Top 5 Reasons Why Some Hate Annuities and Why They’re Wrong

Top 5 Reasons Why Some Hate Annuities and Why They’re Wrong

There’s no question that annuities have their share of detractors. Some people complain about the fees associated with annuities, while others don’t like the idea of tying up their money for a set period of time. But are these criticisms really justified? Let’s take a closer look at five common reasons why people hate annuities – and how these cons can be overcome.

#1 They are complex instruments.

Not all annuities are the same, as several different types of annuities cater to different types of investors and different long-term goals for retirement. These instruments can be radically different from one another.

Even though the base contract of an immediate annuity is very simple to understand, the other types of annuities can be much trickier. Variable annuities and fixed index contracts with the potential to earn returns on market performance are all difficult enough to comprehend. They come with all sorts of conditions, caps, fees and other contract terms that are not only hard to get your head around, but they can sometimes be even harder to keep track of, even if you understand them.

Things get even more confounded once you start personalizing your contract by adding extra perks in the form of contract riders, all of them at additional costs. While disclosures have improved, they’re still tough nuts to crack.

#2 Annuities can be some of the most expensive investment products on the market.

Annuities are costly. The majority of simple, immediate annuities and deferred-income annuities have upfront commissions ranging from 1% to 4%. More complicated products, such as variable and fixed index annuities, may have 7% or more upfront commissions.

Besides upfront costs, overall annual costs can also be very high, depending on the type of contract you choose and the inclusion of different riders or provisions. For example, annual fees can be upward of 2% for mortality and expense fees or insurance charges. Underlying sub-account costs for variable contracts and administrative expenses are also an issue. Since insurance companies aren’t dedicated exclusively to managing investment portfolios, their management expense ratios or MER fees are usually a lot higher than those of a good broker, which hinders your potential gains.

#3 They lock in your investment.

Another key downside to annuities, especially deferred annuities, is their notorious lack of flexibility. If you purchase a deferred annuity and need to withdraw money early, it’s going to cost you a lot. Annuities are long-term contracts, which can be expensive to break.

To start, individuals who buy annuities must wait until they are 59½ years old before withdrawing money from their account. Otherwise, on top of the normal income tax, you’ll have to pay the IRS for the early withdrawal (it is a tax-deferred investment for retirement, after all), you’ll be hit with a 10 percent penalty from the IRS.

Yay be thinking:

“That happens if I withdraw early from any retirement account, including a 401(k), not just with annuities.”

While this is perfectly true, the problem with annuities is that there is also a second fee called a surrender penalty fee charged by the insurance company for early withdrawals. This fee doesn’t usually relate as much to your age when withdrawing but rather with the time since you bought the annuity, These fees are usually in effect anywhere between 6 and 10 years after entering the contract, and they can be as high as 10%.

#4 Variable and indexed annuities offer no real access to market upsides.

Firms pitch variable annuities as a safe investment vehicle that offers high returns and ensures your capital is protected and will grow over time. This sounds like the deal of a lifetime, but the truth isn’t as pretty.

As I already mentioned, variable annuities come jam-packed with fees and commissions, eating into whatever profits you stand to make.

On the other hand, indexed annuities follow stock market indexes, offering access to the upside of the markets without the risk of loss. However, they don’t only cut your losses but also severely cut your potential profits. They don’t usually include dividends in the contract, and they can include a “participation rate,” which lowers your percentage even further.

Indexed annuities also frequently include “performance caps,” which limit how much money you can make in a specific period of time. For example, if your stock returns are capped at 5%, and the stock index jumps up 15%, you’ll receive the maximum of 5%, and the insurer will get the rest. This can make you miss all major upsides.

#5 Annuities can bring a heavy tax bill.

Annuities are tax-deferred investment instruments. So, with a variable annuity, you will not pay taxes on your gains as long as the money remains inside the account. But when you withdraw money from it, those gains will be taxed as ordinary income, not capital gains. This means that you’ll lileñy be taxed up to 39.6% on both the distribution of your principal and gains. If you had earned those profits through regular investing instead, you would only pay the 15% capital gains tax instead.

How can these cons be overcome?

After reading these cons, it is evident why some people won’t go near annuities. However, most, if not all, of these pitfalls can be avoided to some extent, making certain annuities a good choice. Here are some tips on how to go about it:

#1 Learn first, shop later.

Learning the ins and outs of annuities, their types, fees and the different riders you can choose ahead of time will make everything less overwhelming once you start looking for a good option. Seeking the help of a fiduciary financial advisor can also make a big difference.

#2 Keep it simple.

Avoid overcomplicating things with exotic annuities filled with customization since these will be very costly. Most financial advisors suggest going minimalistic and avoiding variable, indexed, hybrid or other types of annuities. It’s better to invest your money in your 401(k) and on a different investment account once you max out the first. Then, you can use your savings to buy an immediate annuity with a single lump sum upon retirement.

This will let you take advantage of all market upsides, it will give you a bit more flexibility at lower costs, and your gains will be taxed as capital gains and not as regular income. The annuity will then give you guaranteed income for life.

#3 Don’t put short-term money in an annuity and be patient.

You can usually forgo some flexibility if you plan and budget correctly. For example, by keeping a liquid emergency fund apart from an annuity, you’re less likely to need to make any early withdrawals from the latter. Another option is to include a contract rider that allows penalty-free withdrawals, but remember, these almost always come with an upfront fee. What’s important is that you be patient and avoid withdrawing early any way you can.

The bottom line

Annuities are complex and expensive. They can lock in your investment, offer little to no access to market upsides, and bring a heavy tax bill. But you don’t have to be dissuaded by these cons if you do some homework first before shopping around. It is possible to find an annuity that meets your needs while not locking up all of your funds or giving away too much control over profits from long-term investments. Seek help from a fiduciary financial advisor who understands this product well enough to make the best choice for you today and tomorrow!

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