Should You Buy an Annuity?

Annuities are contracts sold by insurance agents or financial advisors who have licenses to sell insurance. The insurance industry invests a significant amount of money to advertise and actively promote the benefits of these products. However, in addition to the advantages frequently marketed in advertisements, annuities have disadvantages, which everyone should be mindful of.

Many different annuity offerings are available in the financial marketplace, but they generally fall into two broad categories: fixed annuities and variable annuities. Fixed annuities offer a guaranteed rate of return (interest rate) over a designated time frame. Variable annuities are more complex because they have the potential to achieve higher returns by investing in a range of underlying investments, including equities and fixed-income. So, just like any other investment, your payout won’t be as big if your investments do poorly.

Annuities are a popular way to guarantee an income stream. However, ensuring an annuity is the right option before you purchase it is critical, as once you have signed, you cannot get out of the contract (without incurring penalties). Before deciding, you should evaluate your overall retirement plan and income needs.  Many advisors may recommend you roll a portion or all of your retirement accounts into an annuity, but is this the right choice?

Beware of the Fees Associated with Annuities

Annuities are complex financial products created by insurance companies with significant fees, surrender charges, and potential hidden costs that can eat into your returns. These fees are often not transparently disclosed upfront, leading many investors to realize the actual cost once they have made the purchase (and see it live). For example, agents and brokers who sell fixed-indexed annuities generally earn approximately 4% commission or more. The buyer bears this cost. These advisors are not fee-only, meaning they can earn compensation and commissions from the products they sell you and use to implement your investments.

Furthermore, annuities are often not very liquid investments, meaning your money may be tied up for an extended period, blocking access to your funds when you need them most. If you withdraw your money before a certain predetermined period, typically five to ten years, you’ll likely incur surrender charges, which can be significant.

What are the Tax Consequences and Alternatives?

Alternative solutions to annuities might be more appropriate and offer greater flexibility (and long-term returns!).

Similar to traditional retirement accounts like 401(k)s and IRAs, annuities allow for tax-deferred growth but not the same tax benefits. Your earnings will be taxed at your ordinary income tax bracket rate when you withdraw money from an annuity, which could be significantly more than the tax rates (capital gains) applied to investments in taxable accounts. So, the annuity is not a superior option, as taxation is generally a significant factor. An annuity investment could also come with an early withdrawal penalty from the IRS. If you start taking money before age 59.5, you will likely have to pay a 10% early withdrawal penalty in addition to your regular tax.

Investors can potentially receive higher returns than those offered by annuities by utilizing investment vehicles like low-cost, tax-efficient ETFs and index funds. The most effective way to invest in a tax-efficient portfolio of stocks is to max out your retirement plan (401(k), 403(b), SEP IRA), and a Roth IRA (consider a Health Savings Account (HSA) also).  So, an annuity will typically fail at giving you long-term growth (which is essential to outpace inflation). Fixed annuity payments may lose purchasing power over time due to inflation- and this is an understated but considerable risk.

When Does an Annuity Make Sense?

Annuities are not always bad despite their shortcomings and complexities. Their usefulness depends on how and when they are applied. Unlike 401(k)s or IRAs, annuities typically don’t have annual contribution limits, which can allow investors to save more on a tax-deferred basis until withdrawal.

An annuity might make sense for very conservative and risk averse individuals nearing retirement seeking a guaranteed income stream to cover expenses during their later years.

Also, not all annuities are created with the same terms.  Some may not come with comparatively high fees and hidden costs. Some low-fee annuities do exist and offer a better overall choice for potential annuity buyers. Some financial advisors may offer “no-load” annuities. This means they may not have any upfront fees but often have surrender charges you need to factor in.

In Conclusion: Is an annuity worth investing in?

Annuity contracts can be confusing and unclear, making it challenging for investors to make well-thought-out and informed decisions and this is a considerable risk. It is crucial to be sure that an annuity fits with your specific financial goals and circumstances. It’s also worth investing the time to understand the specific tax implications for your situation, as annuity taxation can be complex and depend on individual circumstances. The safety provided by annuities may come at the cost of lower long-term returns than other investment options.