Annuities
“Annuities are not bought, they’re sold"
An annuity is a contract between you and an insurance company that is designed to meet retirement and other long-range goals, under which you make a lump-sum payment for periodic payments to you in return.
There are three types of annuities; fixed, indexed, and variable.
Fixed: The Insurance Company agrees to pay you no less than a specified rate of interest during the time your account is growing.
Indexed: The Insurance Company credits you with a return that is based on changes in an index (such as the S&P 500 Composite).
Variable: You can choose to invest your purchase payments from among a range of different investment options, typically mutual funds. Your payments will be based off of the performance of the investment options you chose.
You can choose between an Immediate Payout or a Deferred Payout:
Immediate: You exchange your lump sum of money for an immediate income stream paid to you as stated in the terms of the annuity contract.
Deferred: Your money either earns interest (fixed) or is invested in mutual fund-like sub-accounts (variable) while you delay payments of income until you elect to receive them. For example, you can defer income payments until retirement.
People are interested in annuities because they are attracted to the language “guaranteed withdrawals” or “minimum returns” that seemingly take the risk out of investing. Broker dealers who earn commissions from selling these products usually tout the positive features of the annuity and downplay the drawbacks.
PROS
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Deferring Taxes: The biggest advantage of an annuity is that you can save a larger amount of cash and defer paying taxes on your earnings growth. However, the earnings growth is taxed at ordinary income rates rather than at long term capital gain rates.
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No Contribution Limit: Unlike Retirement Plans, there is no contribution limit for an annuity. This allows you to save for retirement with after tax dollars that compounds year after year without a tax bill.
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Death or Survivor Benefit: An annuity can have a death benefit provision attached that will guarantee at a minimum upon your death your total premiums invested will be paid to your beneficiaries. Your other options to ensure a survivor benefit are:
Joint Life Annuity: Guarantees income for both you and your beneficiary’s lifetime.
Fixed Period Annuity: Guarantees payments to the annuitant for a predetermined length of time. If you die before the defined benefit is paid, some plans provide for the remaining benefits to be paid to a beneficiary.
Life-with-period-certain Annuity: The annuitant is guaranteed payment for life but also can elect a fixed period of guaranteed payment. If the annuitant dies before the fixed period ends, then the beneficiary will get the remainder of the payments.
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Stream of Income: An immediate annuity offers a stream of income which will return your principal and any gains in the form of payments.
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Principal Protection: Fixed (and sometimes variable) annuities offer principal protection.
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Performance Floors: Performance floors provide a minimum level of return you can earn, and are meant to protect investors from losing too much when the market is down.
CONS
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Surrender Fees: Surrender Fees are charges tacked onto the back of an annuity contract. These often start at 5-7% of principal and decline annually until it hits zero. You may be able to withdraw a small percentage each year without a penalty, but do not have access to the full amount (without penalty) for usually about 7-8 years.
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Taxes on Inheritance: When someone inherits your annuity, they’ll have to pay taxes on all of the earnings that you haven’t paid taxes on during your lifetime. On the other hand, if your money was in a mutual fund or stocks, they would be eligible for a step-up in cost basis, in which beneficiaries must only pay taxes on investment gains after the inheritance date.
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Inflation: Annuity Income is not typically adjusted for inflation. Since 1925, inflation has averaged about 3%. See below the impact that average inflation would have compounded over time. So while a monthly income of $100 is attractive in today’s dollars, the effects of inflation minimizes your future spending power.
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Inflation Adjusted Annuities: There are inflation adjusted annuities that promise to pay you a sum that will rise with the cost of living every year until you die. Insurers usually charge additional fees and/or offer lower payout rates for this option.
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Limitation on Investments: When investing in a variable annuity, you are limited to pre-selected mutual funds that are available with the particular insurance company. The funds are often their own proprietary funds allowing them to charge additional fees. There is no flexibility for choosing the best funds or securities.
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Commissions: Most annuities are sold by brokers who collect a commission that can be as much as 10%. By the end of 2017, all annuity salesmen must disclose the commissions they earn both upfront and on an annual basis per the new Department of Labor (DOL) Rule.
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High Annual Fees: Some annual annuity fees range from 2-3% a year. The fee structures can be complex and unclear and usually are not a single flat fee. This annual fee is in addition to the commission paid to your Broker.
Hypothetical Impact of Fees on a $100,000 investment
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Performance Caps: (Generally on Indexed Annuities) Performance caps set a maximum monthly or annual return and are meant to protect the insurance company from paying out too much when the market is up. This means you could miss out on big returns.
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Taxes on Withdrawals: When withdrawals are taken from annuities, the gains are taxed at ordinary income rates, not capital gain rates. Long-term capital gains rates range from 15-20% depending on your tax bracket.
CONCLUSION:
Annuities should not be seen as an investment but as an insurance product that guarantees a steady payout during retirement. A person should only buy an annuity for what it will do (contractual guarantees) and not what it might do (hypotheticals).
There are some limited instances where an annuity may be appropriate, but a full financial review should be performed to determine if it is ideal to accomplish your goals.
While guarantees are attractive especially when it comes to money, it is important to factor in the added commissions, fees and lack of liquidity when determining if an annuity is right for you. Always consult your financial advisor, not the Broker trying to sell the annuity, for their advice.