Annuities are a major staple for retirement planning in the financial products marketplace today. Their guarantees of principal protection and lifetime income make them attractive to many people, especially in the aftermath of the pandemic.
Nevertheless, some financial advisors and retirement savers just don’t like annuities, and there are a variety of reasons for why. Annuities have limits, just like any other financial product, and you should understand what you will get with an annuity before signing on the dotted line. Here’s a quick rundown of some drawbacks of annuities – and also other places in which they come out strong.
Common Annuity Disadvantages
Here are a few annuity downsides – and some counterbalancing upsides that might be worth keeping in mind. These annuity disadvantages can include:
- Back-end surrender charges
- Complexity of annuity products
- High fees
- No step-up in cost basis at death
- Don’t have capital gains treatment
- Not as much liquidity as other assets
- Irrevocable choice with annuitization (alternative choices open)
- Loss of principal (with variable annuities)
- Misrepresentation when being sold at times
Below, we go over each annuity drawback in depth, and how different strengths can also add to one’s financial picture when an annuity is used correctly.
Back-End Surrender Charge Schedules
In order for life insurance companies to maintain their long-lasting promises to you and thousands of contract holders, annuities have back-end surrender charges should you take out excessive money during a certain period. This period is called the ‘surrender period’ or the ‘maturity period.’
Some surrender periods go as long as 15 years, but the vast majority of annuity contracts have 10 years or less. Many annuities permit free withdrawals of 10% for some liquidity, but taking money out above this may mean that you have to pay a penalty on the withdrawal. Income tax will be due on the withdrawal, as well as a 10% early withdrawal penalty if someone is under age 59.5.
Why do life insurers do this? To prevent ‘bank runs’ on annuity contract money and maintain their long-term obligations to you, which can span years (especially if you are tapping your annuity contract for guaranteed retirement income). According to historical data, life insurance companies have low instances of failure due to their risk management.
Complexity of Annuity Products
Fixed annuities are relatively straightforward. They pay a fixed rate of interest for a set period of time. On the other hand, depending on what you shop around for, fixed index annuities and variable annuities can be quite complex.
Fixed index annuities have evolved as retirement investors want more yield or variety in their annuity benefits. They can offer many crediting methods for earning interest. In exchange for protection against market losses, they come with caps, spreads, or other features that limit the amount of interest that might be earned.
Variable annuities may have an excess of investment options – subaccounts – that are confusing to decide on where to put money, let alone understand. Their rider benefits can also add more complexity to the picture.
The good news is most annuities are built to provide one primary benefit or do one thing well. Should you value simplicity and still want annuity guarantees, make sure to speak with your financial advisor or agent about how that is important to you.
Annuities have a reputation for high fees, but the good news is most annuities actually don’t have high fees. It depends on the type of annuity you open, and what benefits are included in the contract. The no-free-lunch principle of economics applies here as well, so you usually give something up elsewhere in exchange for more annuity benefits.
For these benefits, annuities often charge additional fees. Guaranteed income riders for fixed indexed and variable annuities might run 1% per year to cover the lifetime payments guarantee. Some fixed index annuities let you have higher interest-earning potential in exchange for a strategy fee (as opposed to no-cost growth options).
Variable annuities are the type of annuity that have the ‘bad rap’ for high fee charges. Their fees can be as high as 3% per year. This can include mortality and expense fees, administrative fees, and investment management fees for the mutual fund subaccounts. There is also usually a cost associated with living and death benefit riders with variable annuities.
The good news is that the annuity marketplace is becoming more competitive, and that includes for cost-conscious buyers as well. Mention to your financial professional as you explore different annuity options.
No Step-Up in Cost Basis at Death
If you own highly appreciated stock, you can leave it to your heirs and the cost basis of the stock will step up to its current value on the date of your death. This isn’t the case with annuities. Their cost basis will remain the same if you pass one on to your heirs.
