Please don’t…at least not without getting a second opinion from an outside advisor…especially if you are using retirement account funds to buy it. There is almost no situation we have found where an annuity should be placed inside an IRA before the account owner starts taking mandatory distributions. Be very wary of an annuity salesperson who is pressuring you to use any retirement funds to purchase an annuity.
We meet with dozens of folks every year who are stuck in inappropriate annuities who are just looking for a way out. Unfortunately, getting out usually involves some stiff penalties. Don’t sacrifice flexibility for a guaranteed return. That guarantee comes at a cost.
Under no circumstances should you ever sign anything under pressure from a salesperson to, “lock in this minimum, guaranteed interest rate or bonus before the company rolls out new pricing.” Keep in mind, these salespeople get paid by the annuity company, not by you. Some will even offer that as a selling point saying, “you don’t pay my commission. The annuity company does.” Is this really what you want? How do you know the salesperson is offering you the product that best for you? How do you know they’re not just selling the product from the company that pays the highest commission?
Please, be very careful and get an outside opinion from a fee-only advisor who does not sell annuities before signing anything.
Top Ten Issues to Consider Before Buying an Annuity
It is easy to find more than 10, but these should be sufficient to convince you to be very careful before purchasing any annuity, and whether or not to seek alternatives.
10. Complexity: Annuity contracts are very difficult for the average investor to read and understand. Annuity salespeople are taught to “gloss over” the details and dismiss them as standard industry “boilerplate.” Do not accept this. If they can’t explain the details in terms you can understand, they have no business selling and you should not be buying.
9. Mutual Fund/Investment Choices: Annuities often invest in proprietary funds for which independent research is not available. In addition, their fund selection can be limited to mutual fund companies with which the annuity company has a fee-sharing arrangement. This is a potential conflict of interest, and can result in your owning funds that underperform their peers. There is nothing in an annuity contract that requires your investments to be managed in your best interest.
8. Taxes on Gains: The growth of an annuity is fully taxable as income, to you and your heirs. The growth of an investment held longer than one year is taxable as capital gains to you (which is good because capital gains taxes are almost always lower than ordinary income,) and subject to zero income tax to your heirs. See below about annuities in IRAs or other retirement accounts.
7. Cost Basis and Tax Treatment of Withdrawals: If you remove money from a stock or fund, the cost basis may be the cost of your most recent purchase. By contrast, any money you remove from an annuity is taxed at 100% of its value until the annuity's value is down to the size of what you put in.
6. Performance: It is nearly impossible to find any annuities that outperformed the S&P 500 Index over the past five, ten or twenty years,net of fees.
5. Fees and Expenses: Annuities are expensive to own and are laden with hidden fees. There are usually large up-front sales charges and back-end surrender charges, which linger around 7% if you withdraw the money too soon. There can also be mortality and expense charges that cover the risk the insurance company accepts to pay your lifetime income, not to mention administrative and annual records maintenance fees. All those fees can easily overcome the entire selling point of tax deferral on your earnings. The industry's average expense ratio averages 2.35%, according to Morningstar, with some plans as high as 3.5%. The average mutual fund, on the other hand, charges just 1.41%.
4. The Reality of “Guaranteed Returns”: The guarantee on any annuity is only as good as the insurance company that issues it. While it is not a common occurrence that a life insurance company is unable to meet its obligations, it does happen.
3. YTB (Yield To Broker): Brokers and salespeople can receive a commission as high as 7-10% up front as well as trailer fees for years without actually managing the money. This makes if very clear why brokers and insurance salespeople push annuities even when they are not an appropriate investment. The annuity companies and agents engaged in the most aggressive marketing campaigns and seminars represent some of the most expensive annuities available. If you decide an annuity is really what you want, seek the advice of an independent investment advisor (not an insurance salesman) and/or insist on a “no-load” annuity or one with net annual fees below 1.4%.
2. The Reality of “No Risk”: Annuities are not risk-free investments, and are in many ways worse than individual securities because investors are locked into investments due to fees, contract structures, and tax consequences. Investors often have to pay surrender fees to withdraw their money, usually the amount of the commission. Although some annuities come with a guaranteed return upon death of the investor, there usually is no guarantee of value before death and the investments made to ensure that payout can be very aggressive and risky.
