Insurance agents and financial advisors have been investing their clients’ retirement money in annuities for decades.
This practice has its detractors, with the criticism usually focusing on the high commissions paid to annuity salespeople and stiff fees charged to annuity owners year after year.
In fact, if you compare the costs of an annuity to those for a mutual fund, youll find that a mutual fund is much less expensive. So it pays to know the details about annuities before you invest.
Here’s a rundown of the pros and cons of annuities and how they compare with other ways to invest for retirement.
Are you considering an annuity for your retirement planning? STOP and read this first! While insurance companies and their agents might paint a rosy picture of guaranteed income and security, the reality is often quite different. As a financial advisor who’s seen too many seniors get trapped in unsuitable annuity contracts, I feel compelled to share some hard truths about these complex financial products.
What Exactly Are Annuities?
Before diving into why you might want to avoid annuities, let’s clarify what they are. An annuity is a contract between you and an insurance company where you provide either a lump sum payment or a series of payments, and in return, the company promises to pay you either immediately or in the future.
The three most common types are:
- Variable annuities: Returns fluctuate based on market performance
- Fixed annuities: Offer a guaranteed interest rate
- Indexed annuities: Returns are based partly on stock market indexes
Sounds simple enough, right? Well, the devil is in the details.
9 Alarming Reasons to Avoid Annuities
1. Ridiculously High Fees and Hidden Commissions
Annuities are notorious for their fee structures. Some charge annual fees of 2-3%, which is significantly higher than many other investment options. For a $1 million variable annuity contract you could be paying a staggering 3.75% per year in mostly hidden fees!
But that’s not all. The commission structure is equally troubling. Insurance agents can receive commissions as high as 10% for selling certain annuities to seniors. For variable annuities, a typical commission is around 7%. That means on a $1 million investment, the agent pockets $70,000 right off the bat – and you’ll never clearly see this deduction on your statements.
2. All Gains Taxed as Ordinary Income
Some investments, like qualified dividends or long-term capital gains, are taxed more favorably than others. However, ALL gains in an annuity contract are taxed at ordinary income rates. This makes annuities highly undesirable from a tax perspective.
3. No Step Up in Basis When You Die
When you pass away, traditional investments like stocks or real estate provide a “step up in basis” to your beneficiaries, meaning they inherit these assets at their current market value, avoiding taxes on any gains that occurred during your lifetime.
Annuities offer no such benefit. Your beneficiaries inherit your cost basis and will be responsible for paying taxes at ordinary income rates on any gains in the contract at the time of your death. This can result in your heirs receiving hundreds of thousands of dollars less after taxes compared to other investment options.
4. Surrender Charges Lock Up Your Money
There is something called a Contingent Deferred Sales Charge (CDSC) schedule that comes with most annuities. In simple terms, this means that if you don’t pay back the loan within a certain amount of time (usually between 6 and 8 years), you’ll have to pay heavy surrender fees that can be as much as 25% of your principal!
Consider this real-life example: A retired Minnesota farmer on a fixed income needed access to his $24,000 (most of his net worth) that was tied up in annuities. He was charged $6,800 in surrender penalties! Another Minnesota woman was sold an annuity with surrender charges lasting for 16 years (until she was 95 years old), with a surrender penalty of 17% of her investment.
5. Serious Conflicts of Interest
The playing field for annuities is not level. Financial advisors who sell them often have serious conflicts of interest because they receive different commission percentages on different annuity products. This creates a strong incentive to sell you the product that pays THEM the most, not the one that’s best for YOU.
6. Limited Ongoing Advice
Because financial advisors who sell commission-based annuities receive most of their compensation upfront, they have little incentive to provide ongoing advice about your annuity after the sale. Similar to a used car salesman, you might not hear from them again until it’s time to sell you something new.
7. Misleading Riders and Optional Benefits
Insurance companies love to add “riders” or optional benefits to annuity contracts to increase the fees they can generate. Often, these riders are misleading and offer little actual value.
The most deceptive is probably the “lifetime income rider” sold on variable annuity contracts. Despite the name, there’s no actual lifetime income provided! When you start taking distributions, you’re simply spending your own money at a metered rate controlled by the insurance company. Only in the rare event that you deplete all your funds would the insurance company actually provide any income.
8. Limited Investment Options
Annuities restrict you to a menu of investment options that is often very limited. Why would you want to give up the ability to invest in T-bills, CDs, bonds, ETFs, stocks, mutual funds, real estate, and various indexes? Being pigeon-holed into a contract with limited investment options makes little financial sense.
9. High-Pressure Sales Tactics Targeting Seniors
The senior population, which holds approximately two-thirds of individual wealth in the United States, is particularly vulnerable to aggressive annuity sales tactics. Be wary of:
- Agents who “cold call” you or contact you repeatedly
- “Limited time offers”
- Salespeople who show up without an appointment or won’t meet with you if your family is present
- “Estate planning seminars” that are actually designed to sell annuities
- Free meals or gifts (they’re rarely truly free)
- Agents who give themselves fake titles to enhance their credibility
Who’s Actually Pushing These Products?
With billions of dollars in sales to be made, insurance companies may offer commissions as high as 10% to agents who sell products like long-term deferred annuities to senior citizens. This creates a powerful incentive structure that works against consumers’ best interests.
Are There ANY Benefits to Annuities?
In the interest of fairness, I should mention that annuities do have some potential advantages:
- They can provide guaranteed income (though often at a high cost)
- Fixed annuities protect your principal against market losses
- They don’t impose annual contribution limits like 401(k)s or IRAs
- Some offer death benefits to beneficiaries
However, these benefits rarely outweigh the significant disadvantages for most investors.
