Are annuities a good idea for meeting your investment and retirement goals? It depends. Under certain circumstances, the right kind of annuity can be very helpful. For example, a Single Premium Immediate Annuity (SPIA) can be a great way to distribute your savings in a stable, predictable manner during your retirement, kind of like your own personal pension. In most other situations, annuities sold today are a poor choice for building wealth.
Some financial advisors promote annuities heavily, touting features like “guaranteed growth” and high initial interest rates. These products generate a lot of revenue for the advisor and their company, so you really must be on your guard for hyped claims of their benefits. The reality is that annuities are complex vehicles. One can be very different than another. Once you purchase an annuity, you may be stuck with it for many years. And because they are so complex, annuity contracts can be very hard to evaluate. This makes it easy to make a mistake when choosing an annuity.
Here are six common annuity mistakes to avoid.
Falling into the tax deferral trap
Tax deferral is one of the most highly touted features of annuities. The earnings inside an annuity are not taxed until they are withdrawn. As an example, if you invest in a stock mutual fund, the dividends and appreciation it earns are taxable each year, but at special tax rates. If you choose a similar fund inside an annuity, you won’t pay any taxes on the earnings every year. However, when you start taking withdrawals, those earnings will be taxed at ordinary income rates. Those rates may be higher depending on your tax bracket in retirement.
The trap to avoid is having all your retirement income be highly taxed. One way to avoid this is by adding to non-tax deferred investments, so that in retirement, you have already paid much of the tax on those investments.
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Paying too much in fees and costs
Annuities are complex insurance contracts that can have tons of hidden fees and expenses. Let’s say the mutual fund we discussed earlier has an expense ratio of 0.6%. If you buy it from the fund company, that’s your cost. That same fund inside an annuity will have at least that 0.6%, but there will also be the annuity’s contract fees, which I’ve seen as high as 2% or more. There are also annual administrative rider fees (for additional features) and insurance fees. These fees can take a big bite out of your savings over time. Avoid this by carefully evaluating the contract. It’s not easy to do, so you may need the help of a neutral person with experience in reading through them.
Putting too much of your savings into annuities
Annuities can play a useful role in distributing your lifetime savings, but they can also be inflexible and very expensive to get out of. I’ve seen annuities with 5-10% surrender penalties for several years after purchase, so if you need to access those funds, it could be very costly. Avoid this by evaluating the surrender penalties, and also by making sure you don’t have too much of your retirement savings tied up in annuities.
Swapping out a good annuity for a bad one
Brokers who sell annuities may get paid much better to sell you a new one than they do to keep you in a contract you’ve had for a while. This gives them a strong incentive to recommend switching to a new contract. There might be good reasons for the switch but beware of what you are giving up. Some older annuities have higher annuitization rates, while newer ones may offer much lower ones.
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Choosing the wrong payout
When it’s time to distribute your annuity, you may be presented with options to take a life-only payment (just over your life expectancy) or often a slightly lower amount over a joint life (you and your spouse). You may also be offered a fixed period, like ten years. Choosing a payout over joint lives protects the surviving spouse if the annuity owner dies early. That protection is especially valuable if there is a large difference in age between you and your spouse.
Not comparing different annuity choices
Some brokers are only able to sell you financial products from one company. But fixed annuity payouts will vary widely from company to company for the same client and the same starting amount. You should compare quotes for several different products before making your choice.
Annuities are complicated financial products. Before purchasing one, make sure you understand what you are getting into. You may also want to speak with a Certified Financial Planner professional® who is not being paid to sell you that annuity to see if it is really right for your needs and your situation.
At Blankinship & Foster, we help our clients with far more than investment management. We provide proactive, personalized advice on all aspects of their finances.
