or those who are worried about outliving their money.

Variable annuities (VA) have irregular payments and the payment amount is linked to the performance of the underlying assets. The funds are invested in proprietary mutual funds sold by the insurance company. A VA may provide more upside than a fixed annuity but they can also be affected by market fluctuations and the performance of the underlying mutual funds. Because annuities have higher fees they tend to lag the performance of the market in general.  To make them more attractive, insurance companies have added a “guaranteed minimum income benefit” rider to some variable annuities.  For an additional premium you can purchase a 5-6% guaranteed increase to your income benefit base.  This is not an increase to the actual account value but rather an accounting figure that the company keeps to determine your eventual withdrawals.  Other variations on this include the guaranteed minimum accumulation benefit, the guaranteed minimum withdrawal benefit and the guaranteed lifetime withdrawal benefit.  All of these guarantees come with increased costs and restrictions.

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An annuity can begin paying out immediately (also known as Single Premium Immediate Annuities) or payments can be deferred, often to start in retirement. With immediate payments the payments start after a lump sum is paid to the insurance company and can continue for specific amount of years (typically 10-15) or they can continue for the the life of the annuitant and/or the spouse. Immediate annuities are fairly easy to understand.  In return for your deposit the insurance company guarantees a payment to you based on actuarial tables and interest rate assumptions.

Most annuities that are sold are deferred annuities. They can be either fixed rate or variable.  Deferred pay out annuities have the benefit of the investment growing tax deferred over the years until pay out begins and for this reason are sometimes recommended to individuals who have maxed out their employer retirement contributions and want to save additional money.  Deferred annuities are much more lucrative for the insurance company and the commission paid to the insurance agent is three times that of an immediate annuity.

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The Pitch

It sounds too good to be true: you will get a 5% guaranteed return with no risk to your principal regardless of market volatility and no fees. What is the downside?  First, annuities are complex and confusing.  Insurance companies have brilliantly reduced the typical 150 page prospectus to 3 selling points- guaranteed return, no risk, lifetime income stream but they are anything but simple.  Not disclosed upfront are the commissions, fees, surrender charges, liquidity issues and legal disclaimers. Annuities aren’t bought they are sold.  Insurance agents can make their careers selling annuities.  Typical commission for annuities is 5-10% on the total amount of the contract (source: Motley Fool). This means on a $250,000 deferred annuity the agent may receive up to $25,000.  On a $1,000,000 annuity that is $100,000.  Not a bad payday.

Fees, Surrender Charges, and Penalty Taxes

The insurance company is also making money on these contracts through a host of fees. In total, these fees can range from 2.5% up to as much as 4% per year (source: Fisher Investments) and severely erode the performance of a portfolio. The insurance company will also offer to add riders to your annuity, but those will come with a cost. You can add benefits such as lifetime income, guaranteed income, guaranteed withdrawals, guaranteed returns. Rider fees can range from .3 – 3%.

The typical charges consist of management fees, mutual fund fees, mortality and expense fees and administrative fees.  Management fees are paid directly to the insurance company and can be as high as 2% per year. The mutual funds inside the annuity also have expense ratio fees which range from .5 – 2% and you do not have the ability to shop outside the insurance company for better or cheaper investments such as ETF’s. Mortality and Expense (M&E) fees are charged for death benefits, if applicable. These fees range from .5% – 2% per year. Finally, administrative fees are charged as well and these typically range from .1 – .3% per year which covers the cost incurred by the insurance company to maintain the contract.

If you change your mind and want to withdraw your money in the first 5-10 years after purchase you will likely encounter the dreaded surrender fees. These are very expensive and for a good reason.  The insurance company needs to offset the commission that has been paid to the insurance agent.  Generally the higher the commission that was paid, the longer the surrender period.  Surrender fees range from 7-10% of the entire cost of the annuity and are in place for an average of 7 years but can be as many as 10. They are decreased over time, usually by 1% per year. This means your money can be locked up with some sort of penalty for 10 years depending on the contract! If we look at an example of a typical $500,000 annuity the surrender charge in the first year could be $35,000 to $50,000.

There is a 10% penalty imposed by the federal government if you want to withdraw the money before age 59 ½. You will also have to pay income tax on any investment earnings if you need to withdraw early. Keep in mind that if you are still in the surrender period, you will be charged the surrender fee (as high as 10%) as well as the 10% penalty to the Federal government and income taxes on earnings. Ouch.

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Those selling annuities talk a lot about it being a tax deferred investment. This is true and is a great benefit for anyone trying to delay paying taxes. You will pay no taxes until you begin taking payments, even on dividends and interest that is earned. The taxes that are paid are largely dependent on the type of money that was used to purchase the annuity contract.

If you are using pre-tax dollars to buy the contract that is a “qualified annuity”.  All payments from this type of annuity will be taxed at your federal income tax level when withdrawn. Individuals who roll over their IRA’s or 401(k) accounts into an annuity are not improving their tax position.  This is how you would have been taxed anyway, so there is no tax advantage by buying the annuity.  Furthermore, you will lose the flexibility that you had by leaving your money in your IRA and will be subject to higher fees.

If you purchase an annuity with after tax dollars this is a “nonqualified annuity”. This is non-retirement money that you would take from your bank account or taxable investment account to buy the contract. When withdrawn you will not pay taxes again on the portion of the payment that came from the principal or the amount you originally paid. You will, however, pay ordinary income taxes on the gains, these can be as high as 37% (federal) plus state tax. If this money was held in a taxable investment account you would only pay the capital gain tax rate (with a maximum of 20%) on the gains.

Getting Out

Remember that purchasing an annuity is entering into a contract with the insurance company.  They are providing you with a commitment based on the fact that this is a very long-term (lifetime!) agreement.  Should you wish to make a change or get out of the contract there are severe penalties including surrender fees and taxes.  However, there are some ways that you can minimize the damage and move on.  First, if you are beyond the surrender period you may be able to initiate a 1035 exchange and move your assets to another, lower cost, annuity.  A 1035 exchange to an annuity with another company is not a taxable event as long as the annuitants are the same in both contracts.  If you have an IRA inside a qualified annuity, you can also transfer this without tax consequence to another IRA that will give you more investment choices and lower fees.  Non-qualified annuities are the most challenging to surrender.  If you surrender the contract and take a full distribution you will be taxed on any gains in the account at ordinary income rates in the year surrendered plus a 10% penalty if you are under age 59-1/2. An individual must carefully assess the tax consequences of any of these scenarios before taking action.

Final Thoughts

There are some limited circumstances where an annuity makes sense and is beneficial, but it’s important to understand the entire contract; the fees, penalties, how the payments will work, guarantees, etc. As always, talk to a fee-only CERTIFIED FINANCIAL PLANNER™ before signing an annuity contract. There are probably other less expensive, more transparent and more flexible options to accomplish your goals. If you do decide that an annuity is right for you be sure to ask to see the prospectus before you sign and have a CFP® look it over with you, so that you really understand the entire contract and the commitment that you are making.