A Real-World Example: The Deferred Annuity Trap
One particularly troubling type of annuity is the long-term deferred annuity. These products may lock up an investor’s money for years before they can receive payments. The Minnesota Attorney General has filed lawsuits against insurance companies that sold unsuitable deferred annuities with over 15-year deferral periods to investors not expected to live that long, or who needed access to their money for health care or assisted living expenses.
What Should You Do Instead?
If you’re approaching retirement and looking for reliable income sources, consider these alternatives:
- Low-cost index funds or ETFs
- Bonds or bond funds
- Dividend-paying stocks
- Real estate investments
- CDs and high-yield savings accounts
- Treasury securities
Most of the time, these choices are more flexible than annuities and offer better liquidity, lower fees, and better tax treatment.
Protect Yourself: Questions to Ask Before Considering ANY Annuity
If someone is trying to sell you an annuity, ask these critical questions:
- What is the total commission you’ll receive from this sale?
- What are ALL the fees associated with this product (surrender charges, mortality charges, administrative fees, etc.)?
- How long is the surrender period, and what penalties would I face if I needed my money sooner?
- How will gains be taxed, and what are the tax implications for my beneficiaries?
- What investment options are available within this annuity?
- Are there any riders or optional benefits, and exactly what value do they provide?
Final Thoughts
While annuities might make sense in very specific circumstances, they’re generally unsuitable investments for most people – especially seniors. The combination of high fees, unfavorable tax treatment, limited liquidity, and questionable sales practices makes them something to approach with extreme caution.
Remember, the person selling you an annuity stands to make a significant commission – sometimes tens of thousands of dollars – from your purchase. Their interests and yours are fundamentally misaligned.
Before you sign any annuity contract, you should talk to a fee-only financial advisor who doesn’t get paid by selling products. They can give you honest advice about whether or not an annuity is a good idea for your money.
Have you had experiences with annuities – good or bad? I’d love to hear your thoughts in the comments section below!
Disclaimer: This article is for informational purposes only and should not be considered financial advice. Always consult with a qualified financial professional before making investment decisions.
No Added Tax Benefits Over IRAs
Annuities are tax-sheltered. The investment earnings grow tax-free until the owner begins to draw income. If the annuity is a qualified annuity, the owner is also eligible for a tax deduction for the money they contribute to it each year.
A traditional IRA or 401(k) has the same tax benefits. Plus, if invested in conventional mutual funds or ETFs, it typically costs much less than an annuity.
Importantly, some salespeople may try to get you to buy an annuity through your 401(k), but this is not only unnecessary but also expensive since both are tax-advantaged.
To put it another way, why use your retirement plan contribution to buy something that is already tax-free when you can invest in taxable securities with higher yields that will grow tax-free?
If you’re planning to buy an annuity, make sure that you’re dealing with a financially solid insurance company that’s likely to be around—and able to make good on its promises—when you start drawing income.
The Pros of Annuities
Despite the criticisms, annuities do offer some advantages for investors who are looking toward retirement.
Here’s Why Annuities Are SO Bad!
FAQ
Why is an annuity not a good investment?
Generally annuities are a “bad” investment because they return less than market rates in exchange for lowering risk, allowing companies to invest in higher return ventures. In the long run you come out ahead by taking the risk and waiting it out.
How much will a $100,000 annuity pay monthly?
At what age should you not buy an annuity?
Annuities come with various costs, including administrative fees and surrender charges. For adults over 80, these expenses become more problematic because there’s less time for the guaranteed income to offset the costs. Experts say annuities may not make sense in these scenarios: You have your basic needs covered.
Who should avoid annuities?
You may not be the best fit for an annuity if:Your savings are already on track to last throughout your retirement. You have health concerns or otherwise don’t expect to have a long retirement. You don’t have enough money to purchase an annuity contract.
Why should you invest in an annuity?
Annuities play a pivotal role in financial planning with their unique set of advantages. There are four main reasons you might want to buy an annuity: annuities give you a steady flow of money for anywhere from five years to the rest of your life. This feature offsets longevity risk (the chance of outliving your savings during retirement).
Are annuities a bad investment?
Unfortunately, annuities are rife with complexities that can prevent a clear understanding of their benefits and potential pitfalls. This insurance product is often considered a safe investment, but annuities have their own risks. Here’s why they might be a bad investment for you and what you should factor into your decision-making process.
Are annuities a safe investment?
You pay $1 million upfront and receive $5,000 a month after retiring. This sounds easy, right? Unfortunately, annuities are very complicated, which can make it hard to understand their pros and cons. This insurance product is often considered a safe investment, but annuities have their own risks.
Are annuities right for You?
Annuities aren’t for everyone. But experts say they might be a good choice for people who are close to or already in retirement because they can get regular income payments that can help replace regular paychecks.
What happens if you withdraw funds from an annuity?
Withdrawing funds from an annuity before a certain age (usually younger than 59½) results in a 10% penalty tax on the withdrawal. Annuities share this characteristic with IRAs and 401 (k)s, so the lesson here is that an annuity is a retirement savings vehicle instead of an all-purpose investment account.
What is an annuity and what can it do for your retirement?
Annuities are financial instruments that provide an income stream in retirement. You give a lump sum of funds up front to an insurer in exchange for this income stream, either right away (immediate annuity) or at a later date (deferred annuity).