Annuities a Complex and Thorny Investment
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As a tax-deferred tool for retirement, annuities might be the appropriate investment, but they come with a lot of issues. Make sure you know what you’re getting into before purchasing one. Click here to view article.
When it comes to buying annuities, the terminology and choices can be overwhelming as well as word-twisting: single premium annuity, multiple premium annuity, immediate annuity, deferred annuity, fixed annuity, variable annuity, equity-indexed annuity—and that’s just a few. No wonder so many investors give up before they start or buy annuities that might not be appropriate for them.
In its basic form, an annuity is a tax-deferred investment vehicle from an insurance company or other financial institution. They are attractive because you can choose regular payouts, which provide a steady source of income, and you can defer taxes until retirement. When you later make withdrawals, the amount you contributed to the annuity is not taxed, but your earnings are taxed at your regular income tax rate. In some cases, payouts will last as long as you live, so you can’t “outlive your money.”
Because annuities can have high annual expenses, many financial advisors recommend using them only after reaching contributions limits to an IRA or 401(k), because annuities do not have such restrictions. Annuities are helpful for those nearing retirement who might need to sock away more money for when regular paychecks stop. With so many factors to consider, investors need to carefully examine annuities’ advantages and disadvantages before purchasing them.
Types of Annuities
There are two basic types of annuities:
- Deferred annuity: Your money is invested over a period of time until you are ready to begin taking withdrawals, typically in retirement, at which point you hopefully have accumulated interest on your principal. This annuity often is used by those who are several years from retirement and want to accumulate a retirement income.
- Immediate annuity: After you invest your money you can immediately start taking payments. This might be used by those who are already retired or soon to be and want the income now.
Once you decide on the type of annuity, choose from these two options for investing the funds:
- Fixed annuities: The insurance company determines the interest rate, which guarantees principal and earnings, so you can be confident about your investment. However, the guaranteed rate is often relatively low.
- Variable annuities: More choices are available with this type of annuity, including stock, bond, real estate and other investments, meaning that your rate of return will fluctuate with the financial markets.
Options for Payouts
The next decision you need to make is how you want your eventual payouts to be calculated:
- Life annuity: The insurer pays an income for as long as you live. However, there are no survivor benefits, which means all payments cease upon your death.
- Period certain annuity: You are guaranteed a specific payment amount for a set period of time. If you die before the end of the period, your beneficiary will receive the remainder of the payments for the guaranteed period.
- Life annuity with period certain: The insurer will pay you an income for as long as you live, but if you die before the certain period that you have chosen, the income will be paid to a survivor (beneficiary) you designate until the end of that period.
- Joint and survivor annuity: The insurer will pay an income to you during your life, and after your death will pay a percentage of that income (50 or 75 percent, for example) to a survivor you designate for his or her life.
Pitfalls of Annuities
Annuities pose numerous drawbacks:
Maintenance fees: Perhaps the biggest downside is the high annual fees for variable annuities, including an annual insurance charge and investment management fee, plus fees for various insurance riders. These charges can add up to 2 to 3 percent of the annuity. In comparison, a non-annuity mutual fund charges an average of 1.5 percent annually, and unmanaged index funds often charge less than 0.50 percent a year. (Some investment companies sell annuities, called direct-sold annuities, without charging a sales commission or a surrender charge.) Because of these fees, make sure that the tax benefits outweigh the higher costs for variable annuities.
Penalties for early surrender: Most annuities come with a surrender charge: If you decide after a few years that the annuity wasn’t a good investment, you will have to pay a surrender charge, typically about 7 percent of your account value in the first year, with the charge decreasing to zero after a certain number of years.
Also, the IRS will hit you with an early withdrawal penalty of 10 percent if you take out funds from your annuity before you reach 59½.
Commissions: Because the commissions can be high and are generally charged at the beginning—as much as 10 percent—salespeople can be aggressive and not give you the whole story. Because of the inherent complexity of annuities and the potential to either buy an annuity you don’t need or want, or the wrong type, several agencies offer guidelines especially directed toward seniors. Reputable organizations include the U.S. Securities and Exchange Commission, the National Association of Insurance Commissioners, the Arizona Department of Insurance and the California Department of Insurance. In fact, California requires individual annuity contracts for seniors to contain a disclosure regarding the surrender charge period.
As with any big financial decision, consult a professional tax advisor to discuss your individual tax situation. Annuities are complex contracts, and it is easy to misunderstand or be misled about the benefits and risks. Evaluate carefully before buying an annuity (see sidebar).
Evaluating an Annuity
For some, an annuity can be an appropriate part of an overall financial plan. For others, an annuity can be totally unsuitable. Think about what your goals are, as well as how much risk you are willing to take. Consider the following before buying an annuity, and beware of unscrupulous sellers.
- Determine how much retirement income you will need in addition to what you will get from Social Security and/or a pension plan. Will you need that additional income only for yourself, or for yourself and others?
- Calculate if you will have enough money to cover your expenses if you put your money into an annuity.
- Learn how long you can leave funds in the annuity and if you can take out money when you need it.
- Find out how long the surrender charge period lasts.
- For a fixed annuity, know what the initial interest rate is and how long it is guaranteed.
- Ask if you can get a partial withdrawal without paying surrender and/or other charges.
- How much of a partial withdrawal can you take without being penalized?
- Find out the kind of benefits for survivors.
- Ask for an explanation of anything you don’t understand.
- Ask for a complete listing of fees and commissions before buying any investment product.
- Understand contract restrictions such as surrender penalties.
- Compare similar products from several companies before you sign.
- Take notes and get key information in writing. Keep copies of all documents, correspondence, notices, special offers and payment receipts.
- Read the contract promptly upon receipt; if dissatisfied, use your 30-day free look period to obtain a refund.
- Be alert for deceptive sales practices.
- Steer clear of repeated or unsolicited contacts from particular groups or agents that make you feel pressured or uncomfortable. A licensed agent or producer should willingly verify his or her credentials. If it seems too good to be true, it probably is!
Sources: “What Seniors Need To Know About Annuities,” California Department of Insurance and “Tips for Protecting Yourself”, Arizona Department of Insurance