Your heirs could end up with income tax due as they liquidate it. That being said, you may want diversification for your assets, especially if much of your money is in equities. Annuities provide more benefit beyond just market and loss-risk diversification, in that they can provide protection against creditors as well as probate.
If you want a multiple on your money to leave as a death benefit to your loved ones, some annuities can pay out an enhanced death benefit. While income taxes will be in the picture, this can be an attractive option for those with considerable assets to leave to heirs (and want some certainty in how much death benefit is givable to them).
No Capital Gains Treatment
Annuities resemble IRAs in that withdrawals from the contract are taxed as ordinary income. This means that you will pay income tax on the income you receive from your annuity.
Of course, this assumes that you opened the annuity contract with qualified money (or pre-tax money from a 401(k), traditional IRA, or other tax-advantaged retirement account).
This also applies to non-qualified annuities, or those begun with after-tax money (from investment accounts, a home sale, so on), but only the earnings will be taxed as ordinary income in that case. Annuities with Roth IRA funds will be generally tax-free.
Annuities are primarily designed to pay out a stream of income over time. They aren’t meant to be the most liquid of financial instruments. If you are looking for a place to park your money for a year or two, then an annuity may not be the right option for you.
There are some fixed-type annuities with a short maturity period of two years, but generally you will want to tap annuities for more long-term goals. Since they are really designed for retirement purposes, it makes sense that annuities are moreso for medium or long time-frames. You also have some liquidity with free withdrawals, which many annuity contracts allow on a yearly basis.
Irrevocable Payout with Annuitization
If you want to start taking a guaranteed stream of income from an annuity, then annuitization is one option you have. This one-time event converts the accumulation units in the contract to annuity units.
Once you have annuitized your contract, it’s impossible to change the form of payout that you initially chose. For this reason, the vast majority of annuity owners choose not to annuitize, but instead receive income from a lifetime withdrawal benefit rider or another income rider that gives them more flexibility.
Loss of Principal
This applies strictly to variable annuities. It’s possible to lose money in a variable annuity because the variable annuity fund subaccounts will perform based on what the markets do.
If the markets go down, then your subaccounts will most likely drop with them. This is why many folks opt for fixed index annuities, or other fixed-type annuities with some protection benefit.
Misrepresentation When Being Sold
Just as with other financial products, annuities are a tool in a toolkit. When used properly as part of a comprehensive plan, they can do a world of good and solve real problems with their contractual guarantees.
That being said, many annuities can be quite complex, especially as consumer demands for their benefits have evolved over the years. That can tempt some financial professionals to gloss over some annuity features or details in the interest of making a sale.
This can leave people with misunderstandings of how their annuities work and what they are designed to do.
Fixed and indexed annuities aren’t investments. Rather, they are insurance products that are designed to protect someone’s money rather than provide substantial growth. A good benchmark for these annuity types is growth potential above bonds, bank CDs, or other fixed-interest assets.
Variable annuities are really the only type of annuity that can be classified as an investment. They invest in the financial markets instead of paying a guaranteed rate of interest.
What is an annuity misrepresentation example that can come up? Some agents describe income rollups as the rate of growth that the annuity pays. That isn’t the case, however. The insurance company uses these rollups as credits to calculate their income payouts.
Are Annuities Worth It?
Since you are talking about your life savings, never feel pressured to buy an annuity or move forward until you are comfortable with what you will get. Don’t be afraid to ask your financial professional about any questions that you might have.
Despite these drawbacks, annuities can still play a vitally important role in your retirement portfolio. They are still the only financial vehicle that can guarantee a stream of income that you can’t outlive, even if that is for decades. In fact, you can even maximize your retirement income with annuities in ways that other options can’t match.
Fixed and indexed annuities also guarantee your principal, regardless of what the markets do. Consult your financial advisor for more information on annuities and whether they are right for you.
Are you looking for a financial professional to help you explore different options — or just to help you with your personal retirement what-ifs? No sweat, many independent and experienced financial professionals are available at SafeMoney.com to guide you.
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