7 Costly Annuity Mistakes that People Should Avoid

Whether you are considering purchasing an annuity or you already have one, there are some key mistakes to avoid in order to benefit from annuity ownership.

The pitfalls below have tripped up many annuity buyers. Our insider tips on knowing what to look out for can prevent you from experiencing the same fate. Use these tips to help you in simplifying your annuity buying decisions or in optimizing your annuity contract as part of your retirement strategy.

Mistake #1: Thinking you can get out of an annuity at any time.

Insurance companies stipulate “surrender” periods in an annuity contract for a reason. They want you to hold the contract for at least that length of time.

These surrender periods are part of annuity contracts for many reasons. One of the most important is it helps the insurance company maintain the guarantees it’s promised to you as a policyholder.

When you want to break your contract by leaving during the surrender period, you may incur penalties charged by the insurance company, known as “surrender charges.”

You may also face tax consequences for “cashing out.” These could include a 10% early withdrawal penalty if you are younger than 59.5.

Mistake #2: Thinking you will get optimal growth, optimal safety, and optimal income all from the same contract.

If you have done some research about annuities online, chances are you have seen advertisements with certain annuity rates. And there are not only ads, but also “annuity alerts” and other such content promising the world: that you can have a nice bonus rate, seemingly almost unheard-of interest rates for growth, and fantastic income payouts, all from the same contract.

Here’s the thing. That might not communicate the full picture. There is no one-size-fits-all annuity. Each insurance carrier designs their annuity contracts to solve different, particular client needs. By itself, one annuity can’t serve as an end-all-be-all solution.

Just as with other financial products, annuities are built to serve different needs. An annuity will offer a defined set of benefits intended for a certain audience.

While some annuities are structured to supplement the owner’s income, others are built to provide opportunities for growth. In some contracts, that will be with a fixed interest rate or in others with high interest-crediting potential.

Note that a carrier can revise the interest-crediting mechanism during the life of the contract, so know that going in. If you are considering an annuity as a supplemental strategy for conservative portfolio growth, ask your financial professional for the renewal rate histories of any insurance carriers you are exploring.

Mistake #3: Pursuing the “best” bonus.

There are three general types of annuity bonuses: a premium bonus, an income bonus, and a first-year bonus also known as a teaser rate bonus.

An example of a teaser rate would be a Multi-Year Guaranteed (MYGA) annuity with an interest crediting schedule of 8% for Year 1 and 3% for Years 2-5, which would offer growth potential of 4% net for 5 years.

A premium bonus is a bonus credited to the cash value or accumulation value. And an income bonus is a bonus credited to the income value of the contract. If bonuses are viewed as “high” on a contract, there is a likelihood that the insurance company will credit low interest rates in later years.

Mistake #4: Not considering the consequences of how an annuity is funded.

When you are buying an annuity, where your money comes from is an important factor.

If you are using non-qualified funds (or money you have already paid tax on when you received it as income), using a 1035 exchange to purchase an annuity would allow you to defer taxes on any growth in the original life insurance policy or annuity that is funding the new annuity.

In a situation with a 1035 exchange, the new issuing annuity carrier, as well as the existing policy-holding carrier, would do due diligence and research the transaction.

This brings up another important point, which is to pay attention to how you are told to buy a contract. It doesn’t happen often, but sometimes people are told to cash out their existing annuity policy and then write a check to the new carrier.

There can be a steep tax bill for doing so. Not only that, it could have significant consequences if the owner is subject to a 10% early withdrawal penalty (because they are withdrawing before age 59.5) or if they are still in the surrender period of the original contract.

Mistake #5: Confusing different rates.

Let’s face it, there are many rates to consider. There are interest rates, caps, participation rates, spreads, and withdrawal rates. Knowing the difference between them is critical.

An interest rate is the actual growth you will receive on your balance. This is added to your original premium you pay into your contract, which grows in value.

A cap puts a limit on the interest you will receive over time. If you owned an annuity that returned 9%, but you had a cap of 3%, your contract would be credited just 3%. Not all annuities have caps. Insurers may use other controls, like participation rates.

Similarly, a participation rate indicates what percentage of the overall increase in value a particular annuity will be due. For example, on a $10,000 increase in value with an 80% participation rate, the contract would only be credited $8,000.

Think of spreads, which may also be referred to as margin fees, as the icing that is taken off the top of the cake. So, if an annuity index increased in value by 11% and there was a spread fee of 4%, the annuity would be credited just 7%.

Withdrawal rates may refer to the payout percentages available with an income rider. There isn’t anything such as a 5% interest rate guaranteed for the accumulation value in this current interest rate environment. That isn’t to say that can change, though.

Mistake #6: Taking free withdrawals without heeding the potential impact.

In some annuity contracts, taking a free withdrawal doesn’t come without strings attached. That withdrawal affects your income value and sometimes the rollup for the year. In the past, your income rollup may have stopped entirely if you took a free withdrawal. 

If your contract had a “vesting bonus,” or a bonus that depends on you leaving the money alone in the contract to fully take advantage of the bonus, free withdrawals may affect this part, too. Be sure to ask your financial professional for any potential impacts of free withdrawals in any annuities you may be considering.

Mistake #7: Believing that caps and participation rates are good for the life of the contract.

Generally, these rates that put a lid on your annuity’s growth potential are only in force for a one-year period. Because insurance carriers are in business to make a profit, they have a number of control levers at their disposal to adjust interest rates or limits on interest crediting as they see fit.

So that favorable participation rate could be lowered. And that cap rate could be increased.

As a bonus mistake to avoid, consider that annuity contracts are written to give carriers even more robust controls. That may include removing crediting methods from the contract at times.

In this extreme case, no rates are guaranteed (unless you buy a MYGA annuity). Even the fixed-interest buckets on an indexed annuity contract can change.

Simplify Your Annuity Research with a Financial Professional’s Help

With so many annuity contracts on the market, it may be overwhelming. Do you need guidance? No sweat, assistance is just a click away.

To help you sort through your options and get answers to questions that may arise from these potential mistakes, use our “Find a Financial Professional” section to connect with someone who can answer your questions and provide guidance directly. 

You can request a no-obligation appointment or phone meeting to discuss your goals. Should you need a personal referral, call us at 877.476.9723.