1. A Life Insurance Policy with No Benefit to You: Many annuities have been sold as investments which will go up in value if the stock market rises, but are insured against losses if the stock market falls. This should sound too good to be true because it is. What is seldom explained to investors is that someone must die for the guarantee to ever pay off. In reality, most annuities are nothing more than mutual funds with term insurance attached. If the stock market goes up, the mutual funds may appreciate, but the investor has also paid substantial fees and the term insurance portion is worthless. If the stock market goes down, the mutual funds may fall in value and the investor has lost market value in addition to paying substantial fees.
Still not convinced? Here are two more brief comments on specific situations, should you require further proof that annuities are not the “be-all-end-all” investment option.
Annuities in IRAs
Does it make sense to buy a variable annuity inside a tax-deferred plan like an IRA?
First, the tax-shelter benefit is made completely irrelevant if the annuity is held in an IRA or other retirement account. The IRA or retirement plan already provides for the tax deferral and, in fact, distributions are governed by the provisions of Section 72 applicable to IRA retirement plans, not the general annuity provisions. We would go so far as to tell anyone who has someone trying to sell them one of these products in a retirement plan based on the tax benefits to run as quickly as possible away from that sales person. He or she is either misinformed or dishonest. Also keep in mind that annuities may be the only form of investments an insurance agent can solicit.
Second, the beneficiary designation is a non-issue for annuities in a retirement account. IRAs and most other qualified retirement plans already provide for beneficiary designations outside of probate.
What are the alternatives for steady income in my retirement?
We recommend purchasing a laddered portfolio of insured, high-grade bonds or CDs, which can easily provide the cash flow sought in retirement, and guarantee a rate of return over a specified time period. In most cases, this can be done in your existing investment account or IRA for no additional fee. The insurance on treasury securities (U.S. Government) or CDs (FDIC) more than eclipses the rationale of a guarantee from an issuing insurance company.
Equity-Indexed Annuities (EIA’s)
Is this really the perfect investment option for everyone?
In recent years, sales of Equity-Indexed Annuities have grown considerably. These investments, often sold as simple, are anything but. EIA’s share characteristics of both fixed and variable annuities. They contain more risk and volatility than a fixed annuity, and have less risk and potential return than a variable annuity. The typical guaranteed minimum return for an EIA is usually 90% of the premiums paid at a 3% annual interest rate. They are also subject to an early redemption charge, which can be 7% or more.
When considering the benefits of purchasing an EIA, let’s compare it to and Index-linked CD. The CD offers superior insurance (FDIC vs. insurance company), better minimum guarantee (100% of premium paid vs. 90%), lower fees, flexible timelines and defined terms. Some EIA’s allow the insurance company to change participation rates, cap rates, or spread/asset/margin fees annually.
Most EIA’s only count equity index gains from market price changes, excluding any gains from dividends. The dividend yield on the S&P 500 is approximately 2% annually. This 2% difference is paid to the underwriting insurance company…not you!
Lastly, the way that an insurance company calculates interest earned during the term of an EIA can make a big difference in the amount of money you will eventually earn. Many annuities pay simple interest over the term of the annuity. Your return will be lower because there is no compounding of interest for you. The interest earned by the insurance company on your money will be compounded and is yet another “spread” from which they profit.
From the authors: We admit this is a self-serving look at annuities from an independent, fee-based investment manager’s point of view, but we can almost guarantee no annuity salesperson will discuss other investment options with you, because in most cases, they can’t.
Even if they call themselves “fee based”, “Financial Planners” or hold a CFP® designation, unless they are SEC Registered Investment Advisors, they are not required to act in your best interest. In our experience, we have spent far more time, effort and client’s dollars unraveling bad annuity situations for clients than we’ve ever spent discussing how wonderfully an annuity worked out.
We firmly believe we can provide superior flexibility and service at a lower cost outside an annuity contract, but if after all this, you are still convinced that an annuity is exactly what you need, please let us help you find one that is also cost-effective.
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