If you are over the age of 50 and someone hasn’t tried to sell you an annuity yet, consider yourself one of the lucky few. Odds are that you will eventually be pitched “the best annuity ever,” so it’s important to understand some reasons why you might want to take pause before signing on the dotted line.
The mention of annuities brings worried frowns to financial planners (at least to those who do not earn a living based on commissioned insurance sales). That’s because many of these insurance products come with high fees and confusing restrictions, detailed in contracts that are inches thick and difficult to understand.
Annuities aren’t one-size-fits-all, and they are not too good to be true — although too many are sold that way. They may be appropriate when fully understood for the contractual realities of the policy. Unfortunately, most annuities are so complicated that consumers have little idea what they have actually purchased.
To add to the confusion, many annuity products now offer a variety of add-on features. But of course, these features will cost you extra.
Fees and Restrictions
Annuities’ annual expenses vary widely. It is imperative that you understand exactly how much you’ll shell out each year, and assess whether those fees are worth the benefits. Also, find out what you’ll pay if you need your money before the surrender period is finished. Remember that deferred annuities are long-term investments with surrender charges as high as 8 percent on early withdrawals.
In addition to being charged as much as 8 percent if you pull money out in the first year or two, annuities carry commissions as high as 10 percent for the agents selling them.
You might be better off investing directly in mutual funds rather than buying them through variable annuities. Variable annuities charge annual expenses of 2.37 percent on average, according to investment researcher Morningstar Inc. In comparison, a low-cost, tax efficient index fund may charge annual expenses of less than .20 percent.
As explained later in this article, the tax-deferred benefit of annuities may or may not be advantageous when compared to a tax-efficient index fund outside of an annuity. This is something that your tax professional can help you run some numbers, but is also largely up to future tax policy and potential tax rate increases.
Shopping Smart for Annuities
Still, annuities can hold a rightful place in some investment portfolios — but if you are considering an annuity, you should shop carefully, and with a “buyer beware” mindset.
Several larger mutual fund companies like Vanguard Investments, Charles Schwab and Fidelity are seeking to sell lower-cost annuities. You can contact those companies, and also compare quotes on websites like ImmediateAnnuities.com and AnnuityFYI.com.
If you decide that an annuity might be a sound option as part of a comprehensive financial plan, use these tips to help you shop.
- Check the company’s earnings history. An agent will probably give you materials that project an annuity’s growth over time. But remember, projections aren’t guarantees. An agent might show you a high rate of return for a fixed annuity, but you might only earn the guaranteed minimum rate. Also, if financial conditions change for the worse, your earnings could decline.
- Consider tax benefits vs. costs. You’ll pay ordinary income tax on payouts from your annuity, unlike the more favorable long-term capital gains rate you’ll pay on a regular mutual fund. Annuity owners also face a tax hit for withdrawals before age 59 ½. One perk: Unlike IRAs, you don’t have to take withdrawals starting at age 70 ½.
- Consider the impact of inflation. Even though guaranteed income is a major benefit of annuities, that income stream might not look so attractive once inflation takes its toll. You’ll likely pay extra for inflation protection, but it may be worth the cost.
- Beware of “teaser rates.” Confirm the rate of return that the insurance company is promising, and for how long. For instance, a fixed annuity’s guaranteed rate may decline after an introductory period.
- Consider the company’s financial condition. A company that is in solid financial shape is more likely to be around when it is time for you to collect on your contributions. Also, the insurer must be financially sound enough to pay benefits over many decades. Check the company’s standing with ratings firms such as Standard & Poor’s, Moody’s Investors Service and A.M. Best.
- Take your time to consider. It’s probably not a good idea to buy an annuity on the first visit with an agent. Take all the time you need to decide. If you feel you are being pressured to make a decision quickly, go elsewhere. Consider bringing a trusted financial advocate and financial fiduciary with you when you meet with the agent.
- Use the free look period. Almost all annuities come with a free look period. During this period, you may cancel the contract for any reason and get a full refund. Use this time to reread the contract and make sure it meets your needs. If the annuity doesn’t offer a free look period, be especially cautious.
- Max out other retirement accounts first. One benefit is tax-deferral on gains, but your retirement account already offers this perk — and it’s probably much cheaper. Always consider maxing out your retirement accounts before buying a deferred annuity.
- Don’t annuitize all at once. To figure out how much your annuity will pay you every month, the insurance company considers several factors, including your age, how much money you are putting into the annuity, and what the current interest rate is. By waiting before you annuitize, you will get a bigger monthly payout because you’ll be older and have fewer years of life expectancy left. You may also get a bigger payout if you wait, because interest rates in general are low by historical measures now. You may want to consider laddering into an annuity just as you would a bond or certificate of deposit portfolio.
- Don’t buy the first annuity you are pitched. It’s conventional wisdom in financial planning circles that annuities are “sold, not bought.” That means that annuities are generally pitched by well-trained salespeople, rather than recommended by careful retirement planners. And that means that you could easily fall prey to the sales hype and purchase a product that is not the best option for your overall financial plan.
- Don’t let the annuity salesperson switch you into a “new and improved” annuity. If you haven’t yet completed your surrender period, you’ll likely pay steep surrender charges, plus start the clock ticking on a new surrender period. Still, a switch might be acceptable if you move into an annuity with much lower annual expenses and better benefits. Make sure your agent makes the switch through a valid Section 1035 exchange to avoid a tax hit.
Ask yourself what you want the money you are thinking about putting in an annuity to actually accomplish. If an annuity policy will contractually accomplish the specific goal that you have in mind as part of a comprehensive financial plan, then it may be worth considering as a possible transfer-of-risk solution.
The bottom line is to always own an annuity for what it will do, and not what it might do. Finally, given the complexity of these contracts, I recommend meeting with an independent hourly financial planner to objectively assess the details and wisdom of an annuity as part of your comprehensive financial plan.
Lisa Hay, CPA, President and Founder of Ascend Financial, LLC, helps clients objectively navigate the labyrinth of rules surrounding annuities and other retirement strategies, through hourly consulting.
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