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Annuities: What They Are and Why We Are Wary of Them

Over the years, we have not advised clients to buy annuities, but we have had many new clients enter our office for the first time with annuities in their portfolio. This situation often precipitates research on our part and phone calls with the insurance company who issued the annuity to understand its terms and determine where on the quality spectrum the annuity falls–generally somewhere between, “It might be ok” and “This is a very ineffective product that should be disposed of immediately.”

For those unfamiliar, annuities are investment products in which a person invests a lump sum, or a series of payments, in exchange for a stream of income in the future.  For example, invest $100k at retirement, then, 10 years later, start receiving $10k per year for the rest of your life.  Especially for those who are risk averse and wary of fluctuations in the stock market, securing a guaranteed income stream for life may seem like an attractive investment option.  But, annuity companies are keenly aware of this fear of the market and, in our view, often take advantage of investors who feel this way, as we discuss below.

Types of Annuities.  One distinction among annuities is whether, after you have invested the initial lump sum, the stream of income starts right away (immediate annuities) or at some point in the future (deferred annuities).  Another is whether the monthly payment for the stream of income is a guaranteed amount (fixed annuities), depends on the returns of the underlying investments (variable annuities), or is a combination of the two (equity-indexed annuities).

Advantages.  As mentioned, one main benefit of annuities is the stream of income that you will receive in the future and that, in many annuity contracts, you cannot outlive.  Another benefit is that funds invested in annuities grow tax-deferred until they are withdrawn.  Since there are no limits on the amount of money that can be placed in annuities nor any income limits for contract owners, this could be beneficial for high earners who are already maxing out retirement plan contributions. 

Disadvantages.  The costs and fees of annuities (especially variable annuities) are generally very high as compared with other investment products, which can significantly cut into the value of your account over time.  For example, taking into consideration the mortality and expense fee, rider fees, and investment expenses, it is common for variable annuities to cost around 3% per year in fees.  That does not even include the surrender charge, which applies if you try to pull money out of an annuity within a given time frame.  Often, the surrender charge starts around 7% (or higher) of the account value and decreases gradually over the subsequent 5-10 years.  This decreases the liquidity of the annuity, as does the fact that withdrawals prior to age 59 ½ will generally face a 10% early withdrawal penalty.  In addition, annuity owners face ordinary income tax rates on their gains instead of the more favorable capital gains tax rates on taxable investments, often have limited investment choices (for variable annuities), and risk losing a portion, possibly a majority, of the value of their investment if they pass away shortly after annuitizing (i.e. starting to receive the monthly payouts).

Attempts to Reform the Annuity Industry.  Given that annuities are very complicated financial products, most of which result in high commissions for brokers who sell them, they have come under government scrutiny in recent years.  Senator Warren of Massachusetts published a report last year highlighting the prevalence of non-cash incentives in the annuity industry, such as all-expense-paid trips to the Caribbean, golf outings, theater tickets, iPads, jewelry, etc., awarded to salespersons by the annuity companies themselves or by third-party marketing organizations.  This spring, the Department of Labor issued a new rule, which requires those giving retirement advice (including the buying and selling of retirement investment products) to serve as a fiduciary to their clients, i.e. to put the client’s interests above their own.  While this rule did make allowance for the continued sale of variable and fixed-indexed annuities under its “Best Interest Contract Exemption,” it is already impacting the way that some annuity companies structure their fees and will likely continue to do so in the future.

If you feel strongly about having an annuity in your portfolio for added longevity protection, give us a call–we can discuss the pros and cons of the one you are considering.  Together, we can determine an investment strategy that will suit your risk tolerance while also helping you achieve your financial goals